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New IRS Directive Provides R&D Tax Credit Audit Protection

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Authors: Don Warrant and Sam DiSalvo

The federal Research & Development (R&D) Tax Credit can mean tremendous tax savings for companies that fund research and development activities to create new or improved products or processes. Now, a new IRS Directive issued to its examiners aims to streamline the approach to determine the amount of qualified research expenses (QREs) for Large Business and International (LB&I) Taxpayers (i.e. assets equal to or greater than $10 Million).

The Directive applies to LB&I Taxpayers that have Certified Audited Financial Statements (CAFS) prepared in accordance with U.S. GAAP. The CAFS must show QREs calculated in accordance with ASC 730 as a separate line item on the income statement or as a separately stated note.

The Directive may involve some additional work in the first year to establish a framework and schedules to break out certain costs, but should facilitate claiming this valuable tax credit in future years. Under the Directive, IRS examiners are instructed to accept the amount of R&D tax credits claimed by LB&I Taxpayers (based on ASC 730 QREs as adjusted per the Directive) who choose to follow the procedures outlined in the Directive.

The Directive applies to original returns timely filed (including extensions) on or after September 11, 2017. It can also apply to years under an IRS audit if, at the start of the audit, the company indicates that it intends to follow the Directive.  

Get a copy of the new R&D Tax Credit Directive here.


Optional Methods for Claiming Research & Development Tax Credits

LB&I Taxpayers now have the option to have a traditional R&D tax credit study performed to support the tax credits claimed, or to follow the procedures outlined in the Directive which should provide IRS audit protection, but may reduce the amount of the tax credit claimed.

should you use financial statement auditThe Directive effectively provides a “safe harbor” methodology when claiming R&D tax credits. In addition, the LB&I Taxpayer may increase the amount of the R&D tax credit claimed by including additional QREs allowed under the IRC that are not included in the Directive.  These QREs are subject to IRS examination and therefore, this portion of the R&D tax credit claimed may constitute an uncertain tax position impacting the CAFS. A limited scope R&D tax credit study can be performed for any QREs that don’t fall under the safe harbor.

Given the optional methods to substantiate R&D tax credits, LB&I taxpayers should consider having a feasibility analysis performed by an R&D tax credit expert to compare the potential tax benefit and related costs under both methodologies.  In addition, LB&I Taxpayers may realize cost savings in time and effort to compile and substantiate QREs, particularly where the QRE identification process is time consuming or complex.

Eligible QREs under the Directive

The eligible QREs under the Directive focus on wages and supplies.  For instance, generally 95% of the taxable wages of “qualified individual contributors” and “first-level supervisors” (i.e., those with only one level of employees directly below them) whose wages are charged to R&D cost centers and expensed as ASC 730 R&D costs are included in the safe harbor under the Directive.

W-2 wage and supply expenses excluded from the Directive include costs incurred to perform R&D under third-party contracts and other agreements, patent costs, severance pay, and expenditures not otherwise allowed as QREs for income tax purposes such as efficiency surveys, wages used in computing the work opportunity credit, and foreign research.

LB&I Taxpayers who choose to follow the Directive will need to establish the organizational reporting levels and structure of employees whose costs are expensed as ASC 730 R&D costs, as well as identify appropriate financial information. This involves extracting, organizing and validating data needed to breakout the eligible ASC 730 R&D costs for use in calculating the R&D tax credit.  

LB&I Taxpayers who don’t currently disclose ASC 730 R&D costs in their CAFS may also might find it beneficial to identify, compute and report ASC 730 R&D costs.


Talk to the R&D Tax Credit Experts

Calculating your company’s adjusted ASC 730 R&D costs can be complex. If you’re an LB&I taxpayer with CAFSs and have QREs (even if you don’t currently claim R&D tax credits), you owe it to yourself to investigate whether this Directive identifies new QREs or can simplify the time and effort to compile and substantiate QREs.  This could provide the audit protection you desire and limit reporting the uncertain tax position in your CAFS.  

