The federal Research and Development (R&D) tax credit was originally enacted in 1981 as a temporary measure to boost innovation and the economy. Along the way, the R&D Tax Credit, which became a permanent part of the U.S. tax code in 2015, has been amended and expanded. It’s a good idea for companies to take a regular look at how to optimize the credit and reduce income tax liabilities.
The Opportunity for Manufacturers & Distributors
The R&D tax credit is aimed at encouraging businesses to invest in research and development. As companies innovate to release new products, improve existing software or enhance user experiences, the development involved can be costly. By leveraging the R&D tax credit, you can offset a significant portion of innovation costs, allowing to reinvest in further development and stay competitive in the rapidly evolving landscape.
Overall, the IRS requires qualifying R&D activities to meet a four-part test:
- Permitted Purpose: The purpose of the research must be to create or improve a product or process, resulting in increased performance, function, reliability or quality.
- Elimination of Uncertainty: You must demonstrate that you’ve attempted to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.
- Process of Experimentation: At least 80% of the activities must be elements of a process of experimentation designed to evaluate alternatives for achieving the desired results through confirmation of the hypotheses accomplished by trial and error, testing or modeling, and refining or discarding of the hypotheses.
- Technological in Nature: The activity performed must fundamentally rely on principles of physical science, biological science, computer science or engineering.
What types of activities can qualify for companies?
| Activities that generally qualify can include: | Activities that generally don’t qualify include: |
- Developing new software features or functionality
- Improving existing algorithms or optimizing software performance
- Enhancing cybersecurity protections
- Developing AI and machine-learning models
- Conducting experimentation or extensive testing
| - Maintenance of existing software
- Detecting flaws and bugs in software
- Developing interfaces, vendor product extensions or graphical user interfaces
- Re-hosting or porting an application or rewriting an existing application in a new language
- Modifying an existing software business component to make use of new or existing devices
|
Proposed Changes to Reporting Requirements on Form 6765
When preparing your federal R&D tax credit filing, note the revisions the IRS is proposing for Form 6765, the form used to calculate and claim the R&D tax credit. The intent behind the changes is to capture more detailed information on each business component related to a company’s R&D projects.
Currently, businesses report their total qualified research expenses by category with their filing. However, the revised Form 6765 would require documentation for each business component, including:
- How many business components are included in generating the credit
- The category of the business component (product, process, computer software, technique, formula or invention)
- New categories of expenditures included in the current year
- Documentation of what the research sought to discover and one or more alternatives evaluated during the experimentation phase
- Officer wages included in the qualifying research expenses
- Wages by type of work (supervisory, direct research and support)
- Supplies, rental or lease costs of computers and qualified outside contractors
How to Prepare for the Possible Changes
To optimize the R&D tax credit and not leave money on the table, your company should begin to adjust how it tracks R&D expenses in anticipation of the proposed reporting changes. The adjustments often mean implementing more detailed tracking processes to capture the financial and time investments at the project and employee levels, with hours tracked by time spent on supervision, direct research or support.
In addition, you will need to identify the type of software being developed, such as:
- Internal use software
- Non-internal-use software developed to:
- be commercially sold, leased, licensed or otherwise marketed to third parties
- be used internally by the taxpayer but not in any general and administrative function of the taxpayer
- interact with third parties but not to be used in any general and administrative function of the taxpayer
An expert research and development tax advisor can help your company navigate the filing and reporting complexities. They can also provide guidance on the implications for past tax filings and any necessary adjustments to current tracking processes.
The experts at CBIZ can help your business make the most of the federal R&D tax credit. This article includes input from Gary Fujita, Managing Director at CBIZ Advisors, LLC and a leader in tax incentives. Gary is a strategic partner for clients, as he advises companies on best practices for tax credits and provides a detailed action plan and control points for the R&D environment.
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