Reverse Engineering vs. Evolutionary and Revolutionary Development

With the IRS placing more scrutiny on the R&D Tax Credit, it is important to be aware of common myths of the credit as well as areas of exposure when building a claim. To dispel some of these misconceptions and provide clear guidance for CPA firms and businesses that may qualify for the R&D Credit, read this week’s blog exploring the distinction between reverse engineering or duplication efforts vs. developmental projects that are evolutionary or revolutionary in nature.

A common mistake made when preparing R&D Tax Credit claims is the inclusion of projects that were primarily related to repairing a system or reverse engineering a product/system in order to create a duplication of that product. To qualify for the R&D Credit, projects and the research conducted needs to be revolutionary or evolutionary in nature for the company. This means that the research is developing something new or improved and furthering the knowledge and capabilities of the business. Developing a brand-new product or process totally new to the company would be revolutionary in nature while a project intended to add functionality or improve on an inefficiency would be evolutionary.

For instance, when a manufacturer analyzes a competitor’s business component to determine how it works in order to reproduce it, the company is furthering its knowledge but not generating any new development. However, a distinction can be made between the reverse engineering of a component and the subsequent development of a new manufacturing process. The initial portion of the project spent examining and reverse engineering the specifications and characteristics of a component would not be qualified activity. However, as the project proceeds to the stage of developing a new manufacturing process to machine or fabricate the component, a new business component is being developed and could therefore potentially be qualified research.

Similarly, if a customer requests a specialty contractor to repair or rehabilitate an existing system to its original condition, there is no “discovery of new information”. Even if there is technical uncertainty and a process of experimentation conducted to repair the system, or design/engineering work to ensure it is meeting previously established standards, the project is still failing to meet the requirements of the R&D Credit. But if the work conducted goes beyond repair or rehabilitation and a functional improvement requiring new solutions is incorporated into the existing system, then there is potential for claiming a portion of the project as qualified research.

With all that said, another common misconception we encounter when discussing the R&D Credit with CPAs and taxpayers is that only work that is considered revolutionary or a significant breakthrough is qualified. While this type of work almost always qualifies, it is important to understand that many companies are conducting qualified R&D as a part of their standard operating procedures. An initial technical risk and economic risk assessment of the work being done can indicate if qualified research is regularly being conducted. As an example, evolutionary improvements such as newer versions of software applications with new features and efficiencies or an improved machining process to increase output or efficiency are potentially qualified R&D projects.

If you have any questions about the R&D Credit or McGuire Sponsel’s approach to R&D Credit claims, do not hesitate to reach out.