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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 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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Best Practices for Exploring R&D Tax Credit Eligibility

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Be Prepared, and You Can Save Time, Effort, and Money.

If your company relies on the hard sciences or uses technology to create or improve products or processes, you might be able to reduce your federal taxes by a portion of the costs incurred using the Research & Development (R&D) Tax Credit. The credit can be significant and many types of companies potentially qualify. Smart preparation early in the process can also save you time, effort and, potentially, tax dollars.

Best Practices When Exploring the R&D Tax Credit

Reach out to qualified professionals to discuss the credit.

Find out if this professional has experience with the R&D Credit. Have they worked with companies similar to yours? They should ask about your new product(s) or innovation(s), your employees’ time associated with those developments, and if you retain rights to what you developed. Being mindful that your time is valuable, an experienced professional can often make a preliminary assessment in the first meeting as to the likelihood your company is eligible for the R&D credit or provide the preliminary questions needed in order to make that assessment.

Set up a meeting at your facility.

A walk-through helps immensely to educate your chosen consultant. That time walking through your plant or watching your prototype in action tells them a lot about your operations and, in turn, your potential to qualify for the R&D credit. Plan to set aside an hour to three hours, approximately (includes meeting time after the walk-through).

Have your subject matter experts easily accessible to discuss potential R&D activities.

These persons can be your employees or even outside contractors most connected to the development. Not having the right people involved as soon as possible in the exploratory process can negatively impact the amount of credit that you ultimately claim.

Understand that you’re trying to qualify for the tax definition of R&D.

We recently visited a manufacturing company where the chief technology officer claimed the company was doing no R&D. Of course the firm was constantly researching and developing as they were coming out with new products each year and making significant functional improvements to their existing products.

We helped him to understand that the definition of R&D for tax purposes might not match his scientific definition. This a pro-taxpayer credit: The tax definition of R&D can be more liberal and more encompassing than some traditional engineering minds might think.

That same company also experienced a year where technical challenges and other factors kept many of their developments from getting to market. They thought they had no activities to potentially quality for the R&D credit—but failure can be a positive when claiming a credit. It doesn’t mean you have no qualified R&D expenses—it can actually help show that R&D did occur.

Have your documentation ready.

Any contemporaneous documentation that monitors the activities qualifying as research activities will help to support your claim for the credit: blueprints or marketing materials, project write ups, financial information, status reports, modifications’ specs, and so on. (See our recent blog regarding proper documentation when exploring qualification for the R&D Tax Credit.)

Lack of documentation or no documentation makes the process of exploring your qualification for the R&D credit more involved; however, it is often possible to reconstruct information needed to claim the credit.

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

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R&D Credit Rules for Internal Use Software Finalized

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New Rules Represent Significant Easing of Requirements on Businesses That Would Like to Claim the R&D Credit

Regulations finalized by the IRS on October 3 suggest that the costs a business incurs to develop software for internal use may be more likely to qualify for the Research and Development (R&D) Tax Credit than many taxpayers previously understood.

Internal use software (IUS) has always been held to a higher standard than other types of research when it comes to qualifying for the R&D credit. But the new IRS guidance clearly suggests some software development costs that were previously thought to be IUS were in fact likely to be exempt, and the new guidance also eases some requirements on IUS software when it comes to qualifying for the credit.

The new rules don’t change the four criteria that qualify an activity for the R&D Credit:

  • It must be intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a product or business component.
  • It must be undertaken to discover information that is technological in nature.
  • The intended result must be useful in the development of a new or improved business component.
  • Substantially all of the activities must relate to a process of experimentation.

Once an activity meets these criteria, IUS must meet three additional criteria—referred to as the high threshold of innovation test—to qualify for the credit:

  • The activity must involve significant economic risk.
  • It must meet a high threshold of innovation.
  • No comparable third-party software is available for purchase.

The concept of IUS, because of the final regulations, is going to largely be restricted to general administrative functions, such as:

  • Financial management
  • Human resources management
  • General day-to-day support services of your company

Clarification of the 3-Point Criteria

The IRS has made it easier and less controversial to comply with the three additional criteria above that IUS must meet to qualify for the credit. For instance, the IRS concluded that the high threshold of innovation doesn’t require that you make a revolutionary discovery or that the software development be successful.

