Published July 2004

New IRS rules clear some hurdles for R&E tax credit

By Tom Sanger
Guest Editorial

With Boeing’s commitment to build the 7E7 in Washington state, tax incentives have been a hot topic. A tax incentive that is not contingent on the development of the 7E7 and is available to all industries is the federal Research and Experimentation (R&E) tax credit.

With pressure from Congress and taxpayers to more clearly define what is considered research and development, the IRS issued final regulations in January. These regulations are taxpayer friendly and have reduced some of the hurdles and uncertainties that were in place in previous years. As these regulations are retroactive to prior years, many taxpayers are evaluating their prior-year activities and amending their tax returns to obtain significant R&E tax credits.

The IRS defines R&E through a four-part test. The four tests that need to be met include:

• Uncertainty Test: In order to qualify for the credit, uncertainty must exist at the beginning of the project. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or the appropriate design of the product or process. Taxpayers claiming the credit may be certain that they can develop a new product, but uncertainty may exist as to the appropriate method or design for the product.
• Process of Experimentation Test: A taxpayer must be able to demonstrate that a process is undertaken to evaluate the one or more alternatives to eliminate the uncertainty and to achieve the desired result. For many taxpayers, trial-and-error is the main testing mechanism to eliminate uncertainty and qualifies as the process of experimentation.
• Technological in Nature: Resolution of the uncertainties must rely on the principles of the physical, biological, engineering or computer sciences. Companies do not necessarily have to have degreed engineers or scientists on staff, but the process must rely on those sciences.
• Business Component: Research is undertaken for a qualified purpose if it relates to a new or improved function, performance, reliability or quality of the product or process.

Local aerospace companies and other manufacturing clients have been investing in new products and processes and have been qualifying for the R&E tax credits for many years. Some recent examples of research and experimentation relate to developing bulletproof cockpit doors, overhead storage bins, lavatories, components for the 7E7 and the development of various parts or processes.

While the focus of the above discussion is the federal R&E tax credit, many states, including Washington, provide credit against state taxes with similar qualification requirements. Taxpayers developing new product lines, prototypes, one-of-a-kind machines, or experimenting with different materials should talk with an R&E specialist to determine the amount of federal and state research credits available to the company.

Companies with as little as $5 million in revenues may be eligible to obtain $75,000 or more in tax credits. Unfortunately, only a small fraction of companies carrying out R&E are taking advantage of the federal and state tax credits due to a lack of knowledge of the credit and the complexity of the qualification rules and documentation requirements.

Tom Sanger is head of the Research and Development Group for Moss Adams LLP. He can be reached at 425-303-3190 or send e-mail to tom.sanger@mossadams.com.

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