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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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What to Prepare for and Expect From Your First Meeting About the R&D Tax Credit

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Did your company develop any new products for the year? Make significant enhancements to products or processes? If you’re in financial management in any way in your company, you owe it to yourself and your firm to investigate if you qualify for the Research & Development (R&D) Tax Credit.

If you rely on the hard sciences or use technology in your business to create or improve products or processes, you might be able to reduce your federal taxes by a portion of the related costs incurred.

Investigating your eligibility for the credit includes an initial meeting with an R&D credit expert. What should you prepare for your initial meeting? Expect to be able to provide the following:

Access to Key Personnel Who Were or Are Involved in the R&D Activities

This might be one person or multiple individuals depending on your company size. In bigger companies, a team approach can often foster a better discussion, bringing ideas together and identifying other areas where one or more individuals in the company might be engaged in R&D activities.

Your key personnel must be available for meetings and interviews, and should also be able to identify who performed R&D-type work during the year and be able to assist in quantifying their time spent in this work. The identification should include both internal resources (employees) and external resources (outside contractors).

We have had great success with three to five attendees in these meetings with our clients, often one person from finance and others from the R&D activities.

Internal Documentation Concerning Your R&D Activities

Any contemporaneous documentation that monitors the activities qualifying as research activities will help to support the claim for the R&D credit. The more you can share the better—it’s less documentation that we the consultants have to do, and it will reduce the time R&D personnel spend with us on interviews and in other meetings. Examples might include blueprints or marketing materials, project write ups, status reports, modifications, etc. Detail highlighting unique features of your R&D is also generally very helpful. A product catalog with only pictures won’t be sufficient enough to stand on its own.

We understand that you probably won’t have all of this information at the initial meeting, but the more you have the better. As the R&D study progresses, we will work with company personnel to complete the information.

Your documentation should include financial information. Wages (box 1 of Form W-2) is usually the most important part of your potential R&D credit financial information. This includes wages paid to employees directly involved in R&D and employees in direct supervision or support of R&D.

Recording of your R&D activities to separate accounts is helpful. For example, bifurcating R&D material and supplies (property eligible for depreciation is excluded) and non-R&D materials and supplies saves time and effort at year’s end when calculating the credit.

The same point holds true regarding separate accounts for outside contractors for work in any of the four parts. In addition, copies of contracts with outside contractors showing who retains rights is important. As this can be a significant expenditure for many companies, copies of your larger contracts also help at initial meetings.

If you use a job-time tracking system, codes to signify R&D work vs. non-R&D work will assist in determining the project list and qualifying costs at the end of the year. If you don’t use a job-coding system, each eligible employee should keep a list of projects that may qualify for the R&D credit. (Some companies keep a simple Word document to track monthly R&D-related financials.)

If you find you need to retrofit your internal R&D documentation, you can begin to go back and build the records with a list of projects that your teams worked on that you believe are R&D. You will also need a list of employees in R&D with reasonable estimates of how much time they spent on the R&D projects, along with any other materials or outside contractor costs.

Open Communication

After our initial meeting all parties should practice timely follow up to questions, within a week generally. There must also be full disclosure of activities, especially work performed within the U.S. versus outside of the U.S. Only the former can qualify for the R&D credit.

Talk to our experts about your business' potential to claim the R&D credit today.

R&D Tax Credit Assessment - Freed Maxick

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