Understanding the Substantially All Rule for R&D Tax Credits

The research and development (R&D) tax credit is one of the most valuable tools businesses can use to incentivize innovation, offset tax liabilities, and stimulate growth. However, the R&D tax credit comes with specific rules and criteria. And one of the most misunderstood is the Substantially All rule, also known as the 80% rule.

This rule plays a pivotal role in determining what qualifies as research expenses for the credit, and it extends beyond just wages. Businesses often focus on the wage portion, which states that if an employee spends at least 80% of their time on qualified R&D activities, their entire wage can be considered a qualifying research expense. However, the application of the 80% rule goes much deeper, impacting not only wages but also business components and how they qualify under the R&D credit’s four-part test from the IRS.

With the recent changes to Form 6765 and increased IRS scrutiny, it’s more important than ever for businesses to understand the many layers of the Substantially All rule to maximize their R&D tax credit claims without running afoul of tax regulations.

The Importance of the Substantially All Rule

At its core, the Substantially All rule ensures the majority of an expense or activity is directed toward qualified research expenses and R&D efforts. This rule applies primarily in two key areas:

• Wages of employees involved in research and development activities.
• Business components, which must substantially consist of qualified R&D work to be eligible for the credit.

While the wage application of the rule is more widely understood, the application to business components is just as critical. Failing to adhere to this rule could result in overstating credits or missing out on potential benefits.

Wages: The 80% Rule for Qualified Employees

The most commonly known application of the Substantially All rule is related to wages. Under this rule, if an employee spends 80% or more of their time performing qualified R&D activities, the business can take 100% of that employee’s wages as a qualified research expense (QRE) for R&D credit purposes.

Let’s say an engineer at a manufacturing company spends 85% of their time working on developing a new production process, which qualifies under the four-part test. This means 100% of that engineer’s salary can be considered for the R&D tax credit, even though they aren’t working exclusively on R&D.

This is a significant benefit because tracking the exact hours spent on R&D versus non-R&D work can be a challenge for businesses. The 80% rule allows companies to claim the full wage if the majority of the employee’s time is spent on qualifying activities.

Misunderstandings Around the 80% Rule:

Many companies misunderstand or misapply the 80% rule by assuming that the rule applies to all employees involved in any aspect of R&D. In reality, only the wages of employees who spend 80% or more of their time on qualified R&D activities are eligible to be claimed in full. For employees spending less than 80% of their time on R&D, only the actual time spent on qualifying activities can be counted.

Additionally, while this rule applies to direct wages, businesses should also track qualifying expenditures for supplies and contract research expenses (which do not follow the 80% rule).

Business Components: Substantially All Must Qualify for R&D

The Substantially All rule is not limited to wages; it also applies to business components. A business component is any product, process, software, technique, formula or invention that a business is developing or improving. To qualify for the R&D tax credit, the business component must substantially constitute qualified research and activities.

This means that substantially all (i.e., at least 80%) of the qualified research activities related to that business component must meet the four-part test for R&D eligibility:

1. Permitted Purpose: The research must be intended to create a new or improved product, process, software, or invention. The improvement must relate to functionality, performance, reliability or quality.
2. Elimination of Uncertainty: The research must aim to eliminate uncertainty regarding the development or improvement of the product or process. This uncertainty could be related to capability, methodology or design.
3. Technological in Nature: The activities must rely on principles of hard sciences such as engineering, physics, chemistry, biology or computer science.
4. Process of Experimentation: The research must involve a process of experimentation—testing different alternatives to eliminate uncertainties and find solutions.

If less than 80% of the activities for a business component qualify under these four criteria, the entire business component could be disqualified from the R&D credit. Thus, businesses must ensure that most of the work associated with a business component meets the R&D eligibility criteria.

For instance, a software company develops a new application feature. If 85% of the development work meets the four-part test, the business can claim the full costs associated with developing that feature for the R&D credit. If only 50% of the work qualifies, the company may not be able to claim the full costs related to that business component.

The Shrink-Back Rule: Narrowing the Business Component

To further refine how business components qualify for the R&D tax credit, the IRS allows businesses to apply the shrink-back rule. This rule provides flexibility if a business component as a whole does not meet the Substantially All requirement.

If the overall business component does not qualify, the business can “shrink back” the component to a subset of activities or a smaller part that meets the qualifications. The idea is to focus on the portion of the project that involves true research and experimentation, even if the entire business component doesn’t qualify.

For example, a manufacturer is developing a new product, but only a specific feature of the product involves R&D (and the other parts are based on existing technology or standard processes). The company can shrink back the business component to focus on the R&D activities tied to that feature. This way, they can claim the R&D credit for the work related to the qualifying portion of the project.

The shrink-back rule is essential for businesses with complex projects, as it enables them to still claim credits even when the entire project or business component isn’t R&D-intensive.

Why the Substantially All Rule is More Important Than Ever: Changes to Form 6765

Starting in 2024, changes to Form 6765, which businesses use to calculate and claim the R&D tax credit, will place more emphasis on detailed reporting and compliance. These form changes will require businesses to break down their experimental expenditures in more granular detail. This makes it even more critical to understand and correctly apply the Substantially All rule.

With enhanced IRS scrutiny on R&D tax credit claims, particularly regarding wage and business component allocations, businesses must ensure that they meet the requirements of the 80% rule and properly document the research activities that qualify. Misunderstanding or misapplying the rule could lead to disallowed credits, penalties, and audits.

Ensuring Compliance and Maximizing the Credit: The Role of Documentation

Given the complexities of the Substantially All rule and the introduction of more stringent filing requirements, documentation is more important than ever. To ensure compliance and maximize the R&D tax credit, businesses should:

• Keep detailed time-tracking records for employees engaged in R&D to accurately determine if they meet the 80% threshold.
• Document each business component’s activities and assess whether 80% or more of the work qualifies under the four-part test.
• Utilize the shrink-back rule where applicable to focus on the parts of a project that involve research and experimentation.
• Prepare for increased IRS scrutiny by maintaining clear and organized records of all qualifying research activities, expenses, and how they relate to the business components.

Maximizing Your R&D Credit: Consult the Experts

Navigating the intricacies of the R&D tax credit, especially the Substantially All rule and the new filing requirements, can be daunting. Ensuring that your business qualifies for the credit, properly applies the 80% rule to wages and business components, and remains compliant with IRS regulations requires expertise and careful planning.

At James Moore & Co., our R&D tax credit expert, Lucia Valenzuela, and her R&D Tax Credit Services team specialize in guiding businesses through complex tax matters, including the application of the R&D tax credit. We offer tailored advice to help you maximize your research credit potential while ensuring compliance with the latest IRS regulations. Reach out to James Moore for personalized guidance on claiming and utilizing your R&D tax credits, and let us help you turn your innovations into tax savings—now and in the future!

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