Written by Alex Bray
As one of the most taxpayer beneficial credits available at the federal and state levels, the Research and Development (R&D) Credit encourages domestic innovation by rewarding taxpayers for their investment in “qualified business activities.”
The term “qualified business activity” may be defined, and oversimplified for this context, as business expenses associated with the creation of new products, processes, or ideas through conventional and/or unconventional R&D.
Anecdotally, they are the expenses that move the needle of domestic innovation, creating new ideas, or expanding upon existing ideas.
For a taxpayer’s expenses from R&D activity qualified to be eligible to receive the Credit, those expenses must meet all the requirements of the Credit’s infamous 4 part test.
Despite its semi-menacing moniker, conjuring thoughts of late-night cramming and test anxiety, the 4-part test is an extremely useful tool for taxpayers.
The test not only justifies the expenses included in the taxpayer’s existing Credit calculation but also ensures all qualified business activities are accounted for going forward, thus maximizing the credit benefit recognized.
If you’re really looking for a deep dive, the R&D Credit 4-part test is codified in IRC Section 41(d) and supplemented in Treasury Regulation Section 1.41-4. Case law requiring the methodical use of the 4-part test is found in Suder v. C.I.R., (T.C. Memo 2014-201), while contrasting case law outlining a taxpayer’s failure to use the 4-part test methodically is found in Siemer Milling Co. v. C.I.R., (T.C. Memo 2019-37).
Requirements of the 4 Part Test
The requirements of the 4-part test used to determine whether a business expense is deemed qualified for purposes of the Credit include the following:
Qualified Business Component
The expense must be associated with the creation or improvement of a product, process, formula, computer program, software, technique, or invention.
This is a seemingly low barrier to taxpayer credit benefit recognition. So long as the business expenses are associated with the creation of a new product or process or the improvement of an existing product or process, the first requirement is satisfied. Essentially, an R&D project may be evolutionary as well as revolutionary.
Developments that relate to updating or renovating a product or process via style, aesthetic, cosmetic, or seasonal changes do not qualify. The creation or improvements must rise to a level of innovation, not merely updating a product’s color scheme.
Technological in Nature
The expense must fundamentally rely on the principles of a hard science, including but not limited to engineering, physics, biology, chemistry, or computer sciences.
This is another low barrier to taxpayer credit benefit recognition. So long as the activities associated with the business expense involve the use of the “hard” sciences, the second requirement is satisfied.
Hard sciences include a wide array of engineering specialties (mechanical, design, computer, chemical, structural, etc.), as well as traditional science fields like chemistry, physics, mathematics, geology, hydrology, and biology.
The use or methodology of the hard sciences does not need to be new per se, as the taxpayer may rely on existing technology and tools associated with the hard science.
For instance, a taxpayer does not need to create a new mathematical algorithm to satisfy this requirement as they may rely upon an existing mathematical algorithm to improve their product or process.
Although highly esteemed by this author and many others, professional expertise in the fields of the soft sciences like law, accounting, psychology, business management, and the like do not rise to the level necessary to satisfy this requirement.
Eliminate Technical Uncertainty
The expense must be incurred to discover information that eliminates technical uncertainty at the onset of the project.
Our first genuine barrier to taxpayer credit benefit recognition… but you are already past the halfway point, so do not stop now. There must be technical uncertainty at the beginning of the R&D project. While this “technical uncertainty” may initially seem difficult to articulate, so long as there is an “unknown” in between the taxpayer and the desired result of the R&D project, this requirement is satisfied.
For instance, potential “unknowns” may include, but are not limited to, what is the design of the desired result, can the desired result even be accomplished, or what process would be necessary to accomplish the desired result, each of which are qualified technical uncertainties. The associated business expenses then must be incurred by the taxpayer with the intent to gather data, evidence, or information that will eliminate these or other potential technical uncertainties.
Process of Experimentation
The experimentation process needs to include the testing of hypothesis and the evaluation of alternatives. An acceptable process includes systematic trial and error, prototype creation and testing, computer-aided modeling, and simulation to resolve the technical uncertainty.
Alone, the final requirement may seem like a difficult barrier to credit benefit recognition, but in concert with the previous Technical Uncertainty requirement, this requirement is perfectly manageable.
This requirement is satisfied by articulating the process used by the taxpayer to eliminate the aforementioned Technical Uncertainty. Once the uncertainty was identified, the process that ensued to eliminate that uncertainty, to go around, go through, go over, go under, or scrap the investment altogether, is the taxpayer’s Process of Experimentation.
Using the basic principles of the scientific method (evaluating the hypothesis, considering alternatives, testing, modifying the hypothesis based on test results, etc.), the taxpayer can articulate the process or processes used to overcome the Technical Uncertainty and thus satisfy the final 4-part test requirement.
Congratulations! You have completed an overview of the R&D Credit’s required 4-part test. In addition to the cornucopia of new “life of the cocktail party discussion topic” level of information you’ve just learned, also keep in mind that a taxpayer’s successful completion of the 4-part test does not need to be exclusively associated with successful R&D projects.
Even business expenses related to epic R&D failures that still satisfy the requirements of the 4-part test are deemed qualified and thus eligible for credit benefit recognition.
There’s no risk in exploring your options and many qualify for R&D Tax Credits without even knowing it. Click below to learn more about studies that are both sustainable and seriously simple.