We can help.

Click here to schedule a 30-minute consultation regarding whether your company is eligible to claim R&D tax credits and the new Directive.

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3 Reasons That Small Businesses Overlook the R&D Tax Credit

Reasons-Small-Businesses-Overlook-the-R&D-Tax-Credit-LARGE-771845-edited.jpgThe R&D tax credit can deliver significant tax savings, but many small businesses don’t realize it’s available to them.

Yes, there is a tax credit available to all businesses, including small businesses, for R&D costs. The tax credit has been a part of the tax code in some form since the 1980’s, although for the vast majority of that time it was considered “temporary.” It had to be extended 16 times before being made permanent in the Protecting Americans from Tax Hikes (PATH) Act of 2015. Perhaps the on-again/off-again uncertainty of the tax credit’s availability has led to its underutilization by many of the businesses it was designed to help.  

Whatever the cause, so many eligible taxpayers are failing to claim the available small business R&D tax credit that some members of Congress have introduced legislation aimed at improving government efforts to educate small businesses on the topic. There are two bills currently in the Senate and House, S. 650 and H.R. 1543 that would require the IRS and the Small Business Administration to work in partnership to develop basic training sessions and related information relating to federal income tax credits, especially R&D tax credits that benefit small businesses and start-up companies.

Those efforts should focus on 3 main problems:  

  • Small businesses don’t know the R&D tax credit exists. In the early stages of a business, tax planning sometimes takes a back seat to tax preparation. Owners who prepare their own tax returns or rely on tax preparers with limited experience may fall into the trap of “doing it like last year” instead of analyzing each year’s income and expenses with a clean slate. A failure to recognize the availability of the R&D tax credit in one year can be compounded by repeating the mistake in future years.
  • Small businesses don’t think they have R&D expenses. Many taxpayers skim past the R&D tax credit because they assume it’s only available to companies “in the business” of research and development, like a pharmaceutical or technology corporation. In fact, the tax credit is based on the activity performed, not the industry of the taxpayer. Costs may qualify for the tax credit if the activity:
    • --Is designed to eliminate a technical uncertainty,
    • --Includes some process of experimentation,
    • --Is technological in nature, and
    • --Is intended to create a new or improved product or process.

Activities focused on improving or redesigning existing products, as well as designing new products, can qualify. Costs associated with creating or improving a manufacturing process or new software may be eligible. Recent IRS guidance even eased limitations on eligibility of R&D expenses related to the development of internal use software.

  • Small businesses don’t have an income tax liability against which to claim the tax credit. Until recently, this hurdle used to make many startups and small businesses ineligible for the tax credit at a time when they most needed support. As part of the PATH Act, Congress enacted provisions allowing certain qualifying startups and new small businesses to claim the tax credit against the employer’s share of Social Security taxes and to calculate the tax credit without regard to alternative minimum tax limitations. 

Now that the R&D tax credit is a permanent part of the tax code and its applicability to small businesses has been expanded, many businesses are taking the time to learn more about the tax credit and find out if they qualify. The calculation of tax credits and the election to claim them can be a complicated process. If you’re wondering whether your business (small or large) may be missing out on these R&D tax credit savings, please contact us at Freed Maxick.

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Freed Maxick CPAs, P.C. is Western and Upstate New York’s largest public accounting firm and a Top 100 firm in the United States. Freed Maxick’s reputation and experience with business and tax issues has made us a go-to firm for businesses and individuals from all over the U.S. and Canada and around the world.

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Give Yourself Some Extra Credit with the R&D Tax Credit for Start-Ups and Small Businesses

iStock-641194726-189064-edited.jpgR&D Tax Credit allowed to offset payroll taxes for qualifying small businesses and start-ups

It is estimated that more than 70% of eligible small businesses and start-up companies failed to claim start-up R&D tax credits and small business R&D tax credits to which they were entitled for the 2016 tax year resulting in overpayment of taxes. By failing to claim R&D tax credits to which they were entitled, they also failed to make a new election that was first available for the 2016 tax year, to apply the federal R&D tax credit against their federal payroll tax liability. 

