This is one of two articles about how companies may benefit from the R&D tax credit.
There are clear benefits to automation and analytics, but the cost of implementation can be substantial to develop these tools from scratch. Whether starting off small to manage budget, or standing up a full transformation team the R&D tax credit offers one option for managing some of these costs and increasing your ROI.
The R&D tax credit is a direct offset against federal income tax and equals approximately 7-10% of qualified research expenditure. Originally passed in 1981, this tax credit has been popular with software development companies, research groups, and other lab coat-wearing enterprises. However, the expansion of the low-code solutions and Robotic Process Automation (RPA) have dramatically increased the availability of this credit across many different types of organizations.
Qualified research and development activities must be performed in the United States and must meet the following four-part test:
- Permitted Purpose – The purpose of the research or development at the onset of the activity must be to create new or improved function, reliability, quality, and/or performance in a business component. A business component is considered any product, process, computer software, technique, formula or invention.
- Technological in Nature – The activity performed must fundamentally rely on the principles of a hard science (including mathematics and computer science) and must not be cosmetic in nature. Companies are not required to exceed, expand or refine existing scientific principles.
- Elimination of Uncertainty – The activity must be intended to discover information to eliminate uncertainty about the development or improvement of a business component. Uncertainty exists if the information available at the onset of the project leads to unknown methodology and undetermined design to meet the project goals for improving or developing the business component.
- Process of Experimentation – The taxpayer must engage in an evaluative process, through modeling, simulation, or systematic trial-and-error methodology that is capable of identifying and evaluating one or more alternatives to achieve the development goals.
Software developed for internal use must additionally meet the 3-prong test for a high-threshold-of-innovation. The IRS regulations define internal use software as software developed for use in the taxpayer’s general and administrative functions, such as financial management, human resource management and support services functions. The 3-prong test for internal use software (IUS) includes the following:
- Software is intended to be innovative as measured by a reduction of cost, improvement in speed, or other measurable improvement that is substantial. The software need only have the potential to result in such improvements, if successfully developed. For example, building an app to allow a distributed fleet workforce to validate work, generate invoices, and use machine learning to notify the performance staff of potential cross-sell opportunities could qualify.
- The software development has significant economic risk in that the taxpayer commits substantial resources to the development and there is uncertainty due to technical risk as to whether the resources can be recovered.
- The software is not commercially available and cannot be purchased, leased, licensed or used for the intended purpose without modifications that would satisfy the above requirements.
The following types of internal-use software are NOT required to satisfy the high-threshold-of innovation test: (1) software for use in an activity that constitutes qualified research (2) software for use in a production process; or (3)software that is an integral part of a new or improved hardware and software package developed together by the taxpayer as a single product used in providing services in its trade or business. It is important to note that software marketed to unrelated third parties or review data using the taxpayers systems is not internal use software.
This credit lines up with the general use case of RPA and automation! Such projects as building a forecast model for commodities trading for your organization’s hedging strategy that compiles external indicators, identifying supply chain bottlenecks before they affect manufacturing, or projecting accruals based on a model of historical activity could all be recognized under the R&D tax credit. With a structured assessment process, we can identify projects that would qualify so that we can capture the related allowable costs for tax purposes.
Qualified research expenditures include the following for the calculation of the R&D Tax Credit:
- Wages paid to employees working on the project. This includes those individuals supporting or supervising someone who directly participates in R&D activities.
- Supplies used and consumed in the development process
- 65% of third party research expenses incurred regardless of project success (this includes contract labor). Third party contractors face additional review to verify that the taxpayer maintains non-exclusive IP rights and bears financial risk for development work performed.
Leveraging this credit can dramatically reduce the cost of many digital transformation projects, but to qualify, certain documentation must be included in the assessment process. We recommend incorporating the following in your key design documentation:
- Initial Opportunity Assessment – This document is typically generated after the ideation stage when opportunities are being evaluated to determine which will provide the highest and best benefit. To comply with requirements for the R&D tax credit, this should include:
- How does this opportunity improve our existing business component?
- Is the anticipated product an adaptation of an existing automation?
- What is the intended benefit (e.g. hours saved, costs reduced)
- Is there an existing software that performs this function generally available on the market?
Design Documentation – This document is created after determining that a specific ‘bot or automation should be developed. The documentation should include:
- The expected processing path and potential alternative processing paths if the first does not succeed; and
- Automations that include machine learning models or similar functions that require training and tuning, maintain a changelog of each model version correlation to ideal state and the new tuning parameters applied.
While this list gives you some insight into documentation required to qualify for the tax credit, the key to successfully claiming the R&D tax credit is having proper documentation to support your credit claim and having the right team to help analyze the projects performed. Weaver can assist with identifying and compiling the appropriate documentation to maximize benefits from this tax credit.
For more information about how to qualify for the R&D tax credit, or to explore the digital transformation and automation process for your organization or contact us. We are here to help.