Demystifying the Research and Development Tax Credit

Robert Kempf

Have you heard of the Research and Development (R&D) Tax Credit? The Credit for Increasing Research Activities was originally enacted by Congress in 1981 to incentivize research and development in key industries in the United States. Through the PATH Act of 2015, this general business credit became permanent.

The R&D credit rewards taxpayers, big or small, who engage in qualified research activities to take a deduction based on a percentage of eligible expenses. In order to qualify, the business activities must pass a four-part test.

The Business Component Test: Qualifying research must be for a new or improved business component for a permitted purpose used in the taxpayer’s trade or business. Business component means any product, process, formula, invention or computer software that is held for sale, lease, license or used in trade or business. The allowed permitted purpose for a new or improved component must be one of the following: improved performance, new functionality, or improved quality and/or reliability.

Technical Uncertainty: At the outset of the research project, a technical uncertainty must apply to one of the following areas: capability, methodology and appropriateness of final design.

Elimination of Uncertainty: Through a formulated process of experimentation, the unknown capability, methodology, or final design is tested. Random trial and error does not qualify. Creating a hypothesis, confirmation, modification or rejection of the hypothesis, and continued revision and testing, should lead to either a successful or a failed project. Success of the project is not necessary to pass this test.

Discovery Test: The information discovered should be technological in nature. Generally, information is considered technological if the process of experimentation relies on the areas of sciences, chemistry, physics, computer science, and engineering. Marketing, accounting, and psychology are not permitted sciences.

All four test requirements must be met to qualify for the R&D credit. A calculation based on the amount of expenses incurred for wages, supplies and contractor costs related to research and development each year determines the deduction. Depending on the nature and size of a business, this can result in a substantial tax deduction. If you feel your business may qualify, we highly suggest contacting us today so that you can take full advantage of dollar for dollar tax savings.