The Protecting Americans from Tax Hikes Act (PATH Act) of 2015 created this new election allowing “qualified small businesses” to apply R&D tax credits generated beginning with the 2016 tax year, to their federal payroll tax liability instead of their federal income tax liability. Congress recognized that many small businesses and startups weren’t claiming R&D tax credits due to insufficient, or no federal income tax liability.  However, most startups and small businesses have payroll tax liabilities. Therefore, the PATH Act created a new election that was first available for the 2016 tax year, to allow a qualified small business claiming the federal R&D tax credit, to elect to apply the credit against their federal payroll tax liability instead of their federal income tax liability.

Many eligible small businesses and startups failed to claim the federal R&D tax credit for the 2016 tax year. Therefore, they were unable to make this election.  Fortunately, the IRS issued interim guidance in Notice 2017-23 allowing qualified small businesses to amend their 2016 tax returns by December 31, 2017, to claim the R&D tax credit which would then allow them to make this election.

To qualify to make this election, the following requirements must be met:

  • Be a qualified small business which is a business entity (excluding tax-exempt organizations) whose gross receipts for the current taxable year are less than $5 million and who did not have gross receipts for more than five taxable years, ending with the current taxable year. Gross receipts must be aggregated with related persons and among members of a controlled group of corporations.
  • Elect to apply R&D tax credits generated for the 2016 tax year against the employer’s portion of the social security tax.  The election does not affect the payroll tax deduction amount.  In the case of a pass-through entity, the election is made at the entity level.

The payroll tax credit is allowed for the first calendar quarter that begins after the filing date of the original or amended tax return that includes the election. The amount elected may not exceed the lesser of 1) the current year R&D tax credit generated, 2) $250,000, or 3) the amount of the R&D tax credit carryover or carryback to the taxable year. If the payroll tax credit exceeds the employer’s portion of social security tax for the calendar quarter, the excess is applied to succeeding calendar quarters.

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Freed Maxick CPAs, P.C. is one of Western and Upstate New York’s largest public accounting firms and a Top 100 firm in the United States. The start-up R&D tax credit and small busines R&D tax credit experts at Freed Maxick can assist you to determine if your business is eligible for R&D tax credits, whether your business or its owners could benefit from claiming R&D tax credits, and eligibility for the payroll tax election. Please contact us for assistance.  

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Four R&D Tax Credit Documentation Methods

ways to document r&d tax creditIf your company relies on the hard sciences or uses technology to create or improve products or processes, you may know that you can reduce federal taxes using the Research & Development (R&D) Tax Credit. You may not know the best methods to document your activities—a major factor in claiming the credit at all.

We previously discussed the importance of thorough documentation to support your claim for the R&D credit. Let’s take a look at documentation methods—the good and the bad.

Methods to Keep Records (From Best to Worst)

METHOD 1: Use time-and-expense (“T&E”) tracking software and track activities project by project.

Wages are usually the largest component of most R&D tax credit claims and the amount of time for each employee allocated to R&D activities is important to substantiate.

T&E software and project-by-project tracking will provide the most reliable information and will be contemporaneous (looked at favorably by the IRS).

Accurate tracking may be time-consuming for employees involved in R&D, but will help save time at year’s end. Set up codes for qualifying and non-qualifying activities and expenses within a project (that is, activities’ costs you can apply for and those activities’ costs you can’t apply for). For instance, if reverse engineering is part of a project, that time is not qualified and would be indicated as non-qualified.

You may be surprised how much of your wages for employees or expenses for outside consultants or supplies can qualify for the credit.

METHOD 2: Have individual employees keep a monthly or weekly summary of what they worked on.

These documents can be in diary form, in Word/Excel, or even in the notes on your iPhone. Accumulate the information periodically (quarterly, semi-annually or at least annually). This will also be contemporaneous documentation—but you might have to devote effort later to clarifying work time that does and doesn’t qualify for the R&D credit.

