The research and experimentation credit: new rules make it easier for businesses to qualify.

For the past 20 years, a research and experimentation (R&E) credit has been part of the tax law. Unfortunately, because of its complexity, many businesses (particularly smaller ones) have failed to take advantage of this credit. Recently issued proposed regulations should make it easier to qualify.

R&E CREDIT

In general, businesses can claim a credit for the amount of any qualified research that exceeds a base amount.

Expenses qualifying for the R&E credit include in-house expenses for wages, salaries and supplies (but not computer hardware), computer leasing or time-sharing costs and certain contract research. The costs must be incurred on preproduction research for a new or substantially improved business component in physical, biological, engineering or computer science. Costs incurred after a product is ready for commercial sale or use do not qualify. Costs incurred to duplicate or adapt an existing product, those related to style, taste, cosmetic or seasonal design factors and those related to research conducted in the social sciences also do not qualify.

QUALIFYING TESTS

A company must meet four tests to claim the R&E credit:

* Sec. 174 test. The costs must be trade or business expenses for experimental or laboratory research. These generally include all costs incident to a product's development or improvement.

* Business component test. The discovery must be intended for developing a new or improved business component.

* Discovery test. The purpose of the research must be to discover information that is technological in nature.

A taxpayer meets this test if the intent of its research efforts is to eliminate uncertainty in the development or improvement of a business component.

* Process-of-experimentation test. Substantially all (80% or more) of the research must be conducted through a process that evaluates one or more alternatives to a final result and which, at the outset, is uncertain as to the capability, method or appropriate design of achieving it.

A taxpayer is not engaged in a process of experimentation if the solution to the research is readily known at the outset. Likewise, the experimentation process does not include merely selecting among several alternatives if such alternatives are readily discernible and applicable at the beginning of the research efforts.

PLANNING

Businesses seeking to claim the R&E credit should consider taking certain steps:

* At the start of a research project, a business should write a statement of the problem, the desired goal and the preliminary alternatives to be used in achieving it. The company should indicate the uncertainty that exists as to which alternative (if any) will be successful. It should set up job-costing codes to use in tracking time and supply costs.

* As research proceeds, the business should describe each approach actually used and document any revisions, tests or rejections. As it develops new alternatives, the company also should document the initial uncertainty as to whether these will succeed. In addition, it should record information gained from the project, as well as any new product or improved functionality. The business should note the project completion point, as well as document the costs and research alternatives explored (and their outcomes) in sufficiently usable form and detail to substantiate the claimed expenses.

For a detailed discussion of the new R&E rules, see "R&E Prop. Regs. Ease Eligibility," by Debra Grace, in the March 2002 issue of The Tax Adviser.