The credit was enacted in 1981 and has been extended multiple times. In order to be eligible for it, a four-part test is applied to a company’s activities and expenses. The four-part test consists of the following issues:
• The purpose of the research and development activity is to create a new or improved project, process, computer software, techniques or formulas that would serve the general business purpose of the company.
• The activity must be technological in nature. For example, there must be some engineering or computer science involved in the construction process.
• There must be a level of uncertainty in the product or process development when the research is undertaken.
• The costs are directly attributable to a process of experimentation (i.e., trial and error, prototypes and testing), and there is no assurance of success.
In the construction industry, the R&D credit opportunity can exist when a contractor utilizes internal use software (software developed or acquired to meet a contractor’s internal needs with no intention to market the software). Three additional tests apply to internal-use software in order to qualify for the R&D credit:
• Innovative. The software is intended to be “unique or novel” and must differ in a significant way from previous software implementations.
• Significant economic risk. Substantial resources must be committed to the development, and there is a technical risk involved.
• Not commercially available. Substantial modifications must be made to any software purchased.
Expenses that are included in the R&D credit calculation include wages, outside contractors and certain supplies. A simplified credit generally allows a taxpayer to use the average qualifying expenses over the preceding three years as the basis of the credit. The credit is generally 14% of the excess qualified expenditures over 50% of the average qualified expenditures for the previous three tax years. In general, any unused credits can be carried back one year and forwarded for up to 20 years.
Toby Ellison is a senior tax manager based in CB&H’s Richmond office and focuses his practice on serving the tax needs of real estate entities, closely held businesses and individuals. E-mail: firstname.lastname@example.org.