Section 41 of the Internal Revenue Code provides a tax credit that is based on qualified research. The credit is available for both in-house qualified services costs and contract costs incurred by a company that has another company conducting qualified research on its behalf. The Internal Revenue Code provides a detailed definition of qualified research, but simply stated it consists of research and development activities involving a process of experimentation, designed to develop new or improved products, processes, or assets. The following contains descriptions of both qualified services and qualified research.
Supplies used in the conduct of qualified research are considered as qualifying for the credit. These supplies would be any tangible property other than:
- Land or improvements to land, and
- Property that must be depreciated
65% of any contract research expenses paid for the performance of qualified research done on behalf of the taxpayer that is performed by another company also qualify for the credit.
Qualified services are services that satisfy one of three conditions:
- The services consist of engaging in qualified research. Actual conduct of qualified research (ex: scientist conducting laboratory experiments)
- The services consist of engaging in the direct supervision of research activities which constitute qualified research. Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.
- The services consist of engaging in the direct support of research activities which constitute qualified research.
Services in the direct support of either persons engaging in the actual conduct of qualified research, or persons who are directly supervising those engaging in the actual conduct of qualified research (ex: machinist that is machining a part of an experimental model used in qualified research, clerical staff typing reports describing lab results derived from qualified research, a lab worker cleaning equipment used in qualified research, and a clerk compiling research data)
Does not include general & administrative services, or other services only indirectly of benefit to research activities
Qualified research is research that satisfies four conditions:
- The expenditures must represent a research and development cost in the experimental sense. Expenditures represent research and development costs in the experimental sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available does not establish the capability or method for developing or improving the product or the appropriate design of the product. This means at the outset of the development activities, based on the information available, they are uncertain.
- Substantially all of the research activities must be elements of a “process of experimentation” for a qualified purpose.
Research is conducted for a qualified purpose if it relates to a new or improved function, performance, reliability, or quality.
Research is not conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors.
The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
The process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the research activities.
- If it can develop the component it wants to develop, or
- How to develop the component it wants to develop, or
- Of the appropriate design of the component it wants to develop
- The research must be undertaken for the purpose of discovering information that meets two tests:
- The information must be technological in nature and
- The application of the information must be intended to be useful in the development of a new or improved business component for a qualified purpose.
The discovering information test is met if the research is intended to eliminate uncertainty concerning the development or improvement of a business component. A business component is described as any product, process, technique, formula, or invention which will be held for sale, or used in the business of the company.
In applying the discovering information test, it is not required to seek to obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research, and it is not necessary to succeed at the conclusion of the efforts.
- The research must not be prohibited research.
Prohibited research is:
- any research that is conducted after the beginning of commercial production of the business component;
A product is considered ready for commercial production when it is developed to the point where it is ready for use or meets the basic functional and economic requirements.
Following activities are deemed to occur after the commencement of commercial production:
- Preproduction planning for a finished product
- Tooling up for production
- Trial production runs
- Troubleshooting involving detecting faults in production equipment or processes
- Accumulating data relating to production processes, and
- Debugging flaws in the product
- related to the adaptation of an existing business component to a particular customer’s requirement or need;
- related to the reproduction, in whole or in part, of an existing business component from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to the business component;
- any efficiency survey, any activity relating to management function or technique, and market research, testing, or development, any advertising or promotions, any routine data collections, or any routine or ordinary testing or inspection for quality control;
- conducted outside the United States, the Commonwealth of Puerto Rico, or any U.S. possession;
- in the social sciences, arts, or humanities; or
- funded by any grant, contract, or otherwise by another person or governmental entity.