R&D credits: A crash course in the basics

A QRE is the building block of the R&D credit. QREs include employee wages for qualified services, certain supply costs, contract research expenses, and certain computer rental or lease costs. The key is that each QRE must be connected to qualified research. An examiner will test whether the expenses you claim are properly tied to the research activities you describe. Through a successful claim, $10 of QREs become approximately $1 of credit.

Qualified research must satisfy a four-part test, and the four-part test is applied separately to each business component:

• Domestic research or experimental expenditures: The research must involve costs deductible under Section 174A – costs incurred in connection with your trade or business that represent research and development, conducted in the United States, in the experimental or laboratory sense.
• Technological in nature: The research must be undertaken to discover new information that fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
• Business component: The research must serve the purpose of developing a new or improved business component, such as a product, process, technique, formula, invention, or computer software.
• Process of experimentation: Substantially all research activities (at least 80%) related to a business component must constitute a process of experimentation. (You can also think of this as a scientific method requirement.) If 80% of a business component’s activities are experimental, the remainder also qualifies.

The process of experimentation test focuses on how your company addressed uncertainty. It requires more than developing something new. You need to consider several factors:

• Uncertainty: Was information unavailable regarding capability, methodology, or appropriate design?
• Alternatives: What alternatives were identified or considered to address that uncertainty?
• Evaluative process: How were those alternatives evaluated – through modeling, simulation, systematic trial and error, or another evaluative process?
• Qualified purpose: Was the experimentation directed toward a qualified purpose, such as improved function, performance, reliability, or quality?
• Substantially all: At least 80% of relevant research activities must constitute elements of a process of experimentation.

The shrinking-back analysis comes into play when a company’s research activities do not satisfy the four-part test as a whole. It is a fallback step that allows you to narrow the scope to the next subset of activities that pass all four tests, instead of scrapping the research credit claim entirely.

Section 41(d)(4) excludes certain research activities, even if they satisfy the four-part test:

• Research after commercial production
• Adaptation of an existing business component to a particular customer’s requirements
• Duplication of an existing business component
• Surveys or studies
• Certain internal-use software
• Foreign research
• Research in the social sciences, arts, or humanities
• Funded research

This list is not exhaustive.

There is also a separate Section 174A(d)(2) limitation: Exploration expenditures incurred to ascertain the existence, location, extent, or quality of ore or other mineral deposits (including oil and gas) are excluded from Section 174A and therefore do not qualify for the Section 41 credit.

Form 6765 is the form used to claim the R&D tax credit. Recent changes to the form give the IRS greater visibility into research credit claims than before.

Under the 80% / Top 50 reporting rule, at least 80% of total QREs must be reported by business component, with no more than 50 business components separately reported, and the remaining QREs reported in aggregate.

For each reported business component, you must provide the business component’s name or identifier and type, wages for conduct, wages for direct supervision, wages for direct support, supplies, computer rental or lease costs, contract research expenses, and additional information for software components.

The practical effect is that the IRS now has detailed information about your claim at the outset, which shapes how an examination will proceed.

While no structure can guarantee that a claim will avoid examination, you can build a claim that is prepared to withstand one.

Start with the case you want to present: Identify the actual research and business components, apply Section 41 to the facts, identify the people with firsthand knowledge, and gather evidence. Define your business components at a level you can defend, and make sure your documentation matches your definitions and is consistent with your Form 6765 reporting. Avoid vague labels, such as “testing,” “quality,” or “project management,” that invite examiner questions – instead document what uncertainty existed, what alternatives were considered, and how they were evaluated. Pressure-test your study before the IRS does, looking for inconsistencies between your conclusions and contemporaneous records.

The study is important, but the ultimate question is whether you can establish that your company is entitled to the credit under Section 41.