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 Adaptation Exclusion and how to maximize a sustainable R&D Credit claim.
A commonly misunderstood exclusion of the R&D Credit is the Adaptation Exclusion described in §41(d)(4)(B). Misapplying the exclusion can lead to R&D claims inappropriately including non-qualifying projects or conversely not including all qualified projects due to an overly conservative application of the rules. Due to the intricacy, this exclusion has been an area of increased federal and state scrutiny and also given some taxpayers and CPAs pause for pursuing claims.
The Adaptation Exclusion is defined by §1.41-4(c)(3) as “activities relating to adapting an existing business component to a particular customer’s requirement or need are not qualified research”. While the regulation further clarifies that the exclusion does not apply just because a project is intended for a particular customer, understanding the correct application is vital to preparing a defendable R&D Credit claim.
The key items to examine when determining whether the Adaptation Exclusion applies to customer-driven projects are the technical uncertainty contained within the project and the process of experimentation conducted to resolve the uncertainty. Good indicators of projects that are not merely “adaptations” of existing business components include new or improved features, functionalities, performance specifications, or quality enhancements. To qualify the project, it is imperative that the “Technical Uncertainty” component of the four-part test is clearly identifiable. Additionally, being able to showcase the Technical Risk, that there is a risk of failure of the development objectives, will further accentuate the qualifications of the project.
Should a customer-specific project possess these elements or present other unique challenges that require a process of experimentation, that project will likely overcome the Adaptation Exclusion. While a process of experimentation can take many forms, a positive sign that adequate experimentation occurred is multiple iterations of a design or multiple rounds of testing taking place. The process of experimentation must rely upon the scientific method to evaluate one or more alternatives to resolve the uncertainty. This should showcase that there was sufficient technical uncertainty and a comprehensive process of experimentation for a business component to elevate above the Adaptation Exclusion.
If the level of technical uncertainty in the customer-specific project does not rise to the level where experimentation is required to eliminate it, then the project would be subject to the adaptation exclusion. Examples of non-qualified adaptations and modifications include adjusted layouts or sizing, utilizing different materials that the company regularly works with, changes for aesthetic or stylistic purposes, and customization or configuration of features already developed by the business.
Recall that just because a project is intended for a specific customer, it does not mean that the adaptation exclusion automatically applies. However, this exclusion must be considered for all customer-specific projects to ensure a proper R&D Credit claim is prepared. Beginning with a technical risk assessment is an efficient method to identify which projects may qualify. While the adaptation exclusion is one of many considerations to make when evaluating a potential R&D Credit claim, correct interpretation is a key point for building a defendable claim that appropriately maximizes the taxpayer’s credit while limiting exposure.
If you have any questions about the R&D Tax Credit qualifications or McGuire Sponsel’s approach to R&D claims, do not hesitate to reach out.