Preface: If your business is spending significant money to research or develop, smile and consider the research or development tax credit. Before taking the tax credit, however, consult with appropriate tax counsel.
Tax Credit for Research or Development
By Jacob M. Dietz, CPA
The IRS allows a tax credit for increasing research or development activities. If you are a business owner spending on research and development, then you may have felt pain watching money flow out the door to develop a product before you can even sell the product.
If you find yourself grimacing as you pay to research or develop, consider if the research credit will put a smile on your face with a tax credit.
Furthermore, you may even doubt if the product you are researching and developing will ever succeed. If you find yourself grimacing as you pay to research or develop, consider if the research credit will put a smile on your face with a tax credit.
Different industries can qualify for the research credit, and manufacturing is a prime industry for this credit. For example, suppose you are a small equipment manufacturer. You want to create a much larger version of your current equipment, but when you do that the axle tends to break. You therefore try a larger diameter for the axle, but then another part of the machine hits the axle. Then you try a second material for the axle, but one of your shop machines has trouble with it. Too much of the second material gets destroyed in the manufacturing process. Next you try a third material, which works well. Does that scenario sound familiar? If so, keep reading.
Another industry that can qualify is construction. Suppose a construction company wants to move into the energy efficient market. They may incur some qualifying research and development costs along the way.
If you are interested in this credit:
- Determine if you have qualifying activities
- If yes, then track your qualifying expenses and
- Document both your qualifying activities and your qualifying expenses.
What type of activities qualify?
Not all expenses qualify. For an expense to qualify, it must be a qualifying expense of a qualifying activity. Also, you should document how the activity qualifies.
Make sure the tax documentation for a project indicates what uncertainty is trying to be researched and overcome.
In determining which activities qualify for the credit, check for these qualifications:
- There should be uncertainty to overcome. For example, perhaps the project is to make a larger piece of equipment, but it is uncertain how to make an axle to withstand the additional stress. Make sure the documentation for a project indicates what uncertainty is trying to be researched and overcome.
- The research should be technological in nature. If it relies on engineering or some type of physical science, that helps. The documentation that shows what the problem is may make it clear that it is technological, and that physical science or engineering should help. For example, maybe the research is to make something stronger, more powerful, larger, etc. Maybe the research is to make a new kind of equipment. This type of research would rely on physical science, and possibly engineering.
- There should be a process of experimentation, in which the company strives to solve a problem. The problem should somehow relate to quality, reliability or similar features and not merely be cosmetic. Ideally, there should be records indicating what the problem is, and what steps are being taken to improve it. If one attempt at improving ends up failing, that can be documented. Documenting a failure in the process helps to demonstrate that experimentation occurred.
- The research and development should be to either create an improve a new product, invention, technique etc.
To be continued….