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Summing It Up

Keeping you ahead of the curve with timely news & updates.


Joe Burwick, CPA

Recent Posts

Siemer Milling Company v. Commissioner: Siemer Down! It Wasn’t All Bad for the R&D Tax Credit

Siemer Down-1

New call-to-actionApril 15 is usually a happy day for tax practitioners and taxpayers alike. April 15, 2019 was not a happy day for Siemer Milling Company and their tax advisors after Siemer Milling Company v. Commissioner (TC Memo 2019-37) was decided. This case focused on seven projects the company claimed the R&D tax credit on in 2011 and 2012. 

Here’s a summary of Freed Maxick’s R&D Tax Credit Team’s perspective on this case and its consequences for the credit:

R&D Tax Credit documentation is KEY.

As you can see from the chart below, ALL seven projects reviewed were denied as Siemer Milling Company was not able to prove they engaged in a process of experimentation (and in some instances other parts) of the 4-part test.

chart

The big takeaway from this case is that it reinforces the fact that documentation is vital to the successful claim for R&D tax credit. IRS stated that “the record is devoid of evidence that petitioner formulated or tested hypotheses, or engaged in modeling, simulation, or systematic trial and error…” Unfortunately for the taxpayer, the Tax Court agreed and denied each project!

Based on the results of the case, three of the seven projects would appear to have qualified for credit (#’s 1, 4 and 7 in the chart above) if there was sufficient documentation to a process of experimentation. 

Key takeaway…document, document and document!      

Siemer down, it wasn’t all bad for other taxpayers!

The IRS took draconian positions in a few areas that the Tax Court summarily shut down!

  • Uncertainties - IRS asserted that Siemer could not face the same uncertainty for more than one year. The tax court responded that this argument was unpersuasive and that Siemer “could have faced the same uncertainties for several years in a row and not all uncertainties are neatly resolved within the confines of a single taxable year.”
  • Education - IRS asserted that Siemer could not have engaged in R&D activities as they did not employ anyone with the title of engineer or anyone with an engineering degree. The tax court responded that this argument was unpersuasive and that nothing requires a taxpayer to employ or contract with someone with a specialized degree to prove that research relied upon physical or biological sciences, engineering, or computer science.
  • Multiple tax periods - IRS asserted that Siemer could not have “new” projects for more than one year. The tax court responded that this argument was unpersuasive and that “the development or improvement of a business component can span more than one tax year.”

Uncertainties and projects themselves spanning multiple tax periods is VERY common.  Not only could projects that start very late in a year continue into the subsequent year, some projects are very complicated and time consuming, which could result in the project spanning more than two tax periods.  We agree with the courts argument that this is unpersuasive and doesn’t have any standing in the legal statute or case law.

While education may be very important for a taxpayer’s employees to perform their function, there is no statute or legal requirement that a skilled tradesmen (or anyone else for that matter) without a formal education isn’t performing R&D for a taxpayer. You have to look at the ACTIVITY not the EDUCATION of the individuals engaging in R&D. 

Key takeaway…it is the activity that matters, not when or how it is done!

Connect with Our R&D Tax Credit Experts for More Information

New call-to-actionThe 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 joe.burwick@freedmaxick.com, or simply click on the button to complete and submit a meeting request.

For more insight, observations and guidance on the R&D tax credit, click here.

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Why You Might Want to Wait on an R&D Tax Credit Study… Even if You Pass the 4-part Test

BlogBefore spending, consider these 2 additional R&D tax credit tests from the experts at Freed Maxick

New call-to-actionWe’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

New call-to-actionThe 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.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

 

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Good News: No Changes to the Research and Development Tax Credit

research and development deductionsHowever, 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).  

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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:

   

2017 Rates

 

2018 Rates

 

Difference

 
 

Taxable Income

20,000,000

 

20,000,000

 

-

 
 

Corporate tax rate

35%

 

21%

 

-14%

 
 

Corporate tax

7,000,000

 

4,200,000

 

(2,800,000)

 
               
 

R&D tax credit gross

615,385

 

615,385

 

-

 
 

R&D tax credit after 280C reduction

400,000

 

486,154

 

86,154

 
               
 

Net tax

6,600,000

 

3,713,846

 

(2,886,154)

 
 

Effective rate

33%

 

19%

 

-14%

 
               
 

% benefit of R&D credit (Effective rate - Corporate tax rate)

-2%

 

-2%

 

0%

 
               

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).  

Corporate AMT

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

Tax Situation ReviewThe 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 joe.burwick@freedmaxick.com, 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.

