Before spending, consider these 2 additional R&D tax credit tests from the experts at Freed Maxick
We’ve written a lot about how the Research and Development (R&D) Tax Credit delivers tax savings for businesses with qualifying activities.
It’s important to know that claiming the Credit involves preparing a detailed study, documentation, and interactions with the IRS. Most firms engage a professional to help them claim the credit and consider the fees they pay as an investment.
In our work helping businesses identify costs and calculate the credit, we’ve noticed that even though some businesses may have expenses that meet the 4-part test, they may still not benefit from the credit because of circumstances that limit its applicability.
That’s why our R&D Tax Credit Team does a Situation Assessment prior to an engagement. That includes performing two initial additional “tests” complementing the 4-part test that can identify factors limiting your company’s ability to claim the credit.
If the company does not pass these tests, we may recommend deferring activities pursuant to claiming the credit until a later date. These include:
Additional Test 1: Do You Own the Risks and Rewards of the R&D Activity?
If a business is hired to conduct qualified research activities by another business, the claim for the credit will generally flow to the business that bears the risk of failure and owns the rights to success. Businesses may be hired to develop a product or process by another company. These contracts often call for the researching business to receive a fixed fee for the work regardless of result and it transfers the rights to the results to the hiring business.
Even though research costs might qualify for the credit, the company that hired the research business would be the one to claim it.
The determining factor in a situation like this will be the contract between the two companies. If your company performs research on a contract basis for other businesses, it’s important to consider the value of the R&D tax credit when negotiating a contract.
Your business might still end up in a better position if you are paid regardless of result, but understanding the value of the tax credit foregone can lead to more equitable pricing for both parties.
Additional Test 2: Do You Owe Taxes?
In addition to the ownership of risks and rewards, businesses sometimes find that they qualify for a credit but can’t claim it in the current year because they aren’t making money, and therefore have no tax liability. For individuals, alternative minimum tax (AMT) limitations could prevent one from claiming credit, but recent tax changes significantly increased the AMT exemptions and therefore reduced the likelihood that AMT would limit credit on an individual taxpayer level.
The R&D Tax Credit is not a refundable credit—it can reduce the balance of taxes that you owe, but if you don’t owe taxes it will not generate a refund. The PATH Act, passed in 2015, allows certain start-up businesses to apply the credit against payroll taxes owed, but if you don’t qualify for that break your business will have to carry the credit forward until a year in which it owes taxes.
So, it may not make sense to invest in having an expert conduct an R&D study and prepare the documentation for claiming the credit. However, at the time when you have taxable income, claiming the credit may be a prudent strategy … assuming the tax benefit you’ll receive is greater than the cost of the study that needs to be performed! Regardless of when you do the study, you will want to maintain good internal documentation. If you do multiple years of R&D credit claims together it is important to have good R&D tax credit documentation so you aren’t “recreating” records and reduce audit risk.
Connect with a Freed Maxick R&D Tax Credit Expert
The important thing to remember is that a claim for the R&D Tax Credit requires careful planning. If you’re looking to hire research on a contract basis or to perform research for hire, your agreements should reflect an understanding of the value of the credit and who will have the right to claim it.
If your business performs R&D activities but isn’t yet profitable enough to claim the credit now, you need to understand how soon you will get the value of those expenditures back on your tax return.
These can be complicated issues, and it’s our recommendation that before pulling the trigger on a R&D Tax Credit Study, you look at applicability issues in detail.
We can help.
In a 30-minute phone call we can identify whether you’re eligible for the credit and if it makes sense to proceed with a claim.
To discuss your situation contact us by clicking the button or call us at 716.847.2651.
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A recent taxpayer-friendly change in the federal tax law has effectively expanded the number of taxpayers that can use research and development (R&D) tax credits to reduce their income tax liability. Companies that rely on the hard sciences or use technology to create or improve products or processes can reduce federal taxes using R&D tax credits.
Historically, the rules applicable to general business credits only allowed the use of R&D tax credits to offset regular tax up to the amount of the alternative minimum tax (AMT). In many cases for corporations, shareholders in S corporations, and partners in partnerships, the high-income earners were paying AMT in excess of their regular income tax liability—meaning they could utilize none of the R&D tax credits generated each year (though the tax credits could then be carried back one year, and carried forward up to 20 years).
This limitation on the use of R&D tax credits discouraged companies and individuals subject to AMT from performing an R&D tax credit study, since they weren’t able to utilize the R&D tax credits generated.
New Opportunity to Claim R&D Tax Credits
The IRS and Congress were aware of this limitation and instituted changes through the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). Effective for tax years beginning after December 31, 2015, “eligible small businesses” and their owners can use R&D tax credits to offset AMT.
The following example demonstrates the impact the PATH Act has had on the ability of a small business owner to utilize R&D tax credits. In this example, the taxpayer is an owner of an S corporation and a Limited Liability Company (LLC) and the taxpayer is actively involved in both entities. The flow through ordinary income and R&D tax credits from the S Corporation are $140,000 and $15,000 respectively. The flow through ordinary income and R&D tax credits from the LLC are $260,000 and $25,000 respectively. The taxpayers’ utilization of R&D tax credits and the resulting tax savings pre and post Path Act are shown below.
|PRE PATH ACT||POST PATH ACT|
|Adjusted Gross Income||$540,000||$540,000|
|Alternative Minimum Tax||$144,000||$144,000|
|R&D Tax Credit Generated||$40,000||$40,000|
|R&D Tax Credit Used||$4,000||$40,000|
Note: AMT limitations continue to apply to any R&D tax credits carried forward from taxable years beginning before 2016.
“Eligible Small Business” Defined
This new tax savings opportunity is available for a non-publicly traded corporation, partnership, or sole proprietorship if the average annual gross receipts for the three-taxable-year period preceding the credit year do not exceed $50 million. Partners, LLC members, and S corporation shareholders must also meet this gross receipts test.
This change in the PATH Act may present your business with an opportunity to re-evaluate your activities to determine qualification for R&D tax credits.
We may be able to quickly tell you if you are an eligible small business that qualifies for R&D tax credits. Have your financial and tech specialist contact us for a no-cost preliminary consultation with a member of our R&D tax credit services team.View full article
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.View full article
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.
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.View full article