For decades, the I.R.C. Section 41 credit for increasing research activities (“R&D tax credit”) has offered substantial annual tax savings to businesses that develop or improve products and technical processes within the United States. Despite its history and status as the federal government’s largest research subsidy, the credit has long been underutilized due to a lack of widespread knowledge regarding the scope and benefits of the program. With tax legislation pending that is expected to further strengthen the incentive, now is a perfect time for taxpayers to evaluate whether they could either begin to take advantage of the benefit, or increase the amount claimed.
Congress created the R&D tax credit in 1981 as a response to the offshoring of engineering and other technical jobs to countries with lower costs of labor, more favorable tax rules, or other advantages. By offering a credit for costs incurred in the U.S., Congress hoped to mitigate the financial benefits of offshoring. As a result, the credit was drafted to incentivize a wide range of engineering and technical activity, rather than focusing only on groundbreaking discoveries or high-technology industries. To qualify, businesses must develop or improve their products or processes through an iterative process based on principles of a “hard science,” such as engineering, chemistry, or information technology.
Many taxpayers and even tax professionals associate the idea of “research” with a much more narrow interpretation than what is provided by the statute and accompanying regulations. For instance, while the “hard science” requirement may sound like a significant hurdle, in practice it primarily excludes functions like accounting and marketing. Eligibility for the credit does not depend on educational or other credentials, nor is there any requirement for invention or innovation. For instance, experimenting with a new ice cream recipe likely qualifies as research. The food industry is one of many that broadly under-claim research credits; other examples include agriculture, resource extraction and processing, digital and physical advertising, cybersecurity, financial services, e-commerce, software implementation, and more.
In addition to the broad definition of research, many taxpayers understate the amount of credit they are entitled to. The credit applies to wage, contract labor, and materials costs either directly associated with research or directly supervising or supporting research. Taxpayers that claim the credit often exclude costs from outside the core development group, missing out on eligible amounts related to functions like business development, technical support of marketing, prototyping, testing, product integration, and higher-tier customer support.
More recently, a change in tax accounting rules that took effect in 2022 has further impeded the utilization of the R&D tax credit. Under I.R.C. Section 174, taxpayers were previously able to deduct research costs as they were incurred, but are now required to capitalize those costs for tax accounting purposes. Since taxpayers are required to use a consistent definition of “research,” this change encouraged companies to define their research activities as narrowly as possible to reduce the impact of the capitalization rule. The tax legislation pending on Capitol Hill is widely expected to address this issue, again making the R&D tax credit one of the most important and lucrative incentives in the tax code. For additional information, please click here to read a more detailed article regarding the R&D tax credit and related considerations. Contact us at (202) 455-6010 or schedule a consultation to discuss R&D credits for your business.
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