The Internet of Things (IoT), which connects physical devices to the digital world, is a hotbed for innovation. From smart factories to connected medical devices, IoT companies are constantly pushing the boundaries of technology. For businesses investing heavily in this complex development, the US R&D Tax Credit (also known as the Research and Development Tax Credit or the Research Credit) offers a powerful incentive to recoup a portion of those IoT expenses.
The R&D Tax Credit encourages companies to invest in domestic research and development. IoT companies, with their inherent focus on developing new and improved products and processes, are often prime candidates for this valuable tax savings.
Four-Part Test: The Gateway to IoT R&D Eligibility
To qualify for the R&D tax credit, an IoT company’s activities must satisfy a strict four-part test established by the Internal Revenue Service (IRS). It is not the project itself that must be innovative, but the activities conducted to achieve the project’s goal.
- Permitted Purpose (Business Component Test): The activity must be intended to develop a new or improved function, performance, reliability, or quality for an IoTrelated business component. This includes custom hardware (sensors, chips),embedded firmware, cloud-based data platforms, or proprietary algorithms used to process IoT data.
- Technological in Nature: The research must rely on the principles of computer science or engineering. For IoT, this typically involves applying principles of electrical engineering, data science, network communication protocols, or software architecture design.
- Elimination of Uncertainty: The activity must be conducted to resolve a technical uncertainty about the capability, methodology, or appropriate design of the IoT component. This means the technical solution, its reliability, or the best way to integrate disparate systems was not known or easily determined by a competent professional at the outset
- Process of Experimentation: The company must engage in a systematic process to resolve the technical uncertainty. This involves activities like prototyping, modeling, simulating, testing, and systematic trial-and-error (e.g., rigorous performance testing of a new communication protocol, or A/B testing different machine learning models for sensor data interpretation).
Examples of Qualifying IoT Activities
The key is to focus on activities that involve technical uncertainty and a process of experimentation. Routine setup, maintenance, or simple configurations of existing technology generally do not qualify.
- Custom Software/Firmware Development: Designing, programming, and testing proprietary operating systems, embedded firmware, or specialized application programming interfaces (APIs) to enable unique device functionality, data collection, or inter-connectivity.
- Hardware and Sensor Development: Researching and prototyping new sensor arrays, microchips, or low-power communication methods that require technical experimentation to achieve a specific performance goal (e.g., battery life, range, data throughput).
- Data and Analytics: Developing proprietary algorithms for real-time data processing, predictive maintenance, or complex machine learning models that interpret data from connected devices to provide new insights.
Eligible R&D Expenditures
Once you identify qualifying activities, a company can claim a credit for Qualified Research Expenses (QREs). The main QRE categories for most IoT companies include:
- Wages: The portion of salaries paid to employees who directly perform, directly supervise, or directly support qualified research activities (e.g., engineers, developers, QA testers).
- Supplies: Costs of tangible property used or consumed in the research process, such as prototyping materials, electronic components, or energy used in testing labs.
- Contract Research: 65% of the amount paid to qualified, unrelated U.S. contractors or consultants to perform qualified research on behalf of the company.
- Cloud Computing: Costs for leased computer time used in qualified research, which can include expenses related to cloud hosting for development, testing, and modeling.
Any company integrating or experimenting with IoT technology to achieve technological advancement can qualify for the R&D Tax Credit, regardless of whether IoT is their primary business.
Rather, it extends to any company that is integrating and experimenting with the technology to achieve technological advancement in its operations.
For instance, a manufacturing company that develops and installs custom sensors on its machinery to collect data and build a proprietary predictive maintenance algorithm aimed at increasing machine lifespan and efficiency is conducting qualifying R&D.
Similarly, a company that provides commercial water heating and cooling systems can claim the credit for developing a custom cloud-based monitoring platform that uses embedded sensors to remotely supervise and optimize water temperatures, energy consumption, and pressure. Thus eliminating technical uncertainty about system performance.
If your company is using IoT to make any product, process, or software better, faster, or more reliable, those innovative activities are highly likely to qualify.
Contact our team at Leyton to help you identify all qualifying activities in your IoT business.
