The words “research and experimentation” tend to conjure images of high-tech laboratories filled with scientists busily working on the next groundbreaking discovery. With this in mind, many businesses erroneously assume that the Research and Experimentation Tax Credit (R&E credit), also known as the Research and Development Tax Credit, does not apply to them. For this reason, the R&E credit, which was created in 1981 to foster innovation and technological advancement in the United States, is one of the most lucrative, yet underutilized, provisions of the tax code. In reality, the credit represents billions of dollars in savings for taxpayers each year and is available to businesses with an array of specializations, including construction, architecture and engineering.

Taxpayers are not required to invent a new product or process in order to claim the credit, and they are often surprised to find that some of their routine functions qualify. For example, qualified research may include activities such as developing prototypes or models, evaluating different design options, and pursuing state, federal or industry certification. Green building initiatives or activities conducted by engineering or architectural employees qualify for the R&E credit.

Businesses may refer to a four-part test to help guide them in determining whether their activities constitute qualified research.
  1. The purpose of the activity must be to create new or improve existing functionality of a business component. This extends to a variety of purposes, but does not include activities such as adapting an existing business component to a customer’s specifications or reproducing an existing business component.
  2. The taxpayer must intend to eliminate uncertainty. At the outset of any project, businesses face questions regarding the means by which the objective will be achieved, and sometimes whether it is worth pursuing at all. If the taxpayer proceeds to conduct experimentation and testing in an attempt to answer these questions, it intends to eliminate uncertainty. 
  3. The taxpayer must engage in some sort of systematic process of experimentation designed to evaluate one or more alternatives. Permissible processes range from informal trial and error to modeling or computational analysis.
  4. The process of experimentation must be technological in nature and must rely on the principles of physical science, biological science, engineering or computer science.
Over the years, this test has grown increasingly complex as case law and U.S. Treasury regulations have been issued to interpret its elements. Therefore, claims must be examined on a case-by-case basis to determine whether a taxpayer qualifies for the R&E credit.

Once a business determines that it has engaged in research that satisfies the four-part test, it must determine how much it has spent on qualified research expenses (QREs). The R&E credit is calculated on the basis of QREs, which include wages paid to employees and amounts paid for supplies used in the conduct of qualified activities. If at least 80 percent of an employee’s activities were dedicated to qualified R&E activities, the taxpayer may apply 100 percent of that employee’s wages toward calculating the credit.

One aspect of the process of claiming the R&E credit that proves daunting for taxpayers is documentation. Unfortunately, many
businesses often forego their opportunity to reap the benefits of this provision because they are not aware of what is required to prove that they qualify. It is imperative that businesses seeking to claim the R&E credit maintain thorough documentation. For example, they should be prepared to show plans, diagrams and timesheets of employees engaged in R&E activities.

The credit also includes a 20-year carry forward provision, which is particularly helpful for start-ups that may not have had much income in the early years of their business when they were performing most of their research. The carry forward provision allows such businesses to claim the credit in later years when they have more significant income.

In addition to the federal credit, most states offer some type of tax incentive for research activities. State incentives typically are modeled on the federal credit and use the federal definition of qualified research, but the rates vary drastically and may be more generous than the federal credit. Some states even provide benefits for businesses with losses. Therefore, businesses should consult their state laws to see if they may garner additional tax savings than permitted under federal law.

Although it has been in existence for more than 30 years, the R&E credit has never been a permanent part of the tax code. Instead, it belongs to a group of provisions known collectively as tax extenders, which repeatedly lapse but are often renewed retroactively each year. The R&E credit lapsed at the end of 2014 and therefore is not available for the 2015 tax year at this time. However, because it is typically renewed retroactively, taxpayers should consider the R&E credit as they plan their  2015 tax strategies, while staying aware of congressional plans for renewal.

Consulting with a tax professional may help taxpayers understand the confusing requirements of the credit and ensure they submit the proper documentation when making a claim. By expending some effort to review and document its activities, a business may join the league of taxpayers that save hundreds of thousands of dollars each year as a result of the R&E tax credit.

 
Marky Moore is CEO of Phoenix-based Capital Review Group. For more information, visit www.capitalreviewgroup.com.