May 5, 2023
- Since the R&D Tax Credit is activities-based, eligibility is determined by testing the research activities a company performs.
- In order to qualify for the Credit, a research activity must pass all four parts of the Four-Part Test:
Part #1: The research activity must be related to developing a new or improved business component for a “qualified purpose”—i.e. related to new or improved functionality, quality, reliability, or performance. The development or improvement doesn’t have to be brand new or vast in scope.
Part #2: The research activity must be undertaken for the purpose of eliminating some uncertainty related to appropriate design, method, or capability. Even research that is ultimately unsuccessful in eliminating uncertainty may still qualify.
Part #3: The research activity must involve some Process of Experimentation designed to resolve the uncertainty. The “Substantially All” Test adds a quantitative aspect to Part #3.
Part #4: The research activity must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering, or their applications.
- Certain activities are automatically excluded from Credit eligibility, including foreign and funded research.
- Thorough documentation is required to demonstrate compliance with all Four Parts of the Test. The recent Little Sandy Coal case serves as a cautionary tale.
Introduction: An Activities-Based Credit
The Federal Research and Development (R&D) Tax Credit is an activities-based tax credit for companies that incur R&D expenses in the United States. Based on IRC § 41 & § 174, the Credit is intended to incentivize innovation and experimentation.
Eligible taxpayers may claim qualifying expenses – wages, supplies, contract research, cloud hosting – for a dollar-for-dollar reduction in tax liability.
The R&D Tax Credit is far more expansive than most people imagine, and many businesses qualify just by performing their day-to-day activities.
Since the Credit is “activities-based,” qualification is determined by examining the research activities a company engages in. If a research activity passes all four parts of the IRS’ “Four-Part Test,” it’s considered “qualified research” and qualifies for the Credit.
These tests must be applied separately to each business component of the taxpayer (see below).
Let’s examine the four tests individually.
Part #1: New or Improved Business Component
The research activity must be related to developing a new or improved business component for a “qualified purpose” – i.e. related to new or improved functionality, quality, reliability, or performance.
A “Business Component” is the IRS’ umbrella term for all sorts of things one could create, including products, processes, software, formulas, techniques, and inventions. Business components are to be held for sale, lease, license, or used in a trade or business of the taxpayer.
To qualify for the Credit, the research activity must be undertaken for the purpose of developing a new business component or improving some aspect of an existing business component.
It’s important to emphasize that research relating to style, taste, cosmetic, or seasonal design, will not pass Part #1, as the research would not have been conducted for a “qualified purpose” (IRC § 41(d)(3)(B)).
The new development or improvement doesn’t have to be brand-new to your industry – it might just be new to your company, and that’s enough to pass Part #1.
Additionally, the improvement doesn’t have to be hugely significant. Small incremental improvements in product and process qualify too – the tax code doesn’t specify that a project must be of a certain size or scope to qualify. The research activity doesn’t have to be groundbreaking – it might just be the next small step in an evolution, and that still satisfies Part #1.
Sometimes taxpayers want to group all their research activity into one general catch-all category, and hope for the best. However, to qualify for the Credit, taxpayers must be able to directly tie each research activity performed to a specific business component. Documentation will be key to pass this part of the Test.
The specifics will vary of course, but often researchers are trying to answer questions like:
- Can I make a brand-new product?
- What will the new product design look like? How can I make it?
- Can I improve an old product? Is this even feasible?
- Can I improve the process by which the product is made?
- How can I incorporate new features and functions into an existing product/process?
Even if you know that you CAN make Product X, you might aim to eliminate the uncertainty of how to make it most efficiently.
What if you don’t know if you can make Product X? And what if turns out that, despite best efforts, you couldn’t? Some good news — research activity that is ultimately unsuccessful can still qualify for the Credit, as long as it passes all parts of the Four-Part Test.
Part #3: Process of Experimentation
The research activity must involve some Process of Experimentation designed to resolve the uncertainty.
Part 1 defined the purpose of the research activity in relation to the business component.
Part 2 defined the uncertainty you hope to eliminate through the research activity.
The process you undergo to eliminate the uncertainty relating to your business component constitutes Part 3, the Process of Experimentation.
The nature of the Process will vary but may include:
- Evaluation of Alternatives
- Hypothesis Testing, Refining, and Discarding
- Systematic Trial and Error
- 3D Modeling or Simulations
Iterative development processes are often employed to effectively evaluate alternatives. For example, in software development there might be testing of different algorithms or source coding iterations. In pharmaceutics, there might be two slightly different iterations of a drug product in pre-clinical trials. In manufacturing, multiple iterations of a prototype might be developed, assessed, and subsequently improved upon in the course of production.
