The Research and Development (R&D) tax credit (IRC Section 41) was created in 1981 and made a permanent fixture of the tax code in 2015. The credit rewards U.S.-based innovation, and companies performing R&D activities can receive dollar-for-dollar federal and state tax credits (depending on the state) totaling up to 22% of their qualified research expenses (QREs). To be eligible for the credit, projects must satisfy the requirements of the Four-Part Test:
- Purpose: The research must impart new or improved functionality, performance, reliability, or quality to a product, process, formulation, software, patent, or technique.
- Technological: The activity undertaken must rely on the principles of “hard” sciences including physics, biology, engineering, chemistry, or computer science.
- Eliminating Uncertainty: The development team must encounter technical uncertainty regarding the optimal design, methodology, or capability to achieve project specifications.
- Experimentation: The activities constitute a process of experimentation with the intent to resolve the technical uncertainty through the systematic evaluation of alternate solutions
The Patent Safe Harbor Provision
Included in Section 41 is a provision known as Patent Safe Harbor (26 C.F.R. §41-4(a)(3)(iii)), which states that the issuance of a patent by the U.S. Patent and Trademark Office (under 35 USC §51) is conclusive evidence that a company “has discovered information that is technological in nature that is intended to eliminate uncertainty concerning the development or improvement of a business component.”
In other words, the issuance of a patent automatically satisfies three of the four qualifications of the four-part test. Part four, experimentation, requires that a taxpayer provide contemporaneous evidence that qualified activities were undertaken by a company to achieve its patentable product/process/technology. The documentation of this process of experimentation is the most important aspect of qualifying projects and associated expenses for an R&D tax credit claim.
The taxpayer has the burden of proof to substantiate that a process of experimentation was performed, and to demonstrate a nexus between the qualifying activities and expenses. These include the associated employee wages, raw materials & supplies, cloud computer rental/lease costs, and 3rd-party contractor expenditures incurred throughout the various phases of development that led to the filing and granting of the patent.
Patents essentially convey to the IRS that the majority of the four-part test has been satisfied. Moreover, documentation collected in the preparation of a patent application can be used to support the R&D tax credit claim. An R&D tax professional should still be consulted for your company to correctly claim the credit.
There are several key factors to consider for your R&D tax credit including not only your process of experimentation, but also substantiation and valuation of your credit (see Suder v. Commissioner, T.C. Memo. 2014-201). Proper documentation of the activities a taxpayer conducted throughout the process of experimentation is critical when claiming R&D tax credits and should be analyzed by a qualified tax consultant in order to ensure you are claiming the credit as per the guidance of section 41 of the R&D tax code (Fudim v. Commissioner – T.C. Memo. 1994-235). Further, gathering supporting documentation of your R&D activities has recently been shown to be key in providing substantiation for your R&D tax credit (see Siemer Milling Co. v. Commissioner, T.C. Memo. 2019-37).
Does your company hold a patent or is it in the process of applying for one? You have done the hard work to develop your patented intellectual property, contact Strike Tax today to speak to an industry specialist to maximize your tax savings.