Automotive R&D Tax Credit Benefits for Businesses

Automotive and the R&D Tax Credit

Small businesses in the automotive sector can significantly benefit from the Research and Development (R&D) Tax Credit, reducing their federal tax liability and increasing cash flow. This applies to activities such as developing new vehicle components, improving manufacturing processes for efficiency or sustainability, enhancing safety features, or even creating advanced vehicle software. Fundamentally, the R&D tax credit payroll offset for startups allows eligible businesses to apply up to $500,000 of their R&D credit directly against their annual payroll taxes. This is a game-changer for pre-revenue or non-profitable startups, providing immediate financial relief by reducing FICA tax obligations, which can then be reinvested into further innovation, hiring, or expansion.

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Founded in 1984 by J.W. Norris as Reed & Co., Swanson Reed has grown to become one of the largest firms in the world specializing in Research and Development (R&D) tax credit consulting. We boast numerous publications. Our AI software, TaxTrex, is a cutting-edge AI language model capable of preparing R&D tax credit claims in just 90 minutes. Our audit insurance policy for R&D credits, creditARMOR, is one of the most cost-effective audit management products on the market.

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Case Study: Automotive Sector

Business Scenario

Raceway Engineering (Raceway) is an automotive company specializing in building sprint car engines for off-road speedways.

To remain at the top of the market, Raceway constantly conducts R&D activities to assist in the creation of innovative ideas and products. Raceway decided to create a new modified version of its super V8 engine to be used in its first futuristic car. The new engine would be based on the company’s previous engine, with upgrades and improvements.

Raceway launched an R&D project with the following hypothesis:

“The super V8 engine can be improved in terms of performance and fuel economy, while complying with safety regulations and outperforming competitor engines.”

Raceway needed to determine the eligibility of its proposed R&D activities to know if they qualified for the Research and Experimentation Tax Credit. To be eligible, Raceway had to be certain that its “qualified research” met four main criteria, known and developed by Congress as the Four-Part Test. After a self-assessment, Raceway decided to record four R&D activities.

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Raceway’s Eligible R&D Activities

Design and development of a series of prototypes to achieve technical objectives and prove the hypothesis (design of the super V8 engine modifications).

The hypothesis for this activity stated that it was feasible to design an improved and highly functional super V8 engine that could outperform its competitors.

To attempt to prove the hypothesis, Raceway designed and redesigned multiple methods and engine parts during this phase.

Testing and data analysis to obtain reproducible results to a satisfactory standard (prototype development and testing of the super V8 engine).

Raceway’s hypothesis stated that the theoretical conclusions of the design phase could be realized through comprehensive and valid testing.

Raceway tested the engine in a workshop environment and in the field to verify functionality, efficiency, precision, and safety.

Background research to assess current knowledge gaps and determine feasibility (background research for V8 engine modification).

Raceway conducted the following experiments during its research phase:

Literature research and review, including maintaining awareness of evolving legislation in different states and zones
Consultation with industry professionals and potential clients to determine the level of interest and commercial feasibility of such a project
Preliminary review of equipment and resources regarding capacity, performance, and suitability for the project
Consultation with key experts to determine the factors they considered important in the design and to gain an understanding of how the design needed to be structured accordingly

Ongoing analysis of customer or user feedback to improve prototype design (feedback-based R&D for V8 engine modifications).

Raceway’s eligible R&D work during this experimentation phase included:

Continuous analysis and testing to improve the efficiency and safety of the project.
Continuous development and modification to interpret experimental results and draw conclusions serving as a starting point for the development of new hypotheses.
Commercial analysis and functionality review.

These activities were considered “qualified research” because they were necessary to evaluate the performance capabilities of the new project in the field and to improve any design flaws.

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An overview of R&D Tax Credits
Identifying Qualifying Research Activities
Defining the 4-Part Test
How to substantiate activities through documentation
Identifying Qualifying Research Expenses

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Knowledge Level: Basic*

R&D Tax Credit Training for the Automotive Industry

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Definition of Qualified Research

Qualified research consists of research activities aimed at developing new or improved business components. A business component is defined as any product, process, technique, invention, formula, or software that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer’s trade or business.

The Four-Part Test

Activities eligible for the R&D Credit are described in the “Four-Part Test,” which must be met for the activity to qualify as R&D.

Permitted Purpose: The purpose of the activity or project must be to create new (or improve existing) functionality, performance, reliability, or quality of a business component.
Elimination of Uncertainty: The taxpayer must intend to discover information that eliminates uncertainty regarding the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability for development or improvement, the method of development or improvement, or the appropriateness of the design of the business component.
Process of Experimentation: The taxpayer must undertake a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or method to achieve that result, or the appropriate design of that result, is uncertain at the beginning of the taxpayer’s research activities.
Technological Nature: The process of experimentation used to discover information must rely fundamentally on principles of the hard sciences such as physical or biological sciences, chemistry, engineering, or computer science.

What specific records and documentation did Raceway keep?

As with any tax credit or deduction, Raceway had to keep business records outlining its R&D activities, including experimental activities and documents to demonstrate that the work was conducted systematically. Raceway retained the following documentation:

Literature review
Meeting notes
Sketches/drawings
Photos
Screenshots
Test protocols
Test results and analysis
Customer feedback
Field test results

By having these records on file, Raceway confirmed it was “compliance ready” — meaning that, in the event of an IRS audit, it could present documentation showing the progression of its R&D work.