4 Part Test of R&D Tax Credit and How Companies Qualify for it

4 Part Test of R&D Tax Credit and How Companies Qualify for it

4 Part Test R&D Tax Credit: Detailed Explanation Of The 4 Part Test And How Companies Qualify

The Research & Development or R&D Tax Credit is an incentive by the federal government to organizations to avail of a massive tax cut on carrying out research-based activities. As a result, companies can save up to hundreds of thousands of dollars.

However, every year most of the eligible companies for R&D could not apply and avail themselves of it due to confusion regarding qualifications, documentation, and certain misconceptions about how the credit works for their business activities. Due to this, many organizations miss out on this saving opportunity. These businesses, in particular, are missing out on significant tax measures targeted to aid businesses during the Covid-19 pandemic.

When finding out whether a business qualifies for claiming R&D Tax Credit, the most important element is the 4 Part Test introduced by the International Revenue Service (IRS). The r&d 4 Part Test helps you figure out whether your business activities qualify for the R&D Tax Credit.

What is the 4 Part Test to Qualify for R&D Tax Credit?

The combined results of this 4 Part Test determine whether your business is eligible to claim the R&D Credit. Any business that is technological in nature may qualify for the tax cut. The requirements of the test include the following:

The Business Component Test or Qualified Purpose

To be eligible for R&D Credit, the business activity must be concerned with an improved business component, including its functions, performance, dependability, etc. An improved or enhanced business component could mean a software, product, technique, or formula developed for the purpose of sales or internal use.

For this, the taxpayer must be able to relate the business component with the research for which the credit is being claimed. Then, companies must proceed to upgrade the performance, functionality, and reliability of the product or process.

Elimination of Uncertainty Test

To pass this test, a company must show that it tends to find out information eliminating technical uncertainties regarding design and capability for improving the business component. To eliminate uncertainty, it is essential to carry out these processes;

  • Spot the uncertainty
  • Identify alternatives to eliminate the uncertainty

If the company’s information does not define the capability or method for developing a new or improving the business component, then uncertainty exists and has to be eliminated. Also, the company must establish that the product and process may not be improved without these processes.

The Discovering Technological Information Test

To satisfy the discovering technological information test, the activity must rely on existing principles of biological, physical, or computer sciences. For instance, to enhance flavours for a food product, simply adding something won’t suffice. Instead, a scientific method has to be put into the process to pass the test. This ensures that the discovered information has been acquired through an approved method.

However, this test is not only confined to traditional sciences like physics, computers, and biological sciences. The business activity must include a wide array of hard sciences, including mechanical, structural, chemical, and other engineering sciences. Nevertheless, companies can’t refine or modify the existing fundamental principles.

Process of Experimentation Test

In this test, the company must demonstrate, through any method, that it has evaluated one or more alternatives to achieve the result of choice. The process of experimentation may include the following methods:

  • Simulation
  • Assessment of Alternatives
  • Testing/Modeling
  • Confirmation of hypothesis via trial and error
  • Accepting or rejecting the hypothesis

If the organization has shown that the improved product is the result of the evaluation of alternatives, trial and error, or other experiments, then it has satisfied the test requirements. Certain activities like software up-gradation, clinical research, and others naturally pass through the process of evaluation of one or more alternatives. Hence, it is essential to keep records of the process to prove the claim.

Which Activities Satisfy the 4-Part Test?

To determine if your business activities meet the 4-part test, you may seek help from a qualified accountant or R&D credit specialist. They may carry out a tax credit analysis to find out whether your business meets the required criteria.

You may also check for your business if your research activities qualify for R&D Credit. Listed below are some examples of research activities that make your business eligible for the tax cut:

  • Testing of the latest technology
  • Making business prototypes
  • Developing or improving new products, processes, or software
  • HVAC designing and related concepts
  • Carrying out environmental testing
  • Applying for patents or developing them

What Excludes a Company From R&D Qualification?

There are certain exclusions to the qualification that are important to note. For example, activities like financed research, research carried out outside of the USA, research in the field of economics, behavioural sciences, arts, etc., as well as those carried out after the launch of production, etc. If a company involves such activities, then the research expenses do not qualify for the R&D Tax Credit.

The funded research is excluded from the Credit. The challenge, however, is how do you determine whether or not research should be considered a funded one? To find out that, you need to look into these issues:

  • Is the contractor’s payment for research efforts “conditional on the research’s success?”
  • Is it true that the contractor has substantial rights to the research findings?

Note that these questions must be seen under the Treasury Regulation Section. If the answer to these questions is in the affirmative, the research is treated as a financed one. If the contractor carrying out the research does not hold substantial rights and if the research funds are conditional on the success of the contractor, then no person (payer or contractor) qualifies for claiming the R&D tax credit.

Companies’ Assumptions: Why they Think they’re Not Eligible?

Certain factors and assumptions prevent businesses from availing of the R&D tax credit. As a result, they don’t claim the credit and miss out on a major saving opportunity for the business. Some of these misconceptions include:

The company is Unsure of the Requirements

Numerous companies are unaware of the criteria that qualify them for the R&D Credit. Small businesses or those who have just started off may apply up to $250,000 annually for up to 5 years.

To qualify, a company must:

  • Possess less than $5 million for the credit year
  • Have no interest income of more than five years.

Company Lacks Dedicated Research Departments

Most businesses don’t have laboratories dedicated to research. However, they are still eligible to claim the credit. Hence, companies need to note that it is not necessary to own special research departments to qualify for the R&D tax credit. Regardless of where the experimentation is conducted, R&D may be applicable.

Workers aren’t Certified, Engineers or Scientists

The R&D Tax Credit holds regardless of who performs the research activities. These employees may be from anywhere and be employed at any job position. Experimentation carried out by workers and contractors (who are a part of the product improvement process) is a part of qualifying research activities and qualifying research expenses.

Organization Doesn’t Produce New

R&D activities do not have to bring something new to the industry. Companies only need to make sure their activities satisfy the four part test mentioned above, and they’re good to go! The R&D credit holds for people who design, develop and modify products and processes. Hence, it is concerned with the increment in innovation the company is able to bring about.

How Can Organizations Claim the R&D Credit?

It takes quite a lot of time for companies to investigate the amount of R&D tax credit they are eligible to claim, but it’s a worthwhile investment of time. For instance, R&D credits can nullify the effect of income tax, as a result of which the companies’ tax burdens may be reduced significantly.

If a company hasn’t already claimed the credit, they may look back at when the tax returns were filed. Companies can avail the opportunity they previously missed. This way, they may gain back the lost amount on account of taxes.

Further, if an organization has limited taxable income, the federal tax credit may be applied to counterbalance the company’s federal payroll tax (as suggested by the amended rules). Also, they may be carried forward for a span of 20 years. In addition to the federal tax credit, state credit also has the potential to be carried forward. However, the length of the span is decided by the state itself.

Necessary Documents for the Credit

To derive complete benefit from the R&D tax cut, companies need to properly document their research and development activities. This way, they can claim credits for the credit year and the previous tax years. Once their documentation is complete, they have factual evidence to prove why they have applied for credits. The necessary documents include the following items:

  • Research Results
  • Lab documents
  • Business emails made
  • Project notes/lists
  • Expenses noted in General Ledger
  • Payroll data

Once a company has the above data, it may successfully make the R&D claim for the current or past years.