The IUS development involves “significant economic risk” if you commit substantial resources and there is substantial uncertainty, because of technical risks, that you might recover those resources within a reasonable period. “High threshold of innovation” is defined as resulting in a reduction of costs or an increase in speed, either of which are substantial or economically significant.

The new rules, which are largely consistent with the proposed regulations, clarify that some types of internally developed software are not IUS. For example, software you might have developed to interact with third parties or to enable third parties to initiate functions or review data on your business’ systems do not need to meet the additional IUS criteria to qualify for the R&D credit. The determination of whether the software was developed for third party use is based in large part on the intention of the company at the start of the software development effort.

Examples of software that may not qualify as IUS include:

  • Bank transaction software
  • Software apps for a mobile device
  • Software developed by a manufacturer to enable its customers to order products online

Furthermore, software developed to be sold, leased, or licensed is generally not treated as software developed primarily for internal use.

On the whole, these new rules represent a significant easing of requirements on businesses that would like to claim the R&D credit for software that they develop themselves or pay outside contractors to develop. If your business incurs costs for software development, this is a great time to take a closer look at those costs in light of the new rules to find out if you may be eligible for additional credits.

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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.

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The 4-Part Test to Qualify for the R&D Tax Credit

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The Research and Development (R&D) Tax Credit, recently made permanent, can be a financial boon as you work to improve cash flow in your business. As we've discussed in previous posts, 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 qualified costs incurred.

A four-part test can help you determine if your company’s activities qualify for the R&D credit.

#1: Permitted Purposes

To qualify for the R&D credit, the activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. You don’t necessarily have to discover an innovation or advancement that’s new to your industry, only what may be innovative or new to you and your company’s processes or products.

#2: Technological in Nature

The activity performed must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering. For example, if you’re in food production, simply adding more salt to your product won’t necessarily qualify—but a method based in hard sciences to enhance your product’s flavor might, as would similar methods designed to keep food fresher longer.

#3: Elimination of Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.

#4: Process of Experimentation

The qualifying activities must constitute the process of experimentation involving: simulation; evaluation of alternatives; confirmation of hypotheses through trial and error; testing and/or modeling; or refining or discarding of hypotheses.

Beyond definitions stipulated by the four-part test, examples of activities that might qualify for the credit include those to advance the design of an existing product or process, or those to correct significant design defects or obtain significant cost reductions or enhanced function. Costs of design, construction, and testing of pre-production prototypes and models can also qualify.

For example...

Let’s say you’re a manufacturing firm developing eyewear and you want to increase productivity 10% to 15%. Your costs for doing an evaluation of the raw materials, considering new molds, and determining such factors as the proper heating and cooling temperatures for that raw material and/or molds may qualify for the R&D credit.

Similarly, if you have a product run by software, costs of developing new software to make that product more reliable and more efficient might quality for the credit. If you’re an architectural or engineering firm, costs of researching and incorporating green technology might qualify.

Other activities potentially qualifying for the credit: conceptual formulation, design, and testing of possible product or process alternatives; launch activities involving a new component or process; or design time, tool design and testing, prototype building, and similar activities. Also:

  • Engineering efforts to develop new plant processes or technical redesign of an existing plant layout that result in substantial production gains;
  • Efforts to solve production problems where there was uncertainty as to the best solution; and
  • Design and testing involved in improving the configuration or altering the composition of an existing product or process to increase efficiency or decrease cost.

Some activities do not qualify for the R&D credit, including funded research (for example, funded by a government grant), ordinary testing and inspection, research done outside the U.S., reverse engineering (unless such engineering involves an enhancement, in which case a percentage of your R&D costs may qualify for the credit), adaptation of an existing business component to a particular customer’s requirement or need (for example, adapting a computer program you sell to a particular customer’s requirement), or research with a non-functional focus such as improving or changing style, taste, or cosmetic changes.

Also not qualifying: research after commercial production; management studies or activities; and efficiency or consumer surveys.

Qualified costs include wages paid to employees directly involved with, in direct supervision of, and in direct support of the R&D; materials and supplies used and consumed in the process; and work performed by outside contractors in any of the four parts of the test qualify as long as you retain substantial rights in what the contractors do.

