Funded Research R&D Tax Credits: A Comprehensive Guide
Businesses are encouraged to invest in innovation through the unique incentive that is known as the research and development tax credit. It allows businesses to lower their tax obligations by claiming a tax credit for a percentage of their qualified research expenseys.
For companies that are interested in pursuing independent research projects, this can really help alleviate some of the financial burden and risk, but it can be a daunting process.
In this article, we will break down the information that you need to know about participating in funded research while trying to claim tax credits. The process makes a lot more sense when you understand the regulations, but it doesn’t mean that you have to face it alone! By consulting with a Certified Public Accountant, you can have all of your paperwork in order without the hassle of trying to figure it out yourself.
What is Funded Research?
Funded research, defined under the Internal Revenue Code 41(d)(4)(H), are qualified research expenses that receive financial support from external sources. These often include a governmental entity, university, or non-profit organization that provides crucial resources to advance scientific and technological development.
These grants play a significant role in research and development, which can impact the eligibility and availability of research and development tax credits.
On top of these grants, contracted research agreements also play a role in determining credit eligibility. These agreements specify the roles of both the funding of the research and the researchers, making sure that the rights and responsibilities of both parties are specifically outlined.
The nature of these agreements can impact eligibility for R&D tax credits, as they have an impact on the amount of risk assumed by the researchers.
Eligibility Criteria for the Funded Research R&D Tax Credit
Determining whether you are eligible for the funded research R&D tax credit means that you have to understand the specific criteria that can exclude certain research activities from qualifying for this incentive at all.
The Internal Revenue Code 41 outlines detailed specifications and a comprehensive framework for this status, including a two-part test that qualified research and expenses must pass:
The first part of the test examines whether the funding entity retains the rights to the research results. If the party providing the funding has the right to control the outcomes of the research, then the activity will be excluded from qualifying for the tax credit.
The second part of this test considers whether the researcher ultimately has the most financial risk for the project overall. If the researcher has a substantial loss if the research isn’t successful, it is a lot more likely to be able to qualify for a research credit.
Both parts of this test have a significant bearing on the eligibility of whether or not the reported research and development activities will be able to have credits that are added to your overall tax liability.
Financial Risk Test (Fairchild Industries v. United States)
The financial risk test, which played a key part in the case of Fairchild Industries v. United States, is one of the key elements of determining the eligibility of qualified research expenses for any tax credits to be able to weigh against your overall tax liability. This case specifically evaluates whether the researcher or the funding entity bears the financial burden of the project in situations where the research may be unsuccessful.
In Fairchild Industries, the court determines whether payments to the researcher were dependent on a favorable outcome of the research for the vendor.
It was found that if the researcher only receives payment upon achieving specific research goals or milestones, it indicates that the financial burden lies with the researcher, which would qualify for a research credit. This is because the researcher assumes a lot of financial risk by making payments contingent on the production of something the company finds useful.
This means that the cost of failed research can cause financial harm to the researcher. If the researcher ultimately bears the cost of the research expenses associated with their unsuccessful efforts, it would meet the financial risk section of eligibility.
Substantial Rights Test (Lockheed Martin v. United States)
The second test for eligibility was investigated in Lockheed Martin v. United States, in which the court analyzed whether the researcher would maintain control of intellectual property and research outcomes after payment by a funding entity.
This influences the qualification for the tax credit through the amount of financial risk and payoff that is dedicated to the funding entity.
The difference between shared rights and exclusive rights further clarifies this test, as when rights to the research outcomes are shared between the funding entity and the researcher, it indicates that there is a collaborative effort where both parties benefit from the results.
However, if the funding entity holds exclusive rights, the research is typically excluded from the tax credit, even if the research expenses would normally qualify.
Royalty payments make the issue even more complex. Suppose the researcher receives royalty payments from the funding entity for the use of research. In that case, it demonstrates that the researcher has a level of control and ongoing interest in intellectual property. This would mean the researcher has substantial rights, giving them a case for tax credit eligibility.
Qualifying Research Expenditures
This research credit is available for any qualified research expenses, encouraging researchers to be able to pursue and continue ownership regardless of the financial risk of pursuing it. These costs are divided into three distinct categories that you can claim: wages that are paid to essential research staff, supplies for the sole purpose of research, and contracted research expenses.
Wages
Wages generally account for a large amount of eligible research expenses. This category includes salary, wages, and other types of pay that is provided to employees directly involved in research activities. To qualify for this category, wages must be directly paid to personnel who do research, directly supervise research, or assist with research initiatives.
Supplies
Supplies used throughout the research process are also considered to be eligible research expenses. These include tangible property, such as lab property, such as lab materials, prototypes, and other necessary objects. This doesn’t include land and depreciable assets such as cars or buildings. This expense must be directly related to research activities and incurred during the experimental phase.
