Tax Credit for Increasing Research Activities, IRS Code Section 41
The federal Research Tax Credit (RTC) rewards activities utilizing experimental processes for the purpose of discovering technological information intended to be useful in developing new or improved business components as it relates to their function, performance, reliability, or quality. The RTC is applicable to a wide range of activities and not only to research labs, high tech endeavors, or multi-billion dollar companies. Its scope is broad, i.e., virtually any company intending to develop new products or processes, or improve its existing ones. In a nutshell, the credit applies to expenditures for qualified research activities identified using what is called the Four-Part Test.
1. Proper Purpose
The proper purpose of the activities must relate to a new or improved function, performance, reliability, or quality of the business component. The RTC defines “business component” as a product, process, computer software, technique, formula, or invention used by the taxpayer in their business or that is held for sale, lease, or license. In regard to production processes, any process, machinery, or technique for commercially producing a business component, is considered to be a separate and distinct business component.
By definition, these are activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. The uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product, or the appropriate design of the product. The rule explicitly states that there is no requirement that a taxpayer must seek to discover information that exceeds a common knowledge standard nor is there a requirement for the taxpayer to actually succeed in developing a new or improved business component. This same rule applies if there is uncertainty regarding either the capability of achieving the result or the appropriate design of that result. As long as one of these three issues is uncertain, the process of experimentation may be present. The RTC also provides a “patent safe harbor” for this element. Accordingly, the issuance of a patent is deemed conclusive evidence that a taxpayer has discovered information that is technological in nature and which is intended to eliminate uncertainty.
3. Information is Technological in Nature
For the information to be technological in nature, the experimental process must fundamentally rely upon the principles of physical science, biological science, computer science, or engineering.
4. Process of Experimentation
The credit applies to projects if substantially all of the activities constitute elements of a process of experimentation. Activities generally constitute a process of experimentation if they involve evaluation of more than one alternative to achieve a result and the method of achieving the result is uncertain at the outset, even if the taxpayer knows at the outset that it may be technically possible to achieve the result. The expenditures are qualified based upon the nature of the activity, i.e., experimental, and not the nature of the product or the level of technological advancement. Typically, qualified research ends after the business component is commercially viable. Commercial viability is generally deemed to be when commercial production begins but the characterization depends more on a determination of whether the business component has met the functional and economic criteria and is ready for sale or use. There are times after commercial viability, however, that a portion of the activity may still be qualified. The qualified portion is that which is directly related to the continuing efforts for a significant improvement of the product.
The basic credit is calculated as the sum of: (1) 20 percent of the excess of the year’s qualified research expenses over a certain computed base amount; and (2) 20 percent of the payments paid to qualified organizations performing basic research for the taxpayer. Until recently, the RTC was not allowed to offset alternative minimum tax (AMT) liability. Now, eligible small businesses with gross receipts less than $50 million averaged over the past 3 years may apply the RTC against the AMT liability. Additionally, a qualified small business (gross receipts than $5 million in the taxable year) may elect to claim up to $250,000 of RTC against certain payroll taxes.