The R&D credit can apply to companies in many industries. We can help you explore the potential of the R&D credit for current and prior open tax years and talk about how your efforts to grow your business could generate cash savings on your federal (and state) tax returns. Contact us to learn more.

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The Process to Claim Your Possible R&D Tax Credit

Claim_RD_Credit_iStock_43230472-650936-edited.jpgAfter years of being temporarily extended, the Research and Development (R&D) Tax Credit has been made permanent, a policy change that might suggest wider IRS acceptance of true R&D credit claims.

Improving your business often has underpinnings in potential R&D credible activities. Every company wants to grow and differentiate itself – and one of the common denominators for differentiation is improvement in technology, whether it is to create a new or improved product or process. 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.

How to See if You Qualify for the R&D Credit

First, it’s very helpful to take a critical look at activities that anyone in your company is undertaking to pursue an idea that would make a process more efficient, more streamlined, greener, and so on. Or perhaps you’re testing the feasibility of a new or improved product, looking at overhauling an outdated software, or exploring how to communicate more effectively with your client base through the internet.

Another helpful step is to identify and review those documents that address/substantiate project initiatives and their progress (or even lack of progress—setbacks can actually be a sign that you probably have some credible R&D activity). These documents can include project reports, engineer reports, data updates, feasibility studies, outside contracts, project aspiration memos, or memos that show your company had to change the course of the project or even abandon the project altogether.

From our experience, accumulating the data and information required to support R&D activities can be fairly easy using, for instance, such readily available financial data as payroll records and supply usage compilations that went into any department or project undertaken for an R&D initiative. It might also be wise to investigate the entire history of the project. It's not unusual to discover there are unclaimed R&D credits for prior years as well.

Don’t assume that your potential credit would be too small to be worth your research time.

Even if your company has only one engineer working on a project, that engineer might need two support staffers and a supervisor. (Experienced advisers can help you determine if your applying for the credit is worthwhile.)

Keep your data and documentation simple by focusing on criteria the IRS is looking for when claiming the R&D credit. If the documentation is not there, your R&D credit team can still vet those business improvement ideas for credibility and potential by talking to project leaders or those who have been involved with the ideas on improvement.

Another key to exploring and securing the R&D credit is efficiency and finding the right advisers to guide you through claiming the credit, both when filing the refund claim and in the unlikely event of an IRS audit. Our firm has had remarkable success in retaining the R&D credits claimed if initially challenged by the IRS. We do our homework up front. For example, we have conversations early on that explore succinctly our clients’ potential for claiming and supporting their R&D credible activity.

We also look at a company’s ability to actually generate cash refunds when claiming the credit. In a limited number of cases, the R&D credit may not generate a cash refund upon filing an amended return to claim such credits. In those cases we explore the amount of benefit and when it is expected to be realized before undertaking an R&D credit study. This rarely occurs and the IRS, beginning in 2016, has further expanded the group of companies eligible for receiving a cash benefit from the credit. Beginning this year, certain small businesses with annual revenues under $50 million may qualify to claim the credit against its alternative minimum tax liability. Prior to this companies paying AMT had to carry forward the credits for use in future years. In addition, certain small business with less than $5 million in gross receipts may offset payroll taxes by the R&D credit.

We can help you explore the potential of the R&D credit for current and prior open tax years and talk about how your efforts to grow your business could generate cash savings on your federal (and state) tax returns via the R&D credit. Contact our R&D credit experts today.

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Time to Investigate Your Possible R&D Tax Credit

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If you rely on the hard sciences or use technology in your business to create or improve products or processes, you’re probably familiar with Research and Development (R&D) Tax Credit that can be used to reduce federal taxes by a portion of the related costs incurred.

In 2015, after 35 years of being extended over and over, the R&D credit has been made permanent—a significant change in policy that suggests a wider acceptance by the IRS of bona fide R&D credit claims.

Beginning with the 2016 tax year, your small business might qualify to claim the credit against your alternative minimum tax liability. (Qualifying small businesses include partnerships, sole proprietorships, and privately held corporations with average annual gross receipts of less than $50 million, among other conditions.) Certain eligible small businesses can also use the R&D credit against the employer’s old-age, survivors, and disability insurance liability (aka FICA taxes).

