Who wouldn’t want to cut their tax bill by as much as $500,000?
It’s no surprise, then, that a lot of companies — especially startups trying to extend their runway as much as possible — explore the R&D tax credit.
Technically called the Credit for Increasing Research Activities, this tax provision allows companies to claim a credit for certain expenses dedicated toward research. As a result, if your startup is exploring launching a new product or service, the money you spend there could help lower your tax bill. That’s particularly true when it comes to certain people’s salaries. If they’re working on research or experimentation, you can likely count their paycheck toward your tax credit.
Long story short, this can be a powerful way for startups to lower their tax liability and keep more money in-house. But for expenses to count toward this credit, they have to meet the IRS’s definition of qualified research activity. And that means passing the four-part test laid out in Section 41(d) of the Internal Revenue Code (IRC).
A quick overview of IRC § 41(d)
For something to count as a qualified research expense, it needs to be money spent on qualified research (very novel, we know). For an activity to count as qualified research, it needs to:
- Be undertaken for the purpose of discovering information
- Be technological in nature
- Be intended to be applied to develop a new or improved business component
- Use a process of experimentation
That probably doesn’t make things overly clear for you. A lot of that terminology is vague and could be construed in multiple ways. The last thing you want, though, is to think you’ve met the four-part test, only to learn you won’t actually get the tax credit you expected.
So let’s dig in. To help you get even clearer on what might qualify for this tax credit, let’s go through the IRS’s four-part requirement for qualified research.
#1: Discovering new information
Often dubbed the “elimination of uncertainty test,” this first part leans on Section 174 of the IRC. Per that section, research expenses need to tick two boxes. First, expenses need to be incurred in connection with your business (i.e., you can’t be exploring an unrelated product or service). Secondly, the expenses need to “represent a research and development cost in the experimental or laboratory sense.”
Enter the elimination of uncertainty. You essentially need to show the IRS that your company is taking on the research because you have no other way to get this information, and you need the info to develop or improve the product or service you’re working on.
#2: Technological in nature
As a tech company, you might be assuming that you’re good to go. Actually, though, when the IRS says technological here, they’re using it to denote hard sciences.
Specifically, your research needs to employ the principles of one of these fields:
- Physical science
- Biological science
- Engineering
- Computer science
Research related to the social sciences, arts, and humanities doesn’t qualify under Section 41.
#3: New or improved business component
This part focuses not so much on what or how you’re researching, but the specific business component to which it’s tied. You need to be able to directly connect the research to something you sell, lease, license, or use in trade, whether that’s a:
- Product
- Process
- Computer software
- Technique
- Formula
- Invention
We pulled that list straight from the IRS, so it might feel fairly broad and vague. Really, it is. But that gives you some wiggle room. You just need to identify a business component — whether that’s one you’re improving or something you plan to bring to market in the future — to which you can link your research activity.
To further clarify here, we should add that the research needs to be aimed at developing new or improved functionality, performance, or reliability/quality for that component. In other words, you need to be working toward a functional outcome. It doesn’t count if you’re working on developing or improving something stylistically or cosmetically. Adding seasonal design features, for example, won’t count as a qualified research activity.
#4: Process of experimentation
The IRS wants to see that you explored alternatives as part of your research activity. Specifically, the IRS uses a three-step test to decide whether or not your activity was experiment-based. They want to see that your company has:
- Identified the uncertainty regarding the business component (this ties back to the first point about discovering new information)
- Identified one or more alternatives to eliminate that uncertainty
- Identified and conducted a hard science-based process for evaluating those alternatives
Simple trial and error count here, provided you properly document the experimentative process that you use. Just remember that your process of experimentation needs to be rooted in engineering or computer, physical, or biological science.
Specific exclusions
Before we wrap up, we should call out that Section 41 includes some specific exclusions. The following can’t count as qualified research activities, even if you could make the argument that they meet the four-part test:
- Research conducted after you’ve started commercial production on the business component
- Work done on adapting a product to meet a specific customer’s requirements
- Duplicating an existing business component
- Surveys, studies, and research related to management functions
- Research for software that will only be used internally
- Foreign research
- Social sciences research (as we noted earlier)
- Research funded by a grant, contract, etc.
Applying the four-part test for your startup
We’ve given you a pretty good overview of how the IRS determines if something counts as a qualified research activity — and if the resulting expenses can get applied to your R&D tax credit. Still, though, your startup might be working on a niche product or with a novel process of experimentation, making it hard to determine if research qualifies here.
That’s where we come in. As specialists in the R&D tax credit, we understand the granular details of IRC Section 41. We can help you determine what counts at your company, and look for ways to maximize this credit for you.
To find out how much you could slash from your tax bill under IRC Section 41, get in touch with our team today.