However, Startups Need to be Mindful About Future Changes to Research and Development Deductions.
Most tax experts would agree that the recently enacted Tax Cuts and Jobs Act of 2017 was generous to businesses of all types. One of the most anticipated events was what Congress was going to do with the very popular Research and Development Tax Credit.
Even though this new tax legislation made sweeping changes to the tax code, the good news is that the R&D tax credit was largely unaffected by this legislation, with the exception that start ups may have to pay income tax in earlier years than they have in the past.
Here’s a summary of Freed Maxick’s R&D Tax Credit Team’s perspective on the new legislation and its consequences for the credit:
Section 174 Costs
The most pervasive and taxpayer unfavorable provision related to research and development activities does not directly relate to IRC Section 41 (Credit for Increasing Research Activities), but rather, IRC Section 174 (Research and Experimental Expenditures).
Currently, taxpayers have the option to immediately expense R&D costs or elect to capitalize and amortize them, but starting in 2022, companies will no longer be able to immediately expense costs allowed under IRC Section 174 related to research activities. At that time, taxpayers will have to capitalize US-based research expenses to a capital account and deduct them over a five-year period.
If such expenses relate to research performed outside of the United States, they will be capitalized and deducted over a more protracted 15-year period.
IRC 280C Reduction
The definition of qualified research activities & qualified research expenses did not change, nor did the methods to calculate the credit (regular credit or alternative simplified credit).
Many taxpayers will generate larger credits as the maximum corporate tax rate decreased from 35% to 21%, thus reducing the reduction under IRC Section 280C (“280C”) or the impact of the expense addback if the 280C reduction is not elected. As you may know, you can’t claim both the credit and the deduction for research expenses. The 280C election, if made, reduces your credit by the maximum corporate rate so you don’t have to add back the deductions.
However, with the corporate rate decreasing, the benefit will decrease and the net effect on the effective rate for corporations may remain similar. Here’s an example:
Under the old rules owner’s of pass-through entities taxed at the highest individual rates and large corporations simply elected the IRC Section 280C reduction because the difference in rates was not that great for the owners (39.6% individuals; 35% corporations) and the percentage reduction (35%).
Research and Development Tax Credit Calculation
An example in the case of a large Corporation:
Corporate tax rate
R&D tax credit gross
R&D tax credit after 280C reduction
% benefit of R&D credit (Effective rate - Corporate tax rate)
A more careful analysis may be needed on individualized bases as the credit is reduced by 21% under IRC Section 280C, but the top rate could be 29.6% (assuming a full 20% QBI deduction & ignoring any affordable care act taxes).
As part of the 2015 PATH Act, President Obama exempted most taxpayers from the AMT limitation that hindered many businesses from claiming R&D credits. With the removal of the Corporate AMT starting in 2018, all corporate taxpayers will now only be limited by the regular tax limitations (taxpayers with over $25,000 in regular tax liability are limited to offsetting no more than 75% of their regular tax liability using the credit).
It is important to note that the individual alternative minimum tax was not repealed. On the bright side, with the higher exemption amount and phase-out income levels, potentially fewer individuals and pass-through entity owner/taxpayers will be subjected to the individual AMT.
Section 59A Base Erosion and Anti-Abuse Tax
The research credit is one of the very few general business credits that can be claimed to offset the new Section 59A Base erosion and anti-abuse tax (“BEAT”) tax through 2025. This tax will only impact multinationals with gross receipts over $500,000. However, those companies are highly likely to generate research credits and the R&D credits they generate can help offset this additional tax imposed upon them.
A Word of Caution for Startups on the R&D Tax Credit
After 2021, start-ups claiming the R&D Tax Credit could be in for a rude awakening. A combination of changes to the limitation on usage of net operating losses and capitalization of previously deductible IRC Section 174 costs for R&D expenditures could result in startups having to pay income tax in earlier years than they have in the past. See the discussion above related to the new Section 174 rules.
We strongly suggest that you connect with us to see how tax reform affects you or your company. The year 2022 is only a few years away, so starting to plan now may help reduce your taxable income in the future.
Connect with Our R&D Tax Credit Experts for More Information
The Research and Development Tax Credit experts at Freed Maxick are standing by to help review your situation and provide guidance on both your eligibility for the credit, and the scope and processes necessary for its capture and claim.
To schedule a complimentary review, call me at 716-847-2651, reach me via email at firstname.lastname@example.org, or simply click on the button to complete and submit a meeting request.
For more insight, observations and guidance on the new Tax Cuts and Jobs Act, visit our Tax Reform webpage.View full article
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.
The 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 may find it beneficial to identify, compute and report these costs in their CAFS.
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. View full article
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
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.
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|
|Materials & Supplies||All 4 Years||None|
|Total QREs||Year 1||$1,065,000|
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|
|Materials & Supplies||Year 1||$35,000|
|Total QREs||Year 1||$1,100,000|
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.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
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.View full article
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.View full article
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.View full article
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.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.
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