One of our clients, for example, keeps a monthly report for R&D tax credit records: one or two sentences or bullet points on their activities, such as “continuing developing the project parameters,” or, “purchased steel from vendor X.” The monthly synopsis clearly shows what that client does through the year that qualifies and doesn’t qualify for the R&D credit. Another client keeps a running Word document with details like “testing this month,” and, “evaluated alternatives after last month’s test results.” This client describes the activities in the document but doesn’t put down the time until later.

METHOD 3: Designate a manager, department leader, or other point of contact to accumulate others’ R&D qualified and non-qualified time.

Who you designate depends on the size of your company. In the office of one of our clients, a small start-up, the controller has each person fill out a brief Excel sheet weekly and then she accumulates the information and breaks it out into qualifying and non-qualifying activity. (The controller reaches out to me if she has questions if a project will qualify or not.) Another company designates one engineering manager who knows what his team is doing and he reaches out to other managers to accumulate what other teams are doing.

The risk here is the potential misinterpretation of information. Non-qualified activities could be designated as qualified and vice versa, as the point person may not know everything every staffer did.

METHOD 4: Backfill your year’s R&D activities once, annually.

This means going back into records of meetings, appointments, and potentially many other source documents.

This is the least-reliable method of documenting R&D activity, as well as the most time-intensive, as individuals need to look back on the past year’s activities. (Bear in mind that some key personnel on an R&D project might also leave the company during the course of a year.) You can also use interviews with personnel who are involved in your R&D activities during the year.

If employees are reluctant or slow to help, stress the importance of the R&D tax credit to the company’s bottom line.

Seek R&D Tax Credit Record-Keeping Help

Solid documentation must support your claim for the R&D tax credit. No single record-keeping method will work for everyone, and combining some of the methodologies above might work best for you.

Contact us if you have questions about determining a schedule for periodic checks of progress and documentation. We’ll work with you to help improve your record-keeping and maximize your ability to claim the R&D tax credit.

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Agricultural R&D Tax Credits: Which Activities Qualify?

agricultural-activities-qualify-r&dtaxcredit.jpgIf you handle finances and expenses for a commercial farm, you know how technology influences food production, from handling crops or livestock to shipping the product to market, especially with ever-evolving food sciences. As a financial professional of a large farm, you can also appreciate that there are business tax benefits available and you can understand the basics of some of those benefits.

What you may not know is how much the federal Research and Development (R&D) Tax Credit may be available to help lower your income tax bill.

What is the R&D Tax Credit?

The now-permanent R&D credit, enacted in 1981, allows taxpayers who use the hard sciences or technology to create or improve products or processes to save up to 13% of eligible spending on their taxes. Often large companies in the manufacturing, software, high-tech, and pharmaceutical industries claim the credit. Beginning last year, if you meet certain criteria the credit can also be used to offset Alternative Minimum Tax for certain small businesses and start-up businesses can utilize the credit against a portion of their quarterly payroll taxes.

Activities that qualify for the credit must meet the following four criteria: involve new or improved (aka “permitted”) products, processes, or software; be technological in nature; work toward elimination of uncertainty; and involve the process of experimentation.

Qualifying Agricultural R&D Tax Credit Activities

The agricultural industry frequently incurs costs for innovations that can qualify for the R&D credit. Technological advancements like robotics to increase yield or improve production efficiency, or technology to evaluate and test soil, are just a few activities performed by farms and other agricultural businesses that could qualify them for the R&D credit.

