R&D Tax Credits and Deductions Explained

Are research and development expenses tax deductible?

Congress created two important incentives for a business to invest in research activities in the United States:

1. The ability to capitalize and amortize specified research or experimental expenditures (SREs) over five years (15 years if the research is performed outside the United States). (I.R.C. §174)
2. The ability to claim an immediate credit for qualified research expenses. (I.R.C. §41)

Eligible research costs include those paid or incurred for research conducted by the taxpayer as well as research conducted on the taxpayer’s behalf.

Amortization of R&D expenses

For taxable years beginning on or after January 1, 2022, I.R.C. §174 permits a deduction for specified research or experimental expenditures (SREs that are capitalized and amortized over a five-year period (15 years for foreign research). The change marks the first time since 1954 that companies have had to amortize their R&D costs, rather than immediately deduct those expenses.

SREs must:

• Be incurred in connection with taxpayer’s trade or business
• Represent a research and development cost in the experimental or laboratory sense.

The purpose of I.R.C. §174 was to incentivize investment in R&D and breakthrough technologies by eliminating the uncertainty concerning the tax treatment of such expenditures. Research and experimentation are basic activities that must precede the development and application to production of new techniques and equipment, as well as the development and manufacture of new products.

Qualifying expenses are a broad category, and include items like patent fees, salaries, drawing and models, and even attorney’s fees.

[Download our R&D Notice 2023-63 Overview for guidance on the capitalization and amortization of specified research or experimental expenditures under IRC 174.]

What is the tax credit for R&D spending?

In 1981, concerned that spending for research activities was not adequate and was in fact declining, Congress enacted a nonrefundable income tax credit for incremental R&D expenses to overcome the reluctance of companies to bear the significant staffing and supply costs to conduct research programs in a trade or business.

The R&D tax credit is incremental in nature to encourage enlarged research efforts by companies that already may be engaged in some research activities. I.R.C. §41 was made a permanent provision of the Internal Revenue Code as part of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act).

R&D limitations

There is no double tax benefit, meaning that a taxpayer cannot both deduct research costs and claim a research credit for the same expenditure. Under I.R.C. §280C, a taxpayer must reduce the research expenditure deduction otherwise allowable by the amount of the research credit claimed.

If a taxpayer capitalizes rather than deducts research expenditures, and the research credit for the year exceeds the amount allowable as a deduction for qualified or basic research expenses, then the amount chargeable to the capital account for such expenses must be reduced by the amount of the excess.

However, taxpayers may elect to reduce their research credit instead of reducing their research expenditure deduction or capitalized amount.

What qualifies for the R&D tax credit?

To qualify for the section 41 R&D tax credit, a taxpayer must be engaged in “qualified research.” To be considered qualified research, R&D activities must meet a four-part test:

1. Section 174 test

Research activity expenditures must be eligible for a §174 deduction. Section 174 deductions are allowed for expenditures incurred in connection with the taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense.

2. Technological information test

The taxpayer must conduct qualifying research for the purpose of discovering information that is technological in nature, with the intent of applying that information in the development of a new or improved business component. However, the taxpayer isn’t required to succeed in developing a new or improved business component from the discovered information for it to be qualifying research.

A taxpayer may use existing technologies and scientific principles to satisfy this requirement; it’s not necessary that the research be undertaken to expand or refine the common knowledge within a field of science.

3. Process of experimentation test

Qualifying research activities must be part of a process of experimentation for a purpose relating to a new or improved function, performance, or reliability, with the intent that information to be discovered will be useful in the development of a new or improved business component. This experimentation process must be evaluative and generally should be capable of evaluating more than one alternative.

Research related to style, taste, cosmetic, or seasonal design factors is not qualified research.

4. Business component test

The tests for determining whether research is qualified research must be applied separately to each business component. If the tests for determining whether research activity is qualified research aren’t met at the level of the entire product, a “shrinking back” rule applies to the tests at the most significant subset of elements of the product or item for sale, lease, or license. This rule continues until either:

• A subset of the product satisfies the tests, or
• The most basic element of the product is reached, and it fails to satisfy the tests

What are eligible R&D expenses?

The IRS defines qualified research expenses (QREs) “as the sum of in-house research expenses and contract research expenses”. In-house research expenses include the costs of:

• Employee wages for qualified services performed by such employee
• Supplies used to conduct qualified research
• Computers used to conduct qualified research

What is the 80% rule for R&D credit?

The IRS notes that if “substantially all” – that is, at least 80% – of the services performed by an employee fit the criteria of qualified research, then all of the employee’s annual wages are eligible as QREs.

But employers must take care to identify workers whose wages are claimed as QREs. The IRS notes that when auditing the research credit, “payroll records, employee job descriptions, performance evaluations, calendars and appointment books are good sources of information.”

And counting up qualified hours worked is what matters most when preparing to take this credit. The agency cautions that “determinations as to whether an employee is (or is not) engaged in qualified services, should not be based solely on job descriptions or titles” and that “eligibility is based solely upon what an employee actually does, or does not, do during a specific time period.”

What does not qualify as R&D?

The IRS provides a brief description of activities for which the section 41 R&D tax credit is not allowed. These include but are not limited to:

• Any research conducted after the beginning of commercial production of the business component
• Any research related to the adaptation of an existing business component
• Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information
• Efficiency surveys, routine data collection, or ordinary testing for quality control
• Research conducted outside the United States
• Research supported by any grant, contract, or otherwise by another person or governmental entity

Who is eligible for the section 41 R&D tax credit?

Tax professionals should refer to I.R.C. §174 when determining who or what qualifies for R&D tax credit.

According to advisory firm Cherry Bekaert, research and development tax deductions had once been associated only with businesses working in fields such as biotechnology and pharmacology. However, the firm notes that recent U.S. Department of Treasury regulations have “substantially broadened the range of taxpayers” eligible for the R&D tax credit.

Case law suggests that a taxpayer may establish that research expenditures were made in connection with a trade or business by showing a nontax profit motive and active involvement demonstrated by substantial and regular involvement in the activity. A good faith intention to make a profit is required, but the expectation of profit need not be reasonable.

Courts have held that expenditures of startup enterprises are deductible where the taxpayer demonstrates a realistic prospect of entering a trade or business involving technology. To this end, an objective intent to enter a trade or business and the capability to do so must be shown.