The Research & Development Tax Credit—or the R&D Tax Credit—is a federal credit that incentivizes, dollar-for-dollar, companies to improve existing processes and products or develop new ones.
Any company that performs qualified research activities in the US can use this credit to offset its tax liability.
Any expenses that qualify for this tax credit are called qualified research expenses (QREs)—here’s what your company needs to know to start claiming its R&D credits.
Related: R&D Credits for Software Companies
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Research Expenses: 3 Types That Qualify for R&D Tax Credits
Qualified research expenses include:
- Wages paid to an employee who performs a qualified service
- Most supplies you use to conduct qualified research
- Amounts paid to contracted researchers to perform qualified activities (up to 65%)
- Research payments you make to qualified scientific research organizations and educational institutions (up to 75%)
You can find the IRS requirements for QREs here, but it isn’t easy to understand as you’d expect.
We’ll break down the three most common types of QREs that companies can claim toward the R&D tax credit:
1. Employee Compensation for Qualified Research & Activities
Various types of employee compensation can qualify as an R&D expense. Whether or not it qualifies depends not on an employee’s job description, job title, or technical qualifications; it all depends on if they performed a qualified service or not.
For most companies, employee compensation is the most significant expenditure when it comes to R&D projects. Therefore, identifying the employees that perform qualified services and determining the amount of time they spend on those activities are two of the most crucial parts of claiming the most extensive tax credit for your business.
To be a qualified service, the activities have to include:
- Engaging in qualified research;
- Directly supporting qualified research;
- Or directly supervising qualified research.
Engaging in Qualified Research
To check this box, the employee must be conducting some type of research. For example, this research could include conducting lab experiments, drawing up new process plans, developing new programming software, or, more generally, using the principles of engineering or science to solve technical problems
Directly Supporting Qualified Research
Direct support means that the services directly support an employee who is conducting the research or supervising those performing the study. For example, direct support can include the services of someone who produces various parts for an experimental prototype. However, it does not include administrative services, even if they are performed as part of the research department.
Directly Supervising Qualified Research
The employee must immediately supervise a qualified research activity to qualify as direct supervision. These employees typically include first-line managers and supervisors. However, it does not include high-level managers to whom those supervisors report, even if they are a part of the research team.
2. Supplies Used to Conduct Qualified Services
According to Section 41 of the IRC Code, supplies that qualify are defined as non-depreciable tangible property that the company uses to conduct qualified research. Employees must use these supplies to perform one of the qualified services listed above, and those supplies must directly relate to the research.
Related: How R&D Credits Affect AMT
However, some types of property, expenses, and supplies do not qualify. These include:
- Land and land improvements
- Property that is subject to the allowance of depreciation
- Non-tangible expenses like rental costs, leases, communications, entertainment, relocation, travel, professional dues, and licensing fees
According to the audit techniques guide by the IRS, the supplies you use should only make a small portion of your company’s overall QREs. If that portion is too high, then the IRS will take a closer look to see if you included non-qualifying expenses.
3. Expenses for Contracted Research
Sometimes, companies will need to contract out the research activities to gain the necessary expertise or facilities for the research. And the R&D tax credit will account for that.
Up to 65% of the total expenses for contracted research may be considered QREs. However, the number can go to 75% if that third party is a known qualified research consortium.
The standards for qualified services and qualified research are the same as in-house research. Prepaid research expenditures are not eligible for the R&D tax credit until the services are performed.
For your contract expenses to qualify, you need an agreement between your company and the third party that passes a three-part test:
- You must enter the agreement before performing the qualified research.
- The third party must perform the research on behalf of your company, meaning that your company has the rights to the research results.
- Your company must bear the expenses of the research even if it was not successful.
On that note, if your company is making a payment is contingent on the research being successful, that means it’s paying for results rather than the performance of the research and is not a qualified expense. One of the primary purposes of the R&D tax credit is to reward companies for taking risks to develop new processes and products – if there is no risk, the company gets no tax credit.
Activities That Do Not Qualify for the R&D Tax Credit
Qualified research expenses do not include:
- Costs from research outside of the US
- Costs from any funded research
- Commercial production costs
- Promotional or advertising expenses
- Improvement or acquisition of the land you use in research
- General administrative or managerial duties, including any supervisory functions that are not related to R&D
- Personnel in HR duties, including recruiting researchers
- Any accounting duties like payroll, budgeting, and bookkeeping
- Customer service support
- Employee training or attending conferences
- Charitable fundraising
Related: How to Claim Your R&D Tax Credit
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How to Claim Your QREs And Get the Maximum R&D Tax Credit
It’s possible for any company to qualify for the R&D tax credit. However, determining if you qualify requires an evaluation of the circumstances and facts surrounding your research activities.
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