The IRS R&D tax credit program has existed for more than 40 years as an incentive for businesses to continue to develop new products. Tax credits are a powerful source of alternative funding — companies can reinvest the additional resources into the business to fuel further innovation, set themselves apart from the competition, and unlock growth.
This reduction of tax liability can be crucial for startups and small businesses in sectors like computer science, software development, biotech, and food and beverage manufacturing.
But many companies neglect to harness the program or don’t use it to its fullest potential because they aren’t sure which expenditures or R&D activities qualify.
Learn what R&D tax credit–qualified expenses are so you can take advantage of the program and continue to push your business toward a new age of innovation.
What Counts as Qualified Research Expenses?
There are two categories of qualified research expenses, which are often referred to as QREs: in-house research expenses and contract research expenses.
In-house research expenses include:
- Wages or payments made to employees for any qualified services performed
- Supplies purchased to conduct qualified research
- Contract research expenses paid to conduct qualified research
In this case, wages include all taxable wages that are reported on an employee’s W-2 form, though they don’t include non-taxed income or benefits.
To be considered as providing qualified services, an employee must be doing the qualified research themselves, directly supervising the qualified research, or directly supporting the qualified research. If only a portion of an employee’s job is spent performing qualified services — for example, one-third of their work — then that is the portion that counts as a qualified research expense.
Any tangible property purchased to carry out qualified research can be considered a supply. A company working to create a new type of cell phone case could include the materials it is experimenting with as supply expenses. Similarly, a pharmaceutical company creating a new drug formulation can include the ingredients it is using in its research as a supply expense.
Contract research expenses are when a person or business performs qualified research on behalf of the taxpayer, in which case 65% of the amount paid to the non-employee can be considered a qualified expense. These expenses can be claimed on the taxpayer’s tax return once the work has been performed.
For any of these expenses to count toward minimizing your tax liability, they must be incurred during qualified research activities.
What Counts as Qualified Research Activities?
Qualified research expenses are incurred when you are completing qualified research activities during the tax year. For the activities to qualify and be claimed on your income tax return, they need to pass what’s referred to as the four-part test.
Qualified research activities should pass all four parts, including the section 174 test, the discovering technological information test, the business component test, and the process of experimentation test.
- To pass the section 174 test, the expenditure made must be connected to your business or trade, and it has to serve as an R&D cost in an experimental or laboratory sense.
- To pass the discovering technological information test, the purpose of your research must be to discover information that helps eliminate uncertainty with the creation or improvement of a business component.
- To pass the business component test, you need to intend to use the information that is being discovered in the development of a new or improved business component.
- To pass the process of experimentation test, your business’s experimentation must:
- Identify uncertainties related to improving an existing business component or developing a new one.
- Identify one or more alternatives that eliminate the uncertainty.
- Identify and carry out a method to evaluate the alternatives.
It’s up to you as the taxpayer to ensure you meet the requirements for the business component. If the requirements aren’t met, then you can dial down to the next subset of elements of the business component until the requirements are met. For example, if you can’t include the entire project, perhaps you can include a smaller portion of the project.
What Expenses and Activities Don’t Qualify as R&D Expenses?
When trying to calculate your tax savings for the taxable year, it’s equally important to know what research expenditures and activities don’t qualify.
For in-house expenses like wages, you can’t include someone’s entire wage if part of their job involves work outside of qualified R&D activities. When calculating supply costs for your R&D credit claim, you can’t include administrative costs you’d pay anyway, like utilities, property that’s subject to depreciation, land, and improvements to your land.
When evaluating research payments for contract research expenses, the work must only be used in the conduct of qualified research. If the work will be applied to other products or projects that aren’t qualified research activities, it’s not eligible to be included in your credit claim.
If your research activities don’t pass the four-part test, then they, and the related expenses, don’t meet the requirements of qualified research activities. In that case, they can’t be used to increase the amount of credit when calculating your R&D tax credit.
How Boast Helps Companies Make the Most of R&D Tax Credits
Internal revenue code comes with plenty of misconceptions, but it’s an important topic to master to make the most of your tax benefits. Having someone in your corner who understands the intricacies of the R&D tax credit program ensures you don’t leave money on the table.
With the help of Boast, healthtech firm Smirta has been able to get larger claims and continually reinvest in more research and development to provide a better experience for cancer patients and get solutions to market faster.
Smirta’s team makes use of artificial intelligence to create innovative solutions for oncologists and cancer centers. For example, Smirta uses advanced algorithms to forecast patient volumes so they can optimize patients’ future appointments, maximize the use of company resources, and improve wait times.
To learn more about how you can get larger claims faster, schedule a free one-hour consultation with a Boast tax expert.
