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What is the R&D Tax Credit?
The federal research and development (R&D) tax credit under Internal Revenue Code (IRC) section 41 was first introduced by Congress in 1981. The purpose of the credit is to incentivize U.S. companies to continue and increase spending on research and development within the U.S. The R&D tax credit is available to businesses that uncover new, improved, or technologically advanced products, processes, principles, methodologies or materials. In addition to “revolutionary” activities, in some cases the credit may be available if a company has performed “evolutionary” activities such as investing time, money, and resources toward improving its products and processes.
The R&D tax credit is available to taxpayers who incur incremental expenses for qualified research activities (QRAs) conducted within the U.S. The credit is comprised primarily of the following qualified research expenses (QREs):
- Internal wages paid to employees for qualified services.
- Supplies used and consumed in the R&D process.
- Contract research expenses (when someone other than an employee of the taxpayer performs QRAs on behalf of the taxpayer, regardless of the success of the research).
For an activity to qualify for the R&D tax credit, the taxpayer must show that it meets the following four tests:
- The activity must rely on the principles of hard science, such as engineering, computer science, biological science or physical science.
- The activities must relate to the development of a new or improved product or process intended to improve functionality, performance, reliability or quality features.
- Technological uncertainty must exist at the outset of the development activities. Uncertainty exists if the information available at the outset of the project does not establish the capability or methodology for developing or improving the business component, or the appropriate design of the business component.
- A process of experimentation (e.g., an iterative testing process) must be conducted to eliminate the technological uncertainty. This includes assessing a design through modeling, proof of concept, computational analysis or trial and error testing.
The credit is reported on Form 6765 and is included with the tax return. There are two standard methods of calculating the R&D tax credit — the traditional “regular credit” method and the alternative simplified credit (ASC) method. Under the traditional method, the credit is 20% of the current year qualified research expenses in excess of a base amount. One of the factors used in the calculation of the base amount is historical qualified research expenses and annual gross receipts.
The ASC credit is 14% of the current year qualified research expenses in excess of 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined. Companies that have not claimed the research credit in the past or that may have difficulty determining their historical qualified research expenses may find the ASC to be more beneficial.