We’ve established that Part #3 involves a Process of Experimentation, conducted for a qualified purpose, designed to resolve some uncertainty related to your business component.
However, there’s one more wrinkle to Part #3, colloquially known as the “Substantially All” Test:
Taxpayers must demonstrate that “substantially all” of the research activities constitute elements of a Process of Experimentation for a qualified purpose.
Essentially, the Substantially All test adds a quantitative aspect to this Part of the Test. In order to pass Part #3, 80% or more of a taxpayer’s research activities must constitute elements of a Process of Experimentation for a qualified purpose. The burden of proof is on the taxpayer, and again, diligent record keeping is key.
The Little Sandy Coal Company, Inc., v. Commissioner of Internal Revenue case may serve as a cautionary tale. Little Sandy Coal (LSC) is the parent entity of a shipbuilding company that claimed the R&D Tax Credit in TY 2014. They had designed and constructed 11 first-in-class vessels, and claimed employee wages, third-party wages, and supply costs. The Credit was disallowed by the US Tax Court in 2021, and the subsequent appeal affirmed the Tax Court’s decision, largely due to a failure of proof that the research activity involved a Process of Experimentation.
According to the opinion of the appeals court, released March 7th, 2023, LSC tested their models for performance, but could not prove that they were actively engaged in a Process of Experimentation. The opinion states that while LSC’s research activity “…confirmed the vessel’s functioning as designed. Its primary function was not to test any hypothesis or evaluate alternatives…”
The author concludes with an explicit statement: “The lesson for taxpayers seeking to avail themselves of the research tax credit is to adequately document that substantially all of such activities were research activities that constitute elements of a process of experimentation. Generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not enough.”
Taxpayers must take heed of this message and ensure that their claims are fully substantiated. The right R&D Provider will carefully document all activities and costs and tie them to a Process of Experimentation.
Part #4: Technological in Nature
The research activity must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering.
These subjects relate to multiple fields of research:
- Physical Sciences – the study of non-living systems — may encompass chemistry, geology, astronomy, physics, even meteorology and oceanography.
- Biological Sciences relate to pharmaceutics, medical device development, food science, and so much more.
- Engineering is key to so many industries – manufacturing, aeronautics, architecture, materials science, etc.
- Computer Science isn’t just for tech companies in Silicon Valley. Virtually every company today requires hardware and software solutions – and don’t forget the apps.
The so-called “soft sciences” – psychology, sociology, etc. – do not pass Part #4, even if they are using hypotheses and a process of experimentation in their studies.
One caveat – qualification is determined by the research activity, not the final use of the business component. For example, painting would not be considered technological in nature. However, enhancing the quality of a paint’s formulation to better serve the artist would certainly qualify.
If your research activity passes all four parts of the Test, then it is eligible for the R&D Tax Credit. What happens next? Take a look at our How to Claim the R&D Tax Credit Guide for further guidance.
For the sake of completeness, let’s review some activities that are automatically excluded from qualification. It doesn’t matter if the activity might appear to pass the Four-Part Test — these activities aren’t even permitted to take the test:
- Foreign Research: In-house or contract research performed outside the U.S. or Puerto Rico is automatically excluded. This applies even if the research is done by American researchers, or performed for an American taxpayer.
- Funded Research: Funded research is automatically ineligible for the R&D Tax Credit.
- Research is not considered funded as long as both of the following are true:
- The taxpayer’s payment for the R&D is “contingent upon the success of the research” (Economic Risk Test)
- The taxpayer retained “substantial” rights in the results of the research activity (Substantial Rights Test)
- Adaptation of an Existing Business Component: If you’re just modifying an existing business component to meet a particular customer’s request, this is considered excluded activity.
- Research activity conducted after commercial/mass production has begun. Activities like these are automatically excluded from Credit qualification:
- Tooling up for production
- Troubleshooting faults in production equipment or processes
- Routine testing or inspections for quality control
- Management, marketing, or consumer-related activities are automatically excluded:
- Management functions including preparation of financial data, development of employee training programs and management organization plans, and management-based changes in production processes
- Market research, testing, or development (including advertising or promotions)
- Efficiency surveys
There are only Four Parts, but this Test can be somewhat tricky. If you’re unsure, why not let our Capstan R&D Division help determine Credit eligibility? In less than a half hour, you can discover if you do indeed pass the Four-Part Test, what kind of documentation you’ll need to support your claim, and even what your Credit might look like.
If your research activity passes all four parts of the Test, then it is eligible for the R&D Tax Credit.
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