What is Qualified Research Activity?

The focus of any R&D tax credit study is qualified research activity. Identifying qualified research activity and connecting the associated expenses will allow a company to claim the tax credit. However, there are a lot of misconceptions about what qualifies for the R&D tax credit. These misconceptions stem from the association of the tax credit with the term “research and development.”

Section 41 of the Internal Revenue Code governs the R&D tax credit. Section (d) defines qualified research and articulates a four-part test to determine qualified research activities. The components of the four-part test are as follows: new or improved business component, elimination of uncertainty, process of experimentation, and technological in nature.

Taking each piece of the four-part test gives insight as to how activities qualify for the R&D tax credit. For the first part of the test, a business must be creating a new or improved product, process, formula, invention, software, or technique. For example, this could be constructing a new building, inventing a software application, improving the production process for the manufacturing of a product, or the creation of design documentation.

The second part of the test ensures that the work being conducted is challenging. More specifically, according to the Internal Revenue Code, uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component. A few uncertainties that might present themselves in real-world situations are uncertainty as to the capability of a manufacturer to create a part within the specified tolerances, uncertainty as to the appropriate method of overcoming unsuitable soil conditions during construction, and the appropriate software design to meet qualify and volatility requirements.

The third, and often most critical part of the test is the process of experimentation. The process of experimentation answers the question – what method does a company use to overcome the uncertainties that arise over the course of a project. Typically, the process of experimentation may involve a systematic process of trial and error, evaluating alternative means and methods, or the use of computer modeling or simulation.

The last part of the test is the most easily satisfied. To satisfy the technological in nature requirement, the activity must fundamentally rely on the principles of the physical or biological sciences, engineering or computer science. Businesses in several different industries rely on the hard sciences every day without putting much thought into it, thus, they believe what they do is too ordinary to qualify for the tax credit. However, it is important to note that the taxpayer does not need to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in a particular field. Routine engineering and architecture work, for example, qualifies for the tax credit.

The approach any taxpayer takes to identify and substantiate qualified activity determines how lucrative the tax credit will be. It for this reason that businesses and their CPAs work with outside consultants that have the expertise to break down the Internal Revenue Code and determine qualified research.