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Monday, April 29, 2019

Take Another Look at the R&D Credit


For decades, the research and development (R&D) tax credit has been subject to expiration dates and last-minute extensions that made it hard to incorporate into long-term strategies. Then the Protecting Americans From Tax Hikes Act of 2015 made the credit a permanent part of the tax law. Now, many businesses are taking a second look at how this potentially valuable incentive could improve their tax positions.

Which Expenditures Qualify

Many qualified businesses leave potential credits on the table at tax time because they do not realize that their activities qualify. Supportable claims for the R&D credit are not limited to industries like pharmaceuticals and high tech. Any business can claim the R&D credit if it makes “qualified research expenditures,” as long as it can identify, allocate and document the costs attributable to any product or process improvement.

To qualify for the R&D credit, expenditures must relate to an activity that passes a four-part test:

  1. The activity must relate to a new or improved business component’s function, performance, reliability, quality or composition.
  2. The activity must fundamentally rely on principles of physical sciences, biological sciences, computer science or engineering.
  3. The activity must be intended to discover information that would eliminate uncertainty concerning the capability or method for developing or improving a product or process.
  4. The activity must constitute a process of experimentation, such as simulation or modeling.

One factor that’s noticeably absent from the four-part test is success. Your research does not have to produce a successful result to qualify for the credit. The credit is based on the amount of resources invested in experimentation with the intent of improving or expanding some aspect of the business.

The tax code does list several types of activities that are specifically excluded from the R&D credit. Some examples are:

  • Funded research (such as activities funded by a government grant)
  • Ordinary testing and inspection
  • Research activities conducted outside the U.S.
  • Reverse engineering (with a limited exception for engineering that involves an enhancement)
  • Adaptation of an existing business component to a particular customer’s need, such as customization of a computer program to meet one customer’s specific requirements
  • Research with a non-functional focus, such as improvements to style or taste, or cosmetic changes

How Eligibility Is Assessed

Eligibility for the R&D credit is assessed at the activity level, so documentation of hours worked and other resources invested is critical in a successful claim. Many businesses that qualify for the credit have a hard time substantiating and calculating their claims because the qualifying activity may include contributions of labor and resources from multiple departments. Businesses that plan to claim an R&D credit often set up specific project designations for each new research activity in order to properly document salaries and other costs.

How to Document an R&D Credit Claim

As with many documentation requirements facing businesses today, software can be the most effective tool for managing information related to an R&D credit claim. The problem is that most general ledger systems focus on feeding information into financial statements or tax returns. They often lack the flexibility to track costs attributed to specific qualified research activities (QRAs) and document the specific qualified research expenses (QREs) that a business is trying to claim.

Records and documents that support an effective claim for the R&D tax credit include:

  • Financial information, including employee wages attributable to QRAs.
  • Segregated records. For instance, supplies used for R&D purposes should be tracked separately from those used in the general course of business.
  • Work plans, committee meeting minutes and projected time allocations that demonstrate advance planning.
  • Design drawings and notes showing a variety of iterations. Documentation that shows how money was spent on failed development efforts is every bit as important as documentation of the successful iteration.

Documentation is most effective when it is prepared along with the activity. When employees update time-and-expense tracking software daily or weekly, the results carry much more weight with an examiner than a report prepared at year-end where participants look back and try to estimate how much of their time and resources were devoted to a particular project. Consider designating a key manager to monitor the updates in the tracking system to determine early if efforts are being over- or under-reported.

The IRS doesn’t give specific rules on what constitutes sufficient documentation, but guidance and rulings have shown a clear preference for records updated frequently throughout the year. The more detail you can provide and the more you can demonstrate a pattern of frequent updates, the more effective your R&D credit claim will be.

Don’t Leave Money on the Table

Many taxpayers have missed out on the chance to claim the R&D credit in the past because they assumed their business didn’t qualify, or that the costs of documenting expenditures exceeded the benefit of a credit that could disappear in six months.

With the credit now a permanent part of the tax code, businesses should consult a tax advisor to determine if their individual facts and circumstances warrant a claim for this money-saving incentive.

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