Qualifying agricultural activities can include developing new or improved:

  • Technologies and/or processes to improve the harvest lifecycle, from planting to harvest
  • Breeding and/or feeding techniques for livestock
  • Waste reduction or reuse
  • Packaging processes for better managing moisture or temperature
  • Methods or technologies to minimize/eliminate crop damage from disease
  • Technologies to improve the ultimate yield and freshness of product from harvest through transport
  • Product development through cross-breeding
  • Irrigation systems, or soil improvement, plant nutrients or fertilizers

While the above might bring to mind crop production, dairy farming, livestock raising, poultry, and egg production, there are other activities that qualify. These include urban agriculture, grocery delivery, nutritional science and industrial trans-fat elimination, as well as wine and craft beer production, coffee and chocolate production, gluten-free production, meat science and fish farming.

Agriculture may present many opportunities fo R&D tax credits now and in the future. Contact us to explore this area further and to help your farming operation apply for the R&D tax credit.

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How Complying with the Consistency Rule Can Increase Your R&D Tax Credit

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If your company relies on the hard sciences or uses technology to create or improve products or processes, you might already know about or even be taking advantage of the Research & Development Tax Credit to reduce your federal taxes. The credit can be a real financial boon to companies that engage in qualified R&D activities.

The consistency rule, Internal Revenue Code 41(c)(6), stipulates that claims for qualified research activities (QRAs) must use qualified research expenses (QREs) in the current year that are reasonably consistent with those used in the base periods. Cases such as Trinity Industries, Inc. v. U.S. and Research, Inc. v. U.S. have shown that violating the consistency rule can produce disallowed research expenses—and sometimes tax penalties.

Boosting Your R&D Tax Credit

Verifying your numbers to comply with the consistency rule can help increase your R&D tax credit.

Let’s say XYZ Company has been claiming the federal R&D tax credit for the past three years. XYZ has had wages, materials and supplies, and outside contractor costs each of the past three years related to qualified research activities (QRAs). The company has not included materials and supplies in their qualified research expenses (QREs), as they lacked a tracking mechanism in their accounting records.

In the fourth year, the company hires a new controller who improves XYZ’s accounting software and the company becomes able to track materials and supplies related to their QRAs.

Their current year materials and supplies are $260,000. Additionally, XYZ has no acquisitions or dispositions of any trade of business in the current or past three years. The company intends to claim the alternative simplified credit (ASC) in the current year and claimed the ASC for the past three years.

Since the company hasn’t quantified prior-year materials and supplies, however, they cannot claim these expenses in the current year.

Calculations

XYZ calculates their QREs for the current year and past three years (as claimed on IRS Form 6765) as follows:

Wages Year 1 $1 million
  Year 2 $1.15 million
  Year 3 $1.2 million
  Current Year $1.3 million

Outside Contractors

Year 1 $65,000
  Year 2 $60,000
  Year 3 $50,000
  Current Year $40,000
Materials & Supplies All 4 Years None
Total QREs Year 1 $1,065,000
  Year 2 $1,210,000
  Year 3 $1,250,000
  Current Year $1,340,000

If the company claims the federal R&D credit using the ASC (14%) based on the information above, they have the following credit for the current year:

  • The current year’s QREs of $1,340,000 less $587,500 (the previous three years’ QREs divided by 6) equals $752,500.
  • Multiplying this figure by the ASC of 14% produces an R&D credit of $105,350.

Benefit of Better Tracking

As XYZ has had material and supply costs in the preceding three credit years, they would have to calculate their materials and supply costs for those years to claim material and supply costs on the current credit year.

Based on the new accounting system, let’s assume that the company can recalculate and substantiate their material and supply costs that relate to their QRAs in each of the preceding three credit years.

The prior three years’ materials and supplies were much lower than the current year’s, as the cost of the materials used in the R&D process increased significantly in the current year as more testing was done. 