Contracted Research
Contract research expenses include payments made to third-party contractors who conduct research on behalf of the person applying for the tax credit. These costs may include fees paid to a governmental entity, a university, or an independent contractor. Using contracted research makes sense for firms that are looking to have access to specialized expertise and resources that may not be available internally.
Funding Agreements for R&D Tax Credit Eligibility
The first stage in determining whether you’ll be eligible for a tax credit for research performed is a thorough review of all relevant contracts, grants, and funding agreements.
This should center on understanding the scope, financial risk, and expectations established by the funding organization and the beneficiary. Examining the test in these contracts is critical to discovering any clauses that may influence eligibility for tax benefits.
It is important to carefully consider risk distribution and the parties’ rights to the agreement. If the researcher assumes the financial risk and keeps the rights of the research, they will have the eligibility to apply for the credit, while the study may not be eligible if the funding organization is found to have taken on a majority of the risk.
If you’re ever unsure about where most of the financial risk lies, contacting a Certified Public Accountant or someone who specializes in financial law is a good idea. They will help you determine eligibility while also giving you more insight into what the application process will look like.
Calculating the Funded Research R&D Tax Credit
Identifying qualified research expenses for financed research projects that fall within wages, supplies, or contracted research will give you the important information that you need to begin to claim your research tax credit.
All of the expenses considered have to be directly related to a project that falls under the specifications of Internal Revenue Code 41(d).
The next stage is to then divide these costs across your sponsored and unfunded research projects. This means that you have to make a distinction between the research initiatives that receive funding from outside sources and those that don’t.
The portion of costs associated with unfunded or eligible funded research activities may be deducted. If you aren’t sure, you can ask a certified professional to remain in compliance with tax laws.
Specific pro-rate allocation rules are outlined in Treasury Regulation 1.41-4A(d)(3)(ii). According to this regulation, costs must be distributed pro rata, according to the degree of their usage in eligible research. For example, only 60% of the cost of an item of equipment can be claimed if it is utilized for research only 60% of the time.
According to Treasury Regulation 1.41-4A(d)(5), timing is a crucial consideration in deciding the funding status of research operations. Specifically, funding decisions for research must be made at the time that costs-related resources are spent. This means that the eligibility of expenses for this tax credit is not affected retroactively if money is obtained after the expenses have already been incurred.
Maintaining Funded Research Activities Documentation
Maintaining contemporaneous is imperative to keep comprehensive records in order to validate your research efforts and prove the expenses that you want to apply this research credit to. Contracts, project descriptions, research activity reports, and employee time are some important paperwork components you will need to keep updated.
Records made at the same time as the research activities and expenses take place are considered contemporaneous documentation. This is a popular way to guarantee precision and dependability in monitoring. Maintaining current documentation helps prevent inconsistencies and upholds research tax credit eligibility accuracy.
The transfer of significant rights and financial risk between the funding organization and the researcher should be demonstrated in the documentation. This will be one of the largest obstacles if not properly documented.
Next Steps
A certified public accountant from TaxCredits.com can help you make the most out of your research credit needs. For company owners and individuals interested in pursuing research projects, having a research and development tax credit can provide significant financial relief from your overall tax burden.
Together, we can help you effectively manage your tax credit documentation and application so that you can help your own small business or company realize substantial financial savings in taxable years. Don’t pass up on saving more money; book a consultation with one of our CPAs today!
FAQs
Is funding research tax deductible?
Research money may qualify for tax deductions; however, the details will vary depending on the type of financing and the relationship between the funding entity and the researcher. Direct research expenses that a business incurs for its own research operations are typically tax-deductible.
These payments may not qualify in the instance where a company gives grants or subsidies to another organization for research without keeping an ownership stake. Expenses for contract research may also be deducted, provided that the company maintains ownership and assumes all financial risk.
What is the R&E tax credit for research and experimentation?
The federal tax credit known as the Research and Experimentation credit is meant to incentivize companies to invest in technological innovation and advancement. This credit was created in 1981 and offers a dollar-for-dollar tax obligation reduction for qualified research expenses.
How should expenses be allocated between funded and non-funded research activities?
It is essential to divide costs between sponsored and unfunded research in order to qualify for the research and development tax credit. Expenses should first be classified as funded or non-funded. Then, you should directly assign costs, such as labor or supplies, that can be linked to certain projects.
If there is an expense that is mixed, use pro rata allocation, which is the percentage of time and resources allocated to each activity.
How do SBIR and STTR grants affect R&D tax credit eligibility?
The eligibility of research and development tax credits may be affected by SBIR and STTR funding due to the shift in financial risk and significant rights. Generally speaking, costs covered by these grants are not eligible for the credit, however, extra costs that are incurred on top of grant financing may be.