The credit allows business taxpayers to receive an income tax credit for a portion of expenses paid or incurred for qualified research activities. The credit was established as an incentive for companies of all types to conduct more research and development in the U.S and has recently been made permanent. Eligible small businesses also may now use the credit to offset AMT (the alternative minimum tax) or elect to apply the credit against payroll taxes.
What types of expenses qualify for the credit?
The general rule permits in-house research expenses and contract research expenses incurred during the taxable year.
In-house research expenses can include:
- Wages paid to employees for performing qualified services. This can include engaging in or supervising research activities.
- Expenses for supplies used in conducting research. Supplies mean any tangible property except:
- Land or land improvements
- Property that can be depreciated
- Expenses paid to another person for the right to use computers in conducting the research.
Contract research expenses are limited to 65% of amounts paid to individuals other than employees.
What types of activities qualify for the credit?
The nature of the research determines whether it qualifies for the credit, in general there needs to be a level of uncertainty associated with the activity. As with many aspects of the tax law, it makes sense to review your specific situation with a tax professional to determine whether certain activities would qualify. In general application, qualified research includes research:
- Which is undertaken for the purpose of discovering information
- Which is technological in nature
- The application of which is intended to be useful in the development of a new or improved business component of the taxpayer
- Substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph
You may qualify for this credit if you conduct research related to a new or improved function, performance, reliability or quality. Research conducted for a purpose related to style, taste, cosmetic, or seasonal design factors will not qualify.
Activities that don’t qualify for the credit
The Internal Revenue Code provides a list of specific activities that the law does not consider “qualified research”:
- Research after commercial production – any research conducted after the beginning of commercial production of the business component.
- Adaptation of existing business components – any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
- Duplication of existing business component – any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
- Surveys, studies, etc., such as:
- Efficiency survey
- Activity relating to management function or technique
- Market research, testing, or development (including advertising or promotions)
- Routine data collection
- Routine or ordinary testing or inspection for quality control
- Computer software – generally, any research with respect to computer software which is developed primarily for internal use by the taxpayer, other than for use in: an activity which constitutes qualified research or a production process that meets specific requirements.
- Foreign research – any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
- Social sciences, etc. – any research in the social sciences, arts, or humanities.
- Funded research – any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).
Iowa also provides a separate R&D Tax credit if you meet the Federal requirements for the Federal tax credit. Qualifying expenditures parallel the Federal requirements:
- Wages paid to employees for research work or supervision performed at an Iowa facility
- Supplies, including tangible property other than land, improvements to land and depreciable property
- 6.5% of contract research-related expenses
With any tax-related issue, it helps to have qualified professional assistance in understanding the tax law and the requirements to take advantage of the law’s benefits. TD&T tax professionals would be happy to assist you in determining if or how your company can take advantage of the R&D Tax Credit, give us a call.