Based on the work performed, the QREs should have been:

Wages Year 1 $1 million
  Year 2 $1.15 million
  Year 3 $1.2 million
  Current Year $1.3 million

Outside Contractors

Year 1 $65,000
  Year 2 $60,000
  Year 3 $50,000
  Current Year $40,000
Materials & Supplies Year 1 $35,000
  Year 2 $60,000
  Year 3 $85,000
  Current Year $260,000
Total QREs Year 1 $1,100,000
  Year 2 $1,270,000
  Year 3 $1,335,000
  Current Year $1,600,000

If the company claims the R&D credit using the ASC (14%) based on this new information, they now have the following credit for the current year:

  • The current year’s QREs of $1,600,000 less $617,500 (again, the previous three years’ QREs divided by 6) makes $982,500.
  • Multiplying this figure by the ASC of 14%produces an R&D credit of $137,550.

Adhering to the consistency rule and using careful tracking increased XYZ’s credit $32,200.

Beware of not being in compliance and your R&D tax credit documentation not meeting the current tax year requirements in terms of past years’ consistency when attempting to take the R&D tax credit. Being able to defend your current year’s credit means not only avoiding possible increased taxes, interest, and penalties, but defending your claims regarding future years’ expenses as well. Contact us for guidance with R&D tax credit services.

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R&D Tax Credit Documentation: What You Need to Know

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Companies in many industries can benefit from the Research and Development (R&D) Tax Credit, and you may not be aware that you qualify as well. However, your ability to claim the R&D credit hinges on backing up your eligibility with the right support.

Tax advisors need to know the knowledge and effort that went into the development of your product or solution for which you’re claiming the credit (not all the details!). With that, we can help determine if each technology and research activity has qualified research expenses under Internal Revenue Code Section (“Sec.”) 174, and then if those expenses meet the more stringent criteria of Sec. 41 for the R&D tax credit. 

Any contemporaneous documentation on the qualifying research activities will help support its claim for the R&D credit. The more you have the better, as thorough documentation can reduce the time your R&D personnel spend with tax advisors in interviews and other meetings.

Do Your QRAs Back Your QREs?

We often find clients have misconceptions about what constitutes important documentation for the R&D tax credit. A simple general ledger account from one department that says “research expenses” will not do. Most companies build financial systems to prepare financial statements or for tax return preparation, but such record keeping often fails to correlate qualified research activities (QRAs) to back up the qualified research expenses (QREs) the company is attempting to claim.

A list of qualified research expenses isn't helpful if the costs cannot be traced to specific projects or activities. Also, under what's called the “Consistency Rule,” you must define QREs in the same manner from year to year.

What’s Needed for Proper R&D Tax Credit Documentation?

What kind of records and documents do you need to keep in order to claim the R&D tax credit?

  • Financial information, including information about wages paid to employees directly involved in R&D and employees in direct supervision or support of R&D.
  • Recording of R&D activities, preferably to separate accounts, such as bifurcating material and supplies into R&D and non-R&D purposes. (The same holds true regarding separate accounts for outside contractors in any of the four parts of the test to qualify for the credit. Copies of contracts with outside contractors showing who retains rights are also important.)
  • Time-allocation determinations with work plans, payroll records, steering committee meetings minutes and similar documentation.
  • Design drawings displaying various iterations, such as blueprints, CAD reports (especially that document modifications), project progress reports, and change orders. Your testing documentation can also support successes and failures, and marketing materials that substantiate a new product design can help qualify.

In many cases, reasonable estimates are OK to use, but they need to be supported by quantitative and qualitative evidence. Your tax advisor should meet with company personnel—engineering or project managers, for example—to document the R&D credit activities or determine a plan to document it, such as through employee surveys and interviews.

Burden of Proof

The burden of proof lies with the taxpayer seeking the R&D tax credit. Many pre-packaged R&D credit studies provide the study methodology, but lack information to help substantiate the credit. Nor does the IRS specifically define “sufficient documentation” to claim an R&D credit—but it's important to note that the IRS strongly prefers contemporaneous documentation. 

Contact us to learn more about R&D tax credit documentation requirements and to maximize your potential to claim the R&D tax credit.

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The R&D Tax Credit for Start-ups: There's Still Time to Claim Your Credit

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Small start-ups still have time to take advantage of a potentially major tax credit—even if you already filed your taxes for this year.

