"Qualified research activities" in plain English

From talking with other CPAs and business owners, it seems pretty clear that even after all the years that the research credit has been around, the types of activities that qualify for the credit are still not widely recognized.

For the record, it does not necessarily require teams of scientists in lab coats, rows of Bunsen burners, and electron microscopes. In fact, it can involve something as seemingly simple as trying to create a nontoxic coating for the inside of a pizza box that minimizes leakage during delivery! Hardly what many people would consider high tech research, but often research nonetheless for purposes of IRC section 41.

Given that common misunderstanding, and in the interest of providing a relatively simple explanation to clients (and prospects) when discussing the research credit, I wrote a memorandum for that very purpose, which I'd like to share here as well.

So, without further ado, I've reproduced it below. (Caveat: I ask that you read it as a general guide and not as a definitive treatise on the subject. It is meant strictly as a starting point for discussion, and by design does not address every possible issue...not even close.)  If you're interested in seeing whether your business might qualify, drop me a note at my email address under "About Me."

(p.s. - While the federal credit did expire for expenditures after 12/31/09, it appears likely to be reinstated.  In addition, California's research credit is permanent, as may be other states.)

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For purposes of the credit, qualified research activities means those which satisfy the following criteria:

• The activity is experimental or laboratory in nature,
• For the purpose of discovering information,
• Which is technological in nature,
• The application of which is intended to be useful in the development of a new or improved business component, 
• Substantially all of the activities of which constitute elements of a process of experimentation, relating to
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.

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• An activity that qualifies as research and development (R&D) is one that is experimental or laboratory in nature. This term generally includes all activities incident to the development or improvement of a product.
• Activities represent R&D in the experimental or laboratory sense if they are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.
• Uncertainty exists if the information available to the company at the outset does not establish either the capability or the particular method for developing or improving the product or the appropriate design of the product.
• note: It is unnecessary that there be uncertainty as to whether the component or improvement can be designed at all; rather, there need only be uncertainty with respect to the best method of design necessary to achieve the desired result.
• Whether activities qualify as R&D depends on the nature of the activity to which the efforts relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.
• An activity which is for the purpose of discovering information,
• Which is technological in nature,
• This test depends on whether the process of experimentation (see below for definition) utilized in the research fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
• Research does not rely on the principles of computer science merely because a computer is involved. However, research is considered to be undertaken to discover information which is technological in nature if such information expands or refines existing principles of computer science. The development or improvement of computer software can, in some cases, be considered an activity which is technological in nature.
• The application of which is intended to be useful in the development of a new or improved business component. A business component is any product, process, computer software, technique, formula, or invention which is:
• To be held for sale, lease or license, or
• Used by the taxpayer in the trade or business of the company.
• Also included in the definition of a business component are certain production processes such as any plant process, machinery, or technique for commercial production of a business component.
• Each business component must be evaluated separately to see if its R&D qualifies under the applicable rules. Thus, any plant process, machinery, or technique for commercial production of a business component is treated as a separate business component (and not as part of the business component being produced).
• If all aspects of the requirement of new or improved function, performance, or reliability or quality (mentioned below) are not met with respect to a business component, but are met with respect to one or more elements thereof, the term “business component” means the most significant set of elements of such product, etc. with respect to which all aspects of the requirement are met.
• The requirement of “new or improved function,” etc. is applied first at the level of the entire business component to be offered for sale, etc. by the taxpayer. If all aspects of that requirement are not met at that level, the test applies at the most significant subset of elements of the business component. This "shrinking back" of the product is to continue until either a subset of elements of the product that satisfies the requirement is reached, or the most basic element of the product is reached and such element fails to satisfy the test.
• Substantially all of the activities constitute elements of a process of experimentation, relating to:
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.
• “Process of experimentation” means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the outset. This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.
• Qualified research does not include the following:
• Any research conducted after the beginning of commercial production of the business component.
• Any research related to the adaptation of an existing business component to a particular customer's requirement or need.
• Work which is related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys and studies of the following nature: efficiency surveys, management studies, market research, testing, or development (including advertising or promotions), routine data collection, or routine or ordinary testing or inspection for quality control.
• Testing or inspection to determine whether particular units of materials or products conform to specified parameters is quality control testing. However, quality control testing does not include testing to determine if the design of the product is appropriate.
• Any research conducted outside the United States.
• Research in the social sciences, arts, or humanities.
• Funded research.
• Activities relating to style, taste, cosmetic, or seasonal design factors.
• If an employee has performed both qualified services and nonqualified services, only the amount of time allocated to the performance of qualified services is treated as research.
• If substantially all of the services performed by an individual consist of R&D services, then all of that individual's time can be considered as R&D. The term “substantially all” is defined as 80% or more of the time spent by an individual on R&D activities.
• Direct supervision and direct support of qualified activities may also constitute qualified R&D under the following circumstances:
• Direct supervision means the immediate supervision (first-line management) of qualified research (as in the case of a scientist who directly supervises research, but who may not actually perform research). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.
• Direct support includes the services which directly assist either those engaging in actual qualified R&D or those who are directly supervising those engaged in qualified R&D. Examples include the services of a secretary typing reports describing research results and a clerk for compiling research data. Direct support of research activities does not include general administrative services or other services only indirectly of benefit to research activities. For example, services of payroll personnel in preparing salary checks of scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters do not qualify as direct support of research. This is true whether general administrative personnel are part of the research department or in a separate department.
• Activities related to the development of computer software for the taxpayer's own internal use (e.g., for payroll, bookkeeping, or personnel management functions) are generally not considered qualified R&D. However, under forthcoming regulations, the development of internal-use computer software may be treated as qualified R&D only if it can established that, in addition to satisfying the general requirements for R&D treatment:
• That the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant);
• Note that the proposed regulations provide a slightly modified standard than the legislative history in that the software “is innovative in that the software is intended to be unique or novel and is intended to differ in a significant and inventive way from prior software implementations or methods”.
• That the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and
• That the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated).