Drilling Into the IRS’ Four-Part Test.
If your company is in an industry that qualifies for R&D tax credits, it makes sense to explore whether any of your operations and related expenses meet the R&D tax credit requirements. Many business owners only think science labs, beakers and test tubes when it comes to R&D. Actually, there are a number of industries that are eligible for these lucrative incentives:
- 3-D Printing and Robotics
- Software Development & Blockchain
- Life Sciences (i.e., Pharmaceuticals, Biotechnology, & Medical Devices)
- Food Science and Bio-Flavoring
- Financial services (e.g., on-line banking and on-line brokerage trading)
- Aerospace and Defense
- Architecture and Engineering
- Energy, oil and chemical companies
- Automotive and Transportation
If you’re in one of these verticals, it’s not automatic that you can claim R&D credits. The IRS established a four-part test that individual companies must apply to their business activities on a project basis to determine eligibility:
The four-part test is a bit arcane. The rest of this post drills down to explain each part of the test and offers examples of key points to give you a clearer idea at a basic level whether you meet R&D tax credit requirements. There are complexities and nuances that make it important to consult an expert in the field before implementing a claim, but this will give you a good start.
Technological in Nature
This part of the test seems fairly simple. However, it’s important to know that the three technological areas – physical or biological science, engineering, or computer science — can cross industries. Certainly, biological science is used in life sciences – like pharma and medical devices. It could also be used in food science and bio-flavoring.
Physical science, the study of non-living things and systems, includes chemistry, geology, astronomy, physics, oceanography and meteorology.
All facets of engineering can apply whether in aeronautics, chemicals, structural engineering and architecture, automotive – even toy companies that engineer products to work properly and use materials science to select the best resins to use in finishes and printed circuit boards for robotic toys, remote controlled toys, etc.
Computer science is not limited to Silicon Valley software tech companies. It can be used by a bank developing an online banking app, an investment firm developing online trading and brokerage services – almost any hardware or software solution for any industry.
There are three types of software:
- Third party sale, lease or license software – software developed for sale like Windows or a subscription-based SaaS service.
- Internal use software – software that a company develops to improve or monitor its own processes or operations.
- Dual use software – software developed for internal use that can also be marketed in a vertical industry.
Process of Experimentation
Companies that claim R&D tax credits must prove to the IRS that they have gone through an iterative development process. You must have explored alternatives to achieve proof of concept – for example, experimental batch trials vs production trials. In software development you’ll need to show iterations of algorithms and source coding, and iterations of alpha testing and beta testing.
In aeronautics you’d have a series of CAD designs for, say, a flight actuation system or gyroscope. In chemical products there will be iterations to arrive at new formulations. In life sciences/pharma you’ll have iterations for the molecular basis of a new drug through pre-clinical trials and a series of clinical trials.
Regardless of the what is being developed, it’s important to keep records of the process to prove your claim.
Elimination of Uncertainty
What technical hurdles or technical uncertainties were anticipated with respect to the R&D undertaken upon the onset of the research? What were the anticipated challenges or difficulties inherent with the R&D processes?
The activity for which you’re claiming R&D tax credit must hit at least one of the following areas related to a product’s or process’s:
- Function – This relates to best in class product rollouts and continuous improvement. A good example would be new automobile models with features that make them more fuel and energy efficient
- Performance – Continuing with the automotive example, this could be better gas mileage.
- Reliability – This could be greater durability, more attrition resilience of its components (e.g., more durable and reliable engine, more durable and reliable tires, etc.)
- Quality – Has the overall quality of the product increased year-over-year through experimentation?
To learn more about R&D tax credit requirements visit our R&D Tax Credit Services page or please feel free to reach out to the PMBA National R&D Tax Credit Practice at R&DTaxIncentives@pmbusinessadvisors.com.