Congress established the IRC §41 Research and Experimentation Tax Credit to reward companies for incurring expenses in the development of new and improved products and processes.  The goal of the credit is to supplant the inherent flaws with the governmental reward systems such as the patent system:

Patent Flaw 1
Exclusive rights are given to the first to develop a technology which disregards the development activities of other companies.

IRC §41 Solution 1
The R&D Tax Credit has been established to reward not only the first entity to develop a technology, but subsequent development performed independently by other entities.    

Patent Flaw 2
Expensive patent application and patent defense processes.

IRC §41 Solution 2
This is a monetary reward that is directly reflected on the company’s bottom line.          

Patent Flaw 3
Ignores the influence of development failures that lead to successful product development.

IRC §41 Solution 3
The credit rewards development efforts regardless of failure or success.

Four-Part Test

Congress established a four-part test that defines qualified research activities associated with new and improved product and process development to exclude routine engineering.

Technological in Nature
Activities must be based on a hard science such as the physical, biological, chemical and computer sciences. The activity cannot be based on the soft sciences which include psychology, social sciences, humanities or arts.

Technological Uncertainty
Designs related to the development activities must have inherent risks or uncertainties associated with their potential for success.

Process of Experimentation
A process of experimentation is the direct result of risk or uncertainty associated with a design. This test requires that a process of theoretical and physical evaluation that can result in the development of several design alternatives.

Permitted Purpose
The goal of the activity must be to improve the fit, form, or function of a product or process. This does not include development related to aesthetic changes or technology that does not build on a company’s knowledge base.

Eligible Expenses

Expenses related to research activities that qualify for the credit include wages, supplies and contract research expenses.

Wages
Taxable wages related to the conduct of qualified research and experimentation are includable as a research expense. The wages are quantified by establishing a percentage of an employee’s time engaged in the direct conduct or direct supervision of qualified research. An employee’s qualified research percentage can be substantiated by means other than a time tracking system.

Supplies
Non-depreciable materials used to test product designs are includable as a research expense. Includable materials are supplies used in design testing procedures, prototype builds and performance evaluations.

Contract Research
Sixty-five percent (65%) of vendor expenses related to design and testing services are includable as long as the company bears the financial risk and maintains the intellectual rights to the resulting information.