How is the R&D tax credit calculated?

The R&D tax credit is for companies who file US taxes and perform research in the USA. But what is
research? And what does development have to do with it? And finally, how does this all fit on a form
6765, which is the IRS’s form for claiming the research credit?

The English word Research and the word Research, as used in the R&D Credit have two different
meanings. The word research is derived from the Middle French word “recherche”, which means “to go
about seeking”. In the US the word research can mean looking up a word on Google or in Funk and
Wagnalls dictionary. Or it can be seeking the proper amount of salt to add to a soup to make it ‘just
perfect’. But the word ‘research’ in the lexicon of the IRS means something different and much more
specific according to Research Study Online.

The IRS code defines research as an iterative process to solve an uncertainty. In the past the IRS’
uncertainty test required someone to ‘discover’ something in science which was not already known to
the industry. But in the past 10 years this uncertainty requirement was changed so that it now requires
the researcher doing the research to not have knowledge of the answer. As straightforward as this
sounds, there are many practitioners who are unaware of the implications of this change.

Another requirement is known, for short, as the ‘174 test’. The 174 test requires that the work being
done uses the principals of a hard science such as Biology, Chemistry, Engineering, Computer Science,
etc. In addition there are some types of work that are specifically not allowed by statute, such as
working involving taste or smell, work modifying an existing design for a specific customer, and others.
A third requirement is that the work is being done for a “permitted purpose”. This relates to changes to
a new or improved function or performance of a business component. The segmentation of your work
into valid business components is important and as of the last two years, is being heavily checked to
meet the Internal Revenue Code by IRS agents. A business component is the “thing” you lease, license,
or sell. It can also be the “thing” that you use internally. By “thing” we mean a product or a process that
your firm has developed in the US. Not China, India, or even Canada.

The final requirement is the process of experimentation. This is the actual iterative process. It can be
done by simulation, creation of a proof on concept, or even by trial and error. Trial and error is the most
common method used. It is a description of what the researchers did, what they changed in each trial,
and how they tested the result. The word “testing” can cause trouble since there are at least 24
different types of testing, some of which are qualified and some of which are not.

On the form 6765 the four types of costs that you need to accumulate are 1) wages 2) supplies 3)
contract research 4) shared computer services. Wages consist of the wages of researchers, employees
who support researchers, and managers who supervise those researchers. Supplies consist of items that
get exhausted during the research. It doesn’t include real assets or anything that can be capitalized.
Contract research is research performed by a third party that you have paid for and own the rights to. It
can also be the wages of 1099 employees or the wages paid to a third party for their consultant’s wages.

4) shared computer services is a historical aberration. In the past, mainframe computer were so
expensive that companies would rent time on one to run their own data. While this use of timesharing
on mainframes is no longer popular, there are new types of computer timesharing that may meet this requirement, if properly positioned. In all of these above examples there are many “twists and turns”,
that only an experienced R&D Specialist should be trusted to ‘bob and weave’ through.
Finally there are two types of calculations for the R&D credit; Regular Credit and Alternative Credit. The
main difference between the two of them is based on the calculation of the base years in one case and
the fixed base percentage in the other case. With the regular credit, the fixed base percentage is based
on previous research that was performed in the 1980s. If you didn’t do any research in the 1980’s your
are better off sticking to the Alternative Credit. It has a calculation of the base years based on the
Research Expenses from the 3 previous tax years.