Understanding the R&D Tax Credit Four-Part Test
The R&D tax credit incentivizes certain research activities by reducing a company’s liabilities for spending money on that research. Expenses that qualify are more comprehensive than you may think. Qualified research expenses (QREs) can include the salaries of employees and supervisors who are conducting research, supplies, and even some contractors. Congress created the “Four-Part Test” that determines eligibility for the credit.
- Qualified Purpose
- Technological in Nature
- Elimination of Uncertainty
- Process of Experimentation
Expenses that qualify for the R&D tax credit are more comprehensive than you may think.
Are you developing or improving a product, process, formula, or software?
To pass this requirement, the activity must create or improve a product, process, formula, or software with respect to its functionality, performance, reliability, or quality. You must intend to use it in your business or retain intellectual ownership. Even if the activity was not successful, you may still qualify for the R&D tax credit.
Is your innovation technological in nature?
If your innovation relies on hard sciences such as physical sciences, biological sciences, computer science, or engineering, then you can answer yes to this question.
These sciences cross many industries. Certainly, biological science is used in life sciences – like pharmaceutical and medical device companies. However, it could also be used in food science and bio-flavoring. Engineering could apply to toy companies that engineer products to work properly or design circuit boards for robotic toys. Computer science is not limited to Silicon Valley tech companies. It can also apply to almost any hardware or software solution in any industry.
Have you eliminated uncertainty in the development of your component?
You must demonstrate that you’ve attempted to eliminate uncertainty. Your innovation must go beyond cosmetic design and seek to improve functionality by gaining information and reducing ambiguity associated with its development.
Did you experiment or test alternatives?
You must be able to show that you have explored alternatives to achieve proof of concept. Through modeling, simulation, systematic trial and error, or other methods, you must have evaluated alternatives for achieving the desired result.
Even if your work passes the four-part test, there are a few exclusions to the R&D tax credit. Expenses incurred under the exclusions will not qualify for the incentive. Some of these already appear in the four-part test, including the need to rely on hard sciences.
The activity must take place in the U.S. and cannot include routine data collection or market research. Also, activities cannot receive funding from an unrelated third party because your company might not retain ownership of the resulting intellectual property.
If you think your work qualifies for the R&D tax credit, our team of experts is here to help.