As business owners, you’re constantly creating new methods, modernizing, and capitalizing on novelty and newness to keep your customers coming back. This process of innovation sometimes results in creating a new product, but sometimes the focus is on improving your own processes to give you a competitive edge in the market place.
While “Spend Money to Make Money” may be the mantra of your marketing department, the reality is many businesses can benefit from the Research and Development Tax Credit. Congress enacted this tax credit in 1981 as an incentive to increase innovation. It is available to companies that invest in the development of new or improved products, manufacturing processes, and software. Like many tax credits, there are qualifications, and this one depends on the nature of the activities performed by a company and the costs incurred for those activities.
What if you’re not a white-lab-coat scientist creating new polymers that will revolutionize plastics? Chances are you may still qualify for the Research and Development Tax Credit. Studies show that less than 33% of companies that qualify for this credit use it. According to the Internal Revenue Code, the credit is for the development of a new or improved business component—that is fairly broad for a tax credit!
Qualifying activities may begin with concept development and end when a product or service is brought to market. All that gray area in between can include but is not limited to evaluating the feasibility of a product, process, formula, or software; beta testing; developing and testing experimental models, processes, products, and prototypes; improving processes or the manufacturability of a product; technical design reviews, and supervising technical personnel engaged in research and development. Qualifying expenses include salaries and wages based on a percentage of time your employees are actively participating in a qualifying activity, the cost of materials used during the development process, and perhaps even the cost of research that you outsourced to a third party.
If your industry is involved with manufacturing and fabrication, software development, engineering, food science or chemicals and formulas, quite possibly, if you meet a four-part test:
Part 1: Develop a New or Improved Business Component. You must be attempting to create or improve product or processes resulting in increased functionality, performance, reliability, or quality.
Part 2: Elimination of Uncertainty. The regulations say, “The taxpayer needs to be endeavoring to discover information that was uncertain at the outset of the project.” That “uncertainty” shows up in three key areas: capability, research method, and appropriate design.
Part 3: Technological in Nature. Your project must fundamentally rely on the principles of either engineering, physical science, biological science, or computer science.
Part 4: Process of Experimentation. You need to evaluate one or more methods to address the aforementioned uncertainty and evaluate alternative methods for achieving the desired result.
Making sure you pass the four-part test seems like a lot of work, but the federal credit averages about 6.5% of combined qualified R&D labor, contractor labor, and supplies. This is a huge benefit to both small and large companies. Furthermore, the credit can be used to offset Alternative Minimum Tax and payroll withholding in certain circumstances. If you’re a business owner and talk to your Tax Consultant about research and development tax credits or a look-back study so you can recognize any unclaimed credits for open tax years.