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The Research and Development (“R&D”) Tax Credit is a federal incentive for companies conducting qualified research activities and is codified by Section 41 of the Internal Revenue Code (“IRC”). IRC §41(d) sets forth the four-part test that must be satisfied in order for a company’s research activities to qualify for the credit. However, if all four parts of the test are not met at the business component level, a company’s activities may still qualify for the credit by way of the shrink back rule. The R&D shrink back rule allows a company to apply the IRC §41(d) test to a smaller subset of the business component. If you have any questions for our experts, schedule a call!
Practical Example (A):
Let’s say there is a scooter company that is working on developing an improved electric scooter that better meets customer demand. The company is looking to create a scooter that is faster, more lightweight, with a more descriptive display screen, and longer lasting battery power. The company is interested in seeing if its research activities done for the development of the new scooter qualify for the R&D credit.
Perhaps when the four-part test is applied to the discrete business component, the whole scooter, it cannot be said that substantially all of the activities constitute elements of a process of experimentation. In this case, the company may still qualify to claim the R&D credit on a smaller level. To figure this out, the company would apply the four-part test to smaller components of the scooter, like the scooter’s body, the battery pack, or the computer software used on the display screen.
Practical Example (B):
Another situation where the shrink back rule might be applied is where a scooter company has a bestselling model scooter but wants to automate its manufacturing process and make some minor changes to the design. The research activities conducted on the scooter itself might not meet the substantially all portion of the four-part test, but we could use the shrink back rule to look at the manufacturing process individually and claim the credit for the efforts in developing that.
Understanding the Shrink Back Rule:
Before further discussion of the shrink back rule’s application, we should revisit the criteria for qualified research set forth by IRC Section 41(d). Qualification for the R&D credit relies on the satisfaction of a four-part test:
1.) The Section 174 Test – The company has demonstrated that the information being discovered is for the purpose of developing a new or improved business component.
2.) The Discovering Technological Information Test – The R&D activity seeks to discover information that is technological in nature.
3.) The Business Component Test – The R&D activity seeks to discover information that is necessary to eliminate uncertainty concerning the development or improvement of a business component with respect to the capability, method, or appropriate design of the business component.
4.) The Process of Experimentation Test – Substantially, all of the activities constitute elements of a process of experimentation for a permitted purpose.
The four-part test must first be applied at the level of the discrete business component, which is the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license or used by the taxpayer in its trade or business. In some cases, analysis at the discrete business component level does not fully satisfy part four of the test – meaning, less than substantially all of the activities constitute a process of experimentation. Under the substantially all rule, if at least 80 percent of the activities performed by an employee constitute qualified services, then all activities performed by the employee with respect to the newly designated business component will be treated as qualified services.
If this is the case, the credit may still be available with respect to the next most significant subset of elements of the business component. Drawing from Practical Example (A), the next most significant subset of elements would be things like the scooter’s body, the battery pack, or the computer software used for the display screen. In Practical Example (B), the subset of elements would be the steps in the manufacturing process. In effect, we would be “shrinking back” the project to its smaller components in order to qualify the company for the credit.
Application of the Shrink Back Rule:
In a situation where initial analysis of the business component fails to fully meet the criteria of the four-part test, application of the shrink back rule first requires confirmation that qualified research expenses indeed were incurred with respect to the overall business component.
Shrinking back continues until either one or more subsets of the business component elements satisfy the four-part test or the most basic element fails to satisfy the test in its entirety. If the most basic elements of the business component fail to satisfy the requirements, then the taxpayer has not performed qualified research.
As with analysis of the highest-level business component, analysis on sub-components through the shrink back rule requires that certain documentation should be kept on hand that the taxpayer would be able to provide should a claim be placed under review by the relevant tax authorities. There is no silver bullet of records that will universally satisfy a review. However, the taxpayer should keep contemporaneous books and records to support why the company qualifies for the R&D credit at the sub-component level. Some examples of the records that should be kept by the taxpayer include general information about the research activities like names of employees, job titles, job descriptions, and dates of employment.
Other information that helps illustrate a company’s appropriation of its resources or details of research projects includes materials explaining research activities such as email correspondences, submissions to management regarding the research projects, investor or management slide decks reporting on the progress of development and alternatives considered, minutes or notes from meetings, and invoices or R&D specific account transaction reports for supplies or contracted work.
Looking back at both Practical Examples, if the companies’ books and records lumped together all costs of the development of the scooters and the companies were denied the R&D credit at the top business component levels, it would be extremely difficult to determine expenses at the subcomponent levels. Instead, the companies should strive to keep contemporaneous records for the sub-components of the scooters in order to successfully defend an R&D credit claim based upon the shrink back rule.
Final Takeaways
Ultimately, the purpose of the shrink back rule is to give taxpayers, whose research activities did not pass the four-part test at the highest business component level, another opportunity to claim the R&D credit for qualified research activities at a secondary level. Implementing the shrink back rule can make an R&D claim easier to defend and justify, making it a valuable tool in R&D credit determination. If a taxpayer is dubious about a business component qualifying for the credit, the shrink back rule’s potential applicability should be considered. Have more questions about the R&D Tax Credit? Here’s everything you need to know.
