It's tax season! Tax return companies and DIY software vendors work hard to convince individual taxpayers that their services and products are the way to maximize tax refunds or pay the lowest amount. Judging from what we see on social media, the companies that specialize in the credit to stimulate research activities (also known as the research and development tax credit) are also selling hard and looking for companies that can benefit from this credit, mainly startups. They are designing an extremely large network. While it is true that small businesses and their return preparers often overlook research and development credit, it is not as easy to qualify for the credit as some businesses want small business owners to believe.
For sole proprietorships, partnerships, and S corporations, the research and development credit is claimed by filing Form 6765 with the Business return (Schedule C of Forms 1040, 1065, or 1120-S, respectively). Qualifying small businesses can choose a payroll tax credit of up to $250,000 instead of an income tax credit. We won't go into the mechanics of getting loans here, but it's easy to see how this choice could benefit startups with the associated expenses and payroll taxes, but not a lot of income to pay. However, the mere fact that a business is new or has a new product does not automatically convert the expenses into eligible research and development expenses for this credit.
Section 174 of the Internal Revenue Code allows the taxpayer to treat "research or experimental expenditures" as expenses instead of writing them off over 60 months. The R&D credit uses the same definition of research or experimentation expenditure in Section 174 of the IRC. Qualified research expenses are defined in Treasury Regulation 1.174-2. The expenses must be incurred within the framework of the activity or the activity of the taxpayer. They must represent the costs of research and development in the experimental or laboratory sense. The regulation further specifies that expenditure is the cost of research and development in the experimental or laboratory sense if it involves activities intended to uncover information that would eliminate uncertainty about the development or improvement of a product. Further, the classification depends on the nature of the business to which the expenditure relates and not the nature of the product or improvement being developed. Many tax credit ships have sunk into these semantic rocks.
In the context of the taxpayer's trade or business
For an expense to be incurred in connection with a business or enterprise, the business must be operational. There are deductions for the business's initial expenses, but they should not be confused with the research and development credit. Research activities conducted before a business becomes a corporation may be eligible (and deductible) startup expenses but do not qualify for research and development credit. In other words, you have to start and then do the research, not develop the product, and grow the business around it, so that the research costs are considered eligible for the research and development credit.
Experimental or laboratory sense
To qualify, you must pay for research and development to take the uncertainty out of developing or improving a product. This concept is probably best described as traditional trial and error using the scientific method. The idea of evaluating alternatives is important, as is the systematic testing of different alternatives. Testing and debugging an existing product is not enough to get the credit. It also doesn't evaluate several alternatives or features for a particular product. For example, research to determine which set of code objects is needed to implement a particular software solution would not be appropriate. Assurance testing and quality control are also expressly excluded. An employee should consider alternatives to create a new product or to improve an existing product. Also, the improvement should be linked to the product's performance and not just a problem of aesthetics, taste, or fashion. Perhaps the best examples of qualification costs are those incurred to develop and test prototypes for a new product.
What about software and application development? Determining whether software development costs are eligible for research expenses requires special analysis. Costs incurred for the development of software for internal use are expressly excluded from the classification. In Accounting Standard Codification (ASC) 730, the Large Business and International Relations Unit of the IRS stated that software for internal use includes software used to provide a service or produce a product that the customer does not use, neither acquire nor obtain the right of use. That is, the expenses incurred to develop a personalized shopping experience for your website's shopping cart will not be eligible. While it is probable that the expenses incurred to develop and test a new game for sale by a gaming company would, at least point to where technology feasibility is established. (again, according to ASC 730).
The nature of the activities, not the nature of the product
In order for the expenditure to be substantially qualified, all (substantially all were defined as 80%) of the research activity must be related to a test of a new or improved product. Corn Island Shipyard, Inc. found this most difficult recently when the US tax court ruled that the 80% requirement was not met simply because at least 80% of the items in the product differ from the product that the taxpayer developed earlier. The Little Sandy Coal Company, Inc. ruling against the Internal Revenue (TC Memo 2021-15) concluded that the "substantially all" test applies to assets, not the physical components of the product under development. . That is to say, although the two products of the company (a ship and a dry dock) were 80% different from the other products of the company because the research activities involved in the development of the two new products 80% of research activities and development expenses were not eligible for the credit. The development of the two new products only required a small amount of actual experimentation to create a substantially different product. For this credit, what matters are the assets, not the proceeds.
Credit for research and development can be a great asset for small businesses, especially those developing new products or product lines. However, the rules for applying credit are complex and nuanced. An adequate credit application can be beyond the capabilities of many tax professionals serving small businesses. Suppose you think your business may be eligible for credit. In that case, it may be a good idea to work with a professional that specializes in assessing the business and determining eligible expenses. These professionals must be tax specialists.
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Don Bell Law