In addition, the Treasury has issued taxpayer friendly regulations that provide guidance on claiming a credit for internal use software (IUS) used principally for general and administrative purposes. R&D credit eligibility for IUS credit is subject to a higher standard and the proposed regulation provided clarity and relaxed the more stringent standards for qualification. There was also guidance that clearly acknowledged that some software development that was thought to be IUS was in fact eligible for the credit under the normal rules—for example, software design costs to improve or allow for third party interfacing.

As a result, you may have a better chance than ever of claiming the credit, one of the most generous tax incentives that the federal government offers to businesses. Now is the time to take a fresh look at your firm’s R&D efforts and your projects over the last couple of years, including software development. Any R&D activities that attempt to bring innovation into the business or its' products or services itself can be eligible for the credit.

In short, costs related to any activity that uses a technical discipline to improve a product or process may qualify. Almost any combination of using hard sciences with uncertainty as to the feasibility or design of a new or improved product or process provides opportunity to claim the federal R&D tax credit. (Note that many states also provide tax incentives for R&D activity.)

Industries That Could Benefit From the R&D Credit

Most manufacturers still don’t know they might qualify for the tax credit, which is designed to reward manufacturers who are bringing a new or improved product to market or who make the manufacturing quicker, cheaper, or greener. All types of manufacturers could be eligible for R&D credit benefits in future and prior tax years.

Similarly, many architectural and engineering firms may overlook activities that could qualify for the credit: green building design and energy efficiency innovation; structural engineering; experimenting with materials, HVAC/plumbing/electrical system designs for increased efficiencies; and high-tech equipment/manufacturing installation and design improvements.

Lastly, as discussed above, (1) software design costs to improve or allow for third party interfacing and (2) costs associated with IUS that is highly innovative may also be eligible.

The federal R&D may be a perfect financial break for your business if you know what to look for and how to navigate terms such as “Permitted Purpose” and “Elimination of Uncertainty”—in other words, the process to claim the credit.

Contact Us

We can help unravel the complexity and get you the R&D credit for your open tax years. Contact us today.

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R&D Credit Rules for Internal Use Software Clarified

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IRS proposed regs indicate that more costs may qualify for the credit than many people realized.

Rules proposed by the IRS suggest that costs a business incurs to develop software for internal use might be more likely to qualify for the Research and Development Credit than many taxpayers had previously understood. Internal use software (IUS) has always been held to a higher standard when it comes to qualifying for the R&D credit. The IRS guidance clearly suggests some software development costs that were previously thought to be IUS were in fact likely to be exempt, and it eases some requirements on software that is IUS when it comes to qualifying for the credit.

The new rules don’t change the four criteria that qualify an activity for the R&D credit:

  • It must be intended to discover information that would eliminate uncertainty concerning the development, improvement, or design of a product or business component.
  • It must be undertaken to discover information that is technological in nature.
  • The intended result must be useful in the development of a new or improved business component.
  • Substantially all of the activities must relate to a process of experimentation.

Once an activity meets these criteria, the business needs to determine if the activity relates to IUS. If it does, it must meet three additional criteria to qualify for the credit:

  • The activity must involve significant economic risk.
  • It must meet a high threshold of innovation.
  • No comparable third-party software is available for purchase.

Non-Internal Use Software

On one hand, the new rules clarify that some types of internally developed software are not IUS. Software that is developed to interact with third parties or to enable third parties to initiate functions or review data on a business’ systems likely no longer need to meet the additional criteria to qualify for the R&D credit. Examples of software that no longer needs to meet the three-part IUS test include bank transaction software, delivery tracking sites, and programs that allow a customer to search a business’ inventory.

Lowering the Bar for IUS

On the other hand, the IRS made it easier to comply with the three criteria that IUS must meet in order to qualify for the credit. The new rules allow that IUS meets the innovation test if the development “is or would have been successful,” a significant relaxation on the previous requirement that the development must be successful in order to meet the innovation standard.

R&D Credit for Manufacturers - Buffalo CPA On the whole, these new rules represent a significant easing of requirements on businesses that would like to claim the R&D credit for software that they develop themselves or pay outside contractors to develop. If your business incurs costs for software development, this is a great time to take a closer look at those costs in light of the new rules to find out if you may be eligible for additional credits.

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