Understanding The Research & Development Tax Credit – What Small Businesses Need To Know

It’s tax season, let the sales pitches begin! Tax return preparation companies and do-it-yourself software providers are hard at work convincing individual taxpayers that their services and products are the way to maximize a tax refund or pay the lowest amount of tax. And, judging by what I’m seeing on social media, companies that specialize in the Credit for Increasing Research Activities (also known as the R&D tax credit) are also selling hard, looking for businesses who may qualify for this credit—especially startups.

They are casting an extremely wide net. While it’s true that the R&D credit is often overlooked by small businesses and their return preparers, it’s not as easy to qualify for the credit as some of these companies want small business owners to believe. Buyer beware.

For sole proprietorships, partnerships, and S-corporations the R&D credit is claimed by filing Form 6765 with the business return (Schedule C of a Form 1040, Form 1065, or Form 1120-S, respectively). Qualifying small businesses can elect an up to $250,000 payroll tax credit instead of an income tax credit.

I’m not going to get into the mechanics of taking the credits here but it is easy to see how this election could benefit a startup in the early stages with payroll expenses and the associated taxes but not much income to be taxed. Nevertheless, the mere fact that a business is new or has a new product does not automatically make expenses qualified research expenses for the purposes of this credit.

Section 174 of the Internal Revenue Code allows a taxpayer to treat “research or experimental expenditures” as expenses instead of having to amortize them over 60 months. The R&D credit uses the same definition of research or experimental expenditures as IRC Section 174. Qualified research expenses are defined in Treasury Regulation 1.174-2. The expenditures must be “incurred in connection with the taxpayer’s trade or business” and must “represent research and development costs in the experimental or the laboratory sense.”

The regulation goes on to state that “expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.” Additionally, qualification depends on the “nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed.” It is on these semantic rocks that many tax credit ships have foundered.

In Connection With The Taxpayer’s Trade or Business

For an expenditure to be incurred in connection with a trade or business, the business must be a functioning business. Deductions exist for startup expenses for businesses but those should not be confused with the R&D credit.

Research activities conducted before a business is a business may be legitimate (and deductible) startup expenses but they do not qualify for the R&D credit. In other words, you must start your startup and then do the research, not develop the product and build the business around it in order for research expenditures to be considered qualifying expenses for the R&D credit.

The Experimental Or The Laboratory Sense

To qualify, research and development expenditures must be paid to eliminate uncertainty concerning the development or improvement of a product. This concept is perhaps best described as traditional trial and error using the scientific method. The idea of evaluating alternatives is important as is systematic testing of various alternatives. Testing and debugging an existing product is not enough to qualify for the credit. Neither is evaluating a set of alternatives or features for a given product.

For example, research to determine which set of code objects are necessary to implement a given software solution would not qualify. Quality control and assurance testing is also specifically excluded. A taxpayer must be evaluating alternatives to create a new product or improve an existing product. Additionally, the improvement must be related to the product’s performance and not simply a matter of cosmetics, taste, or fashion. Perhaps the best example of qualifying expenses would be those incurred to develop and test prototypes of a new product.

What about software and app development? What indeed. Determining whether software development costs are qualified research expenditures requires special analysis. Expenses incurred to develop software for internal use are specifically excluded from qualification. In Accounting Standard Codification (ASC) 730, the IRS Large Business & International unit indicated that internal use software includes software “used to provide a service or produce a product that the customer neither acquires nor gains any right to future use of.”

That is, the expenses incurred to develop a customized user experience for your website’s shopping cart will not qualify where expenses incurred to develop and test a new game for a gaming company to sell, most likely would—at least up to the point that “technological feasibility is established” (again, according to ASC 730).

The Nature Of The Activities Not The Nature Of The Product

For expenditures to qualify substantially all (substantially all has been defined as 80%) of the research activities must relate to a process of experimentation for a new or improved product. Corn Island Shipyard, Inc. recently found this out the hard way when the U.S. Tax Court ruled that the 80% requirement was not satisfied “simply because at least 80% of the product’s elements differ from those of the products the taxpayer previously developed.”

The ruling in Little Sandy Coal Company, Inc., v. Commissioner of Internal Revenue (T.C. Memo 2021-15) held that the “substantially all” test applied to activities, not to physical components of the product being developed or improved. In other words, even though the company’s two products (a ship and a dry dock) were 80% different from the company’s other products, because the research activities involved in developing the two new products did not comprise 80% of the research and development activities the expenses did not qualify for the credit.

Developing the two new products only required a small amount of actual experimentation to create a substantially different product. And, for the purposes of this credit, it’s the activities that count, not the product.

The R&D credit can be an excellent benefit for small companies, especially those who are developing new products or product lines. Nevertheless, the rules for claiming the credit are complex and nuanced. Correctly claiming the credit may be beyond the skills of many tax professionals who serve small companies. If you think your company may qualify for the credit it can be a good idea to work with a company that specializes in qualifying companies and determining qualifying expenses.

Those companies should be willing to work with your tax professional (and vice versa). Startup owners should, however, proceed with caution when it comes to firms with big marketing budgets and great sales pitches that promise to qualify them for this credit without knowing anything about the company or its products. There be (tax) dragons.