So, you want to file an R&D tax credit

Research and development (R&D) conjures images of lab coats, beakers, Bunsen burners and mad scientists, which was not exactly what Congress had in mind for the R&D tax credit. Congress’s intent was to encourage businesses to innovate to make something new or improved so they could then tax it. The tax credit helps offset a portion of the innovation expenses, especially during the development phase when the business may not be generating any revenue.

The idea behind the R&D tax credit is to identify what was made, why it’s allowable and then determine how much it cost to create the item.

Contract analysis is the first step

At the heart of the R&D tax credit is a process of experimentation (POE) to create a new or improved business component (BC). A BC is something held for sale, lease, license or use in the business. A BC is any product, process, computer software (apps are everywhere these days), formula, technique or invention. A BC doesn’t have to be all new; an improved BC is perfectly allowable – think Version 2.0, 3.0, etc.

Before analyzing a taxpayer’s BCs, one must first look to determine if the BC is developed pursuant to a contract. To qualify for the R&D tax credit, a contract must be for research or more specifically, the results of research. Determining if a contract meets the “results of research” test is a comprehensive test beyond the scope of this article. However, in short, a contract may be from an external source or entity that pays the taxpayer to develop a new BC. For example, a shipping company commissioning a specialized shipbuilder to create a new vessel. Alternatively, a contract may also be for development the taxpayer sends to an outside contractor, such as when a specialized tool or specialized knowledge is required that the taxpayer does not possess.

In either case, the taxpayer must first be at risk of payment (qualifying work always involves development risk as that’s the nature of R&D). Risk of payment typically requires a firm fixed price contract for work that is incoming to the taxpayer, and conversely hourly or reimbursable (time and material – T&M) when work is outsourced. Secondly, the taxpayer must have the intellectual property right to what is created without paying for that right. Shared rights are allowable.

Ultimately, contract rules are intended to limit the tax credit to only one party, the taxpayer or the contractor. This prevents both parties from receiving R&D tax credits for the same effort.

Identifying business components is the second step

The IRS circulated a new filing Form 6765 requiring all R&D expenses to be broken out by BC beginning with tax year 2024. The form also requires taxpayers to submit rationale explaining why the R&D is allowable. Under exam, this has always been the case. The IRS has merely updated the filing form to reflect this need. Again, the BC is the “what did you make” portion of the filing.

Identifying why a business component is allowable is the third step

After the taxpayer has determined which contracts are allowable and identified each new BC, the taxpayer must describe the POE used to create each new or improved BC. It’s important to show uncertainty at the onset of development, analysis of alternatives and key steps or milestones in development. The POE typically involves systematic trial and error coupled with success or failure testing to determine if the alternative(s) selected meet(s) the functional, quality or reliability needs of the taxpayer. At a higher level, this may also involve generating a hypothesis, refining or discarding the hypothesis as development proceeds (e.g., most common in new drug development to treat cancers, etc.). Analysis and documentation must show the ‘why’ of why the development meets the POE test.

Identifying how much the development cost is the final step

Lastly, expenses for each business component must be totaled. The expenses then go through a complicated calculation to determine just how much R&D tax credit may be generated. There are multiple calculation methods at the federal and state levels.

Allowable R&D tax credit expenses include:

• Basic research (research where no business component is created. Essentially new knowledge for the sake of new knowledge.)
• Contract research
• Energy consortia (rarely seen and highly specific)
• Leased computers
• Supplies that are the focus of experimentation, not merely present
• Wages (internal labor costs)

In summary, the taxpayer must first qualify any contracts to ensure they are allowable. Then, a taxpayer must identify the BC, document why each BC is allowable and, lastly, determine the cost incurred for development expenses to compute the R&D tax credit. Of note, each tax year BCs and expenses vary, so each year must stand on its own which requires annual work to determine.

Filing for R&D tax credits can be a time consuming, detailed process involving multiple levels of analysis and documentation. For more information or assistance please contact your CPA or Steve Roark, CPA.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.