What do a farm and a software company have in common?
Think about it.
“Nothing,” you say?
Both types of businesses possess the potential to reduce their tax liability with research and development tax credits. It’s true. Nearly any organization can save valuable tax dollars if they perform research and development activities that qualify for the federal Credit for Increasing Research Activities under Internal Revenue Code sections 41 and 174 - commonly known as the R&D tax credit.
The government grants R&D credits to companies that attempt to develop new or improved processes, products, techniques, formulas, or software. The endeavor can be as low-tech as improving an irrigation system. However, according to IRC section 41, the research activities relating to the improvement must satisfy the following four-part test:
- Business Component
The activities to develop the new or improved business component are for a permitted purpose relating to a new or improved function, performance, reliability or quality, which will be “held for sale, lease, or license” or used by the taxpayer in its trade or business (Secs. 41(d)(1)(B)(ii), (d)(2)(B)), and (d)(3)(A)). A business component is defined as a product, process, computer software, technique, formula, or invention.
- Elimination of Uncertainty
The activities to develop the business component must be intended to discover information to eliminate uncertainty regarding the capability or method for development or improvement of the business component, or the appropriate design of the business component. (Sec. 41(d)(1)(B)).
- Process of Experimentation
The development of the business component must have been subjected to a process of experimentation consisting of evaluating alternative designs, testing hypothesis, or systemic trial and error (Sec. 41(d)(1)(C)).
- Technological in Nature
The activities undertaken to develop the business component must fundamentally rely on principles of physical, biological, computer, or engineering science (Sec. 41(d)(1)(B)(i)).
The second prong of the test, the elimination of uncertainty, often draws misunderstandings or misapplications. A taxpayer must identify the uncertainty regarding the development or improvement of the business component for which the research activities relate and eliminate that uncertainty through a process of evaluating alternatives.
Case in Point
In the recent case Siemer vs. Commissioner, the court recounted its opinion in Union Carbide Corp. & Subs. v. Commissioner, writing:
We have previously explained that “the project must involve a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis so that it constitutes experimentation in the scientific sense.”
Therefore, to eliminate technical uncertainty, there must be a systematic approach to evaluate and test alternatives to determine the method, capability, or appropriate design of developing a business component.
The final regulations have provided further guidance on the issue, stating that the “determination that research is undertaken for the purpose of discovering information that is technological in nature does not require the taxpayer be seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research.”
To be clear, the information sought does not need to be groundbreaking or new to the world, but merely new to the company to improve a business component.
This confirms that a systematic approach is required to evaluate alternatives and the refinement of the process based on the information gathered from tests or evaluations of the alternatives. The process of experimentation to eliminate the uncertainty can be achieved through modeling, simulation, or a systematic trial and error methodology.
Some activities that can fall within this process include:
- Modeling of design alternatives
- Testing of design alternatives through simulation
- Developing prototypes to evaluate design feasibility
- Conducting feasibility studies
- Creating 3-D printed mock-ups
Ultimately, the goal is to demonstrate that the organization considered alternatives. The final regulations further elaborate that the process of experimentation to eliminate uncertainty should be capable of evaluating more than one alternative.
However, there does not need to be more than one alternative identified and evaluated. If only one alternative was evaluated it must be demonstrated that it involved a systematic approach to evaluate that one alternative through testing.
As the court also noted in Union Carbide Corp. & Subs. v. Commissioner:
"If only one alternative is tested, the taxpayer should conduct a series of experiments with the alternative in order to constitute a process of experimentation."
This can be demonstrated and documented through testimony and documentation including models, simulations, meeting minutes, emails, etc.
Proof in the Process
The Siemer vs. Commissioner case provides helpful insight into the evidentiary requirements necessary to substantiate the research credit. It underscores the taxpayer’s necessity to provide detailed information from testimony and records on its research activities – with scrutiny paid to identifying, implementing, and memorializing a methodical plan, which involves a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the hypothesis at the outset of its research activities.
It doesn’t matter if the project succeeds or fails, only that the organization used a methodical/systematic process to evaluate alternatives to eliminate the uncertainty of the business component development.
To gain further knowledge regarding the elimination of certainty and the R&D credit’s entire four-part test, contact a tax specialist.