Understanding the Four-Part Test: A Look Into Permitted Purpose

Jan 15, 2019 10:00:00 AM

permitted purpose

Whether your company is developing a new product to expand your offering, developing a new or improved part for your customer, or making changes to improve your production processes, you may be able to claim a significant portion of your investment by filing for the Research and Development (R&D) Tax Credit.

Although the R&D Tax Credit is often associated with the tech industry and startups, the manufacturing industry is the actually the largest beneficiary. That is because many of the activities performed by manufacturers pass the law's Four-Part Test.

Understanding the Four-Part Test

Since the credit was designed to incentivize innovation, there are very specific elements that determine what qualifies as research and development. Each activity must pass the credit's simple but important Four-Part Test:

  • Permitted Purpose
  • Technical Uncertainty
  • Process of Experimentation
  • Technological in Nature

Applying each element of the test to individual activities requires knowledge of your industry and an in-depth understanding of the ins-and-outs of the R&D Tax Credit, but this article will help explain the criteria of the first element: permitted purpose.

What is Permitted Purpose?

This element identifies whether activities conform to the purpose of the tax credit, which is to incentivize the development of new or improved products or processes. To comply, the activity must be intended to yield improvements to functionality, performance, reliability, or efficiencies such as reduced cost. In other words, the activity must add significant value, not just changes to the appearance.

Developing a new product for yourself or a part for your customer is a common example, but other improvements can be more subtle. For instance, improving a process or reorganizing the shop floor to make manufacturing more efficient may qualify.  If you re-tool your machinery to manufacture a different size item or incorporate a different material, that may also qualify.  

What Comes Next?

If an activity passes all four elements of the test, the expenses incurred while conducting those activities qualify for the R&D Tax Credit. Qualified expenses include employee salaries, supplies, computer leasing, and research that has been contracted. Other qualified expenses can include management and supervision of employees who perform the qualified activities.

Keep in mind that record-keeping is important to ensure the activities and expenses can be reported properly. Document your meetings, presentations, and discussions involved in product or process development and improvement, starting as early as the sales process — and throughout development, testing, and production — so your R&D tax expert can properly attribute and calculate the expenses that qualify.

Watch our 4-minute video on how we saved one client enough to buy a huge piece  of game-changing machinery with the R&D Tax Credit