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