Research and Development (R&D) Tax Credit

An R&D study involves an in-depth analysis of each project, or business component, undertaken during a given tax year. A business component is any product, process, software, technique, formula, or invention that is intended to be:

1. Held for sale, lease, or license: This includes tangible products developed for the market.
2. Used in the taxpayer’s trade or business: This encompasses internal use software, manufacturing processes, and other business methodologies.
   Examples of business components that might qualify include:
   • New product designs or formulations
   • Improvements to existing products
   • Development of new or improved manufacturing processes
   • Creation of innovative software solutions
   • Research that supports an application for patent protection

In general, qualified research activities (QRAs) must be part of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality, with the intent that the technical information to be discovered will overcome uncertainty pertaining to the development of a new or improved business component. This four-part test criteria, as detailed below, is the foundation to determine whether a project can be included in the credit calculation:

• Permitted Purpose: Project specifications must aim to improve the functionality, performance, reliability, or quality of a product.
• Elimination of Uncertainty: The research must be intended to eliminate uncertainty regarding the capability or method of developing or improving a product or the appropriate design of the product.
• Process of Experimentation: The activities must involve the development of one or more hypotheses, evaluation of design or process alternatives, and experiments to test and analyze each iteration to ultimately achieve project requirements.
• Technological in Nature: The activities must rely on principles of physical or biological sciences, engineering, or computer science.

Once the list of qualified business components is verified, Ryan’s team begins to quantify the associated QREs to include:

• Wages: Salaries and wages of employees directly involved in R&D activities and technical supervision or support of those employees.
• Supplies: Costs of supplies used in the R&D process, excluding capital items and general administrative supplies.
• Computer Rental: Expenses attributed to the use of off-premises computers to conduct research activities (i.e., cloud computing).
• Contract Research: 65% of the costs for research conducted by outside contractors.

Once the current year QREs are calculated, there are two primary methods for calculating the comparative base amount:

• Regular Credit Method: The base amount represents a company’s historical R&D spending as a percentage of its prior four-year average gross revenues.
• Alternative Simplified Credit (ASC) Method: The base amount equals half of the average QREs for the three preceding tax years.

Maintaining comprehensive documentation is essential for substantiating your R&D tax credit claim. This includes:

• Project Descriptions: Detailed records of each business component, including objectives, methodologies, and results for each research project.
• Expense Tracking: Accurate tracking of all related expenses, including labor, materials, and contract research.
• Evidence of Experimentation: Documentation of the experimental processes and iterations undertaken to resolve technical uncertainties, including the technical contributions of everyone involved in the R&D project.

If certain documentation is limited or not available, Ryan employs IRS-approved methods to accurately estimate QRAs and QREs for each project.