As the 2022 year comes to a close, let us take a moment and reflect, rest, and assess. The past few years have been undeniably difficult for businesses to navigate. From the COVID-19 pandemic to current inflationary pressures, operating a business has been no easy feat. Fortunately, as the old adage goes, “necessity is the mother of invention.” 

Over the course of the past few years, KC & Associates has witnessed countless companies undergo digital transformations, improve internal processes, and expand product offerings, in addition to identifying ways to ultimately improve cash flow. While these companies engage in innovative efforts, the Federal and New Mexico research and development (“R&D”) tax credit serves a key method to recover expenses and reduce tax liability.

The Federal R&D credit, also known as, “Credit for Increasing Research Activities”[1]provides an avenue for businesses across multiple industries to receive significant benefits. Such a benefit permits taxpayers to claim a general business credit for engaging in qualifying activities. Fortunately, eligibility for such a credit is quite expansive—such that the interpretation of what one thinks would constitute traditional “R&D” regularly surprises taxpayers and accountants alike.

Originally, eligibility for such a credit claim was limited to companies that engaged in activities that advanced the applicable industry. Regulatory changes in 2003 explicitly modified eligibility to incentivize businesses to undertake activities that are new to the company engaging in them. However, such activities must still undergo a systemic process of experimentation to develop and ultimately achieve. 

The Federal credit can generate up to 20% of an eligible taxpayer’s qualifying research expenses by utilizing historical averages either through gross receipts or the company’s prior three years of qualifying research expenditures. Moreover, eligible startup companies in their first five years can utilize the credit to offset payroll taxes—as such companies generally operate at a loss during the early stages of relevant business activity. 

To qualify for the credit, taxpayers need to demonstrate four elements: 

1. The activities relate to the development of a new or improved product, process, formula, invention, software, or technique (referred to as a new or improved “business component”);

2. The activities must be undertaken for the purpose of discovering information intended to eliminate uncertainty relating to the following:

• Capability for developing or improving the business component;
• Method for developing or improving the business component; or
• The appropriate design of the business component.

3. The taxpayer utilized a process of experimentation such as systematic trial and error, simulation, or other evaluative processes to assess alternatives intended to eliminate the uncertainty; and

4. The process of experimentation fundamentally relied on principles of physical science, biological science, engineering, or computer science.

Through the demonstration of the above four elements, taxpayers can claim potential qualifying expenses across numerous categories of costs, such as:

· Employee wages;

· Outside contractor costs; 

· Supply/raw material costs; and

· Cloud hosting costs.

While the above information is applicable to the Federal R&D credit, numerous State sponsored R&D programs exist and utilize a similar framework. However, several State programs contain nuances—but nonetheless can be simultaneously calculated alongside a taxpayers Federal R&D claim. 

In the State of New Mexico, for example, New Mexico businesses must generally demonstrate the same activities under the Federal credit. However, New Mexico provides a far more expansive list of eligible expenditures, including:

· Depletable land and rent paid or incurred for land Improvements

· Allowable amounts paid or incurred to operate or maintain a facility

· Buildings

· Equipment

· Computer software

· Computer software upgrades

· Consultants and contractors performing work in New Mexico

· Payroll

· Technical books

Further, New Mexico taxpayers are permitted to claim an additional credit should the businesses be operating in an area classified as “Rural.” Such a classification permits an additional 10 percent in potential credit claims. 

It is important to note that the Federal R&D credit contains numerous exclusions, sophisticated calculation methods, and proper substantiation. Moreover, State specific programs contain nuances and carve outs that must be properly considered and evaluated. 

KC & Associates contains State experts in addition to licensed attorneys to review and evaluate methodologies are conducted in accordance with legislative guidelines. 

Contact us today for your free evaluation! 

[1] See Internal Revenue Code Section 41.