Large companies that rely on the hard sciences or use technology to create or improve products or processes may already know they can reduce federal taxes using the Research & Development (R&D) Tax Credit. The IRS has now issued interim guidance explaining how qualified small businesses can also take advantage of a new option enabling them to apply part or all of their research credit against their payroll tax liability, instead of their income tax liability.

So even if you’ve already filed your taxes, you still have time to file for an R&D credit and potentially save on your tax bill.

Before 2016, taxpayers could only take the research and development tax credit against their income tax liability. IRS Notice 2017-23 provides guidance on a new provision included in the Protecting Americans From Tax Hikes (PATH) Act.

The option for the new payroll tax credit may especially benefit your start-up if it has little or no income tax liability.

Apply Part or All of Your Research Tax Credit Against Your Payroll Tax Liability

To qualify to use all or a portion of your research and development tax credit against your payroll tax liability, your qualified small business must have gross receipts of less than $5 million and have had no gross receipts prior to 2012. This new option will be available for the first time to any qualified small business filing its 2016 federal income tax return this tax season. Those who already filed still have time to choose this option.

Your qualified small business with qualifying research expenses can choose to apply up to $250,000 of its research credit against its payroll tax liability. You choose this option by filling out Form 6765, “Credit for Increasing Research Activities,” Section D and attaching it to a timely filed business income tax return.

Extra Time To Claim the R&D Tax Credit This Year

Under a special rule for tax year 2016, a qualified small business that has filed yet failed to choose this option (and still wants to) can file an amended return to make the election by Dec. 31, 2017 (see Section 4.02 for further guidance).

After choosing this option, your qualified small business claims the payroll tax credit by filling out Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities.” This form must be attached to your payroll tax return, such as Form 941, “Employer’s Quarterly Federal Tax Return.”

Learn More About the R&D Tax Credit for Start-ups and Small Businesses

Correct assessment and filing are key factors in claiming the research and development tax credit. The right professional can help you make the most of this new opportunity. For more information on our R&D tax credit services, contact us.

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Funding, Contracts, and the R&D Credit

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When you think of the Research and Development (R&D) Tax Credit, you might focus on the technology involved and costs incurred to create or enhance a product or process. Another important consideration though is whether the costs incurred in connection with any activity qualifying for the credit are “funded.” The essence of this requirement is to determine if the taxpayer claiming the credit has an adequate financial risk for the costs incurred and retains rights to the research results.

The tax concept of funding was essentially created to eliminate the ability for two taxpayers to claim the R&D credit on the same costs. Seminal questions to ask:

  • Who actually bears the economic risk per the contractual terms of the relationship, particularly if the project is unsuccessful? 
  • Who retains substantial rights to the research results?

Is it "Funded?"

In order for a taxpayer to be eligible for the R&D credit the related activity cannot be funded. Activity is not funded if: The taxpayer is deemed to be at risk for the costs incurred and retains substantial rights.

The questions of adequate risk and retention of rights typically arise when one party hires a contractor to perform qualifying research on a product, process, or other development.

According to the IRS, if a contractor hired to perform research for another company retains no substantial rights to the research developed under the terms of their agreement, the research is treated as “funded” to the contractor and no expenses paid or incurred by the contractor in performing the research qualify for the R&D credit. This would be the case even if the contractor was deemed to be at economic risk for the costs incurred.

Who Has the Right to Use the Research?

Retention of substantial rights does not require that the taxpayer retain exclusive rights to the research. However, a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. Basically, “substantial rights” is interpreted to mean the right to use the research.

For example, does the contract say the research is exclusive to the company that the contractor is under contract with, or can the contractor use the research and resulting technology for other companies/industries without paying royalties?

Contract Language Matters

The concept of substantial rights and risk relies heavily on specific contractual language. If a contract is poorly written, possibly neither the contractor or the company can qualify for the R&D Credit. If there is potential for significant R&D credit in connection with a contract, it is prudent to carefully review the language in the agreement and speak with tax advisors to ensure the intended party or at least one party can claim the credit.

