Guide to IRC Section 41: The Research Credit
Many businesses assume they will not qualify for the research credit, or that the rules are too narrow to apply to their activities. IRC Section 41 provides the statutory framework for the credit for increasing research activities, but eligibility depends on meeting specific legal and regulatory requirements. This guide summarizes the core statutory rules and selected regulatory definitions relevant to determining whether research activities and expenses may qualify.
The Core Definition: What Is “Qualified Research”?
Under IRC Section 41(d)(1), research must satisfy four requirements, often called the Four-Part Test, in order to constitute qualified research.
The Four-Part Test
1. Section 174A Test
Research with respect to which expenditures are treated as domestic research or experimental expenditures under Section 174A.
2. Technological in Nature Test
Research undertaken for the purpose of discovering information that is technological in nature.
3. Business Component Test
Research intended to be useful in the development of a new or improved business component of the taxpayer.
4. Process of Experimentation Test
Research in which substantially all of the activities constitute elements of a process of experimentation for a qualified purpose.
Definition of Business Component
IRC Section 41(d)(2)(B) defines a business component as: Any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.
2. Qualified Purposes vs. Non-Qualified Purposes
Under IRC Section 41(d)(3), research must relate to a qualified purpose. Qualified purposes include improving a business component:
• Function
• Performance
• Reliability
• Quality
Research does not satisfy this requirement if it relates only to:
• Style
• Taste
• Cosmetic design
• Seasonal design factors
3. Qualified Research Expenses (QREs)
Under IRC Section 41(b), “qualified research expenses” means the sum of:
• In-house research expenses, and
• Contract research expenses paid or incurred during the taxable year in carrying on a trade or business.
Breakdown of In-House Research Expenses
IRC Section 41(b)(2) provides that in-house research expenses include:
• Wages: Wages paid or incurred to an employee for qualified services performed by that employee.
• Supplies: Amounts paid or incurred for supplies used in the conduct of qualified research. “Supplies” means tangible property other than land or improvements to land, and property subject to depreciation.
• Computer use: Amounts paid or incurred to another person for the right to use computers in the conduct of qualified research, as provided under Treasury regulations.
What Are “Qualified Services”?
Under IRC Section 41(b)(2)(B), qualified services means:
1. Engaging in qualified research, or
2. Engaging in the direct supervision or direct support of research activities that constitute qualified research.
The “Substantially All” Rule
If substantially all of the services performed by an individual during the taxable year consist of qualified services, then all of the services performed by that individual are treated as qualified services. Treasury regulations generally interpret “substantially all” in this context to mean at least 80 percent of the employee’s services, measured by wages.
4. Statutory Exclusions: What Does Not Qualify?
IRC Section 41(d)(4) excludes the following activities from qualified research:
• Research after commercial production: Research conducted after the beginning of commercial production of the business component.
• Adaptation: Adapting an existing business component to a particular customer’s requirement or need.
• Duplication: Reproducing an existing business component from physical examination, plans, blueprints, specifications, or publicly available information.
• Surveys and Studies: Efficiency surveys, management function or technique studies, market research, market testing, routine data collection, or ordinary testing or inspection for quality control.
• Internal-Use Software: Software developed primarily for the taxpayer’s internal use, except to the extent provided by statute and regulations.
• Foreign Research: Research conducted outside the United States, Puerto Rico, or any possession of the United States.
• Social Sciences, Arts, or Humanities: Research in these fields does not qualify.
• Funded Research: Research to the extent funded by another person, governmental entity, grant, or contract.
5. Definitions of “Wages” and “Supplies”
To calculate QREs accurately, the Code provides specific definitions for these categories.
• Wages (IRC Section 41(b)(2)(D)): Generally has the same meaning as wages under Section 3401(a). For self-employed individuals and certain owner-employees, it includes earned income. It does not include any amount taken into account for purposes of the Work Opportunity Credit under Section 51(a).
• Supplies (IRC Section 41(b)(2)(C)): Means tangible property other than land or improvements to land, and property of a character subject to the allowance for depreciation.
Conclusion
IRC Section 41 can be complex, and applying it correctly requires careful analysis of both the underlying activities and the associated expenses. Businesses seeking to claim the research credit should evaluate their facts against the statutory requirements, applicable Treasury regulations, and current administrative guidance, and should maintain documentation sufficient to support the credit position taken on a return.
RK Partners has tax attorneys, CPAs, and consultants who are focused solely on R&D tax credits. We are highly qualified and experienced in identifying qualifying activities and maximizing credits so that you can continue to grow your business and continue to innovate.