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Does Filing for R&D Tax Credits Raise an Audit Red Flag?

Does Filing for R&D Tax Credits Raise a Red Flag?New call-to-actionIf your company relies on the hard sciences or uses technology to create or improve products or processes, then you may be eligible for the federal Research and Development Tax Credit. Fear of being audited makes certain taxpayers (generally smaller companies, with limited resources) choose not to claim the R&D tax credit even if they may qualify.

IRS or state audits can certainly take an extraordinary amount of time and resources to handle. However, misconceptions abound about attempting to claim the R&D tax credit and the likelihood of a future audit, possibly stemming from the credit being a Tier 1 issue (i.e. top priority for review) in the IRS old “tiered” system for tax examinations and enforcement. The IRS discontinued the tiered system in 2012 and now leaves the choice to audit R&D tax credits to the discretion of field auditors. Further, recent taxpayer-friendly law changes and announcements clearly identify the importance of the credit as a matter of tax policy and global competitiveness. This in turn suggests that the IRS will not view R&D credit claims with the same level of skepticism as they did historically.

Bogus R&D Tax Credit Claims

There’s no doubt that some taxpayers that don’t qualify still claim fictitious or egregious credits. If a company that researched Van Gogh’s life tried to claim R&D credit, they would be denied because research in the social sciences (economics, business management, and behavioral sciences), arts or humanities is excluded from the definition of qualified research. However, a company that developed new formulation of artists’ paint would not be excluded, however.

Factors Considered by the IRS to Audit a Taxpayer

Certain factors can increase the likelihood of your R&D credit claim being audited:

  • The overall size of your credit claim. The larger your credit claim, the higher the likelihood of audit.
  • The credit you claim versus your industry average.
  • Filing an amended return that claims the R&D credit can also increase your chances of an audit, as all amended returns routinely receive additional attention from the IRS.
  • The industry you are in.  If IRS perceives potential abuse within an industry, you may have a higher likelihood of audit.
  • If your NAICS business code is one that indicates you may not be eligible, then you probably have a higher likelihood to get audited. Examples of such businesses include hair salons and restaurants.

How to be Successful on an R&D Tax Credit Audit

One secret: documentation, documentation, documentation. Regarding the quantitative aspects of claiming the credit, it is important to substantiate the amounts of your qualified expenses with proper records that clearly demonstrate the nexus between the activities performed and amount of credit you’re claiming. Regarding the qualitative aspects of the credit, it is important to provide documentation and/or create a narrative that addresses the IRS criteria to validate the eligible nature of qualifying R&D activities. Establishing the proper framework for supporting the R&D tax credit significantly increases the likelihood the claimed will be accepted on audit for both original and amended returns.    

Other tips for a successful audit:

  • Don’t go at it alone or rely on your deliverable alone. Bring in an experienced R&D tax credit specialist.
  • Respond timely to information document requests (“IDR’s”).
  • Know the IRS audit techniques guides, which the IRS publishes to inform field agents of areas to focus on.
  • Treat your IRS agent with respect.  

New call-to-actionThe R&D credit can provide a tremendous benefit to the right companies. Simply filing an R&D credit claim won’t cause an audit. However, working with tax experts familiar with the R&D tax credit and audit process will help to: (1) ensure the R&D tax credit claim will survive an audit (2) to identify efficient processes for supporting the R&D tax credit claimed every year.   

Please call us today at 716.847.2651 if you would like to speak with us in more detail about the audit process or to evaluate whether your company may be eligible for the R&D tax credit.  

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

 

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Four R&D Tax Credit Documentation Methods

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

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

Methods to Keep Records (From Best to Worst)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Seek R&D Tax Credit Record-Keeping Help

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

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

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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R&D Tax Credit Calculation: Using the Proper Method to Calculate R&D Wages

method to calculate r&d wagesNew call-to-actionIf your company relies on the hard sciences or uses technology to create or improve products or processes, you may be engaging in qualified R&D activities and be eligible for the Research & Development Tax Credit. But you have to know how to apply to get most use out of the credit.

One common area where companies incur most of the qualifying R&D credit costs is also the area of most R&D tax credit calculation mistakes: wages.

How not to claim wages for the R&D credit is in IRS Field Attorney Advice 20171601F released in April, which relates how the IRS concluded that one taxpayer used an impermissible method to determine eligible wages related to research expenses.

The Wrong Approach (Don’t Do This)

The taxpayer claimed credit for increasing research activities for at least four years. Employees of the taxpayer performed both qualified and nonqualified services. But in short (see end of