Generally, a contractor who is paid regardless of the success of the project does not bear the economic risk and cannot claim the R&D Credit (i.e. the research is “funded” to the contractor for purposes of the credit). However, if payment will only be made contingent on the success of the efforts, then the contractor bears the economic risk and may potentially claim the credit if it also retains substantial rights to the results.

Courts have held that research expenses incurred by a contractor under fixed-price contracts were not “funded research” under the R&D credit rules because the contractor was at risk for the costs unless the project was successful. Thus the qualifying costs incurred were eligible for the R&D credit to the contractor performing the research, assuming it also retained substantial rights to the results.

Other Payment Arrangements

For cost plus arrangements on the other hand the contractor is not generally deemed to be at economic risk since it is guaranteed to be paid for its efforts. Therefore, it is not eligible for the credit. On the other hand the company paying a contractor is at economic risk and could the claim the credit on the costs paid to the contractor if this company also retained substantial rights.

Other types of contractual payment arrangements can generate costs eligible for the credit to the contractor. For instance, a cap cost-plus margin pay arrangement may allow for the contractor to claim the credit for the qualifying costs incurred. Again, the major issues are whether the taxpayer is at economic risk contingent on the success of the project and whether the taxpayer retains substantial rights to use the work, which are dependent on the terms of the contract.

Whether you are a contractor or a company using a contractor, you can maximize your chances of claiming the R&D credit in the future or allowing the other party to claim the credit by careful consideration of the contract terms. This can be a complicated issue, which can be resolved with simple solutions. Contact us for guidance.

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Start-up Companies, Payroll Taxes, and R&D Credits: What’s the Connection?

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Cash is king in the early days of a new company, and you may be able to use federal R&D credits to generate much needed cash during the initial years of your new company.

R&D and the QSB Election

The R&D credit, which rewards companies for increasing research expenditures, was permanently extended by the Protecting Americans from Tax Hikes (PATH) Act of 2015. In addition, for tax years beginning after December 31, 2015, the PATH Act allows qualified small businesses (QSBs) to elect to offset the employer portion of Federal Insurance Contributions Act (FICA) payroll taxes with R&D credits.

A QSB is a corporation, including an S corporation or partnership that has gross receipts of less than $5 million for the current tax year and did not have gross receipts in any tax year preceding the five-tax-year period that ends with the current tax year.

Start-up companies generally incur losses during the initial years of operations and are unable to use R&D credits. The QSB election allows start-up companies to use R&D credits that might otherwise go unused or are not claimed. In addition, claiming R&D credits in the initial years of operations can generate larger tax credits in future years when research expenditures increase and profits grow.

The QSB election must be made on a timely filed tax return, including extensions, and can be made for up to five tax years. A QSB can elect to apply up to $250,000 of current year federal R&D credits against their employer portion of FICA payroll tax liability beginning with the calendar quarter following the date on which the tax return is filed. Any excess elected amount exceeding the employer portion of FICA payroll tax liability is carried forward to the next calendar quarter. A QSB must also file IRS Form 8974 with Form 941each quarter.

For example, let’s say your new company is a QSB and has R&D expenditures of $25,000 per year for the first five years of operations. As a result, your new company generates $2,500 of R&D credits each year. By making the election to apply R&D credits against the employer portion of FICA payroll tax, your company enjoys $12,500 of cash savings.

Do You Qualify?

Basic questions to determine whether your company is eligible to claim R&D credits include:

  • Do you have payrolled employees?
  • Are you developing a new products or processes? What’s in the pipeline?
  • Do you have wages associated with that development? Who’s doing the R&D?
  • Do you retain rights to what you developed? To qualify, you don’t need to hold exclusive rights, just significant ones. For instance, can you take what you’re developed and apply it to your next project without anyone’s legal permission?

Let our tax credit experts help you determine if your company’s activities are eligible for R&D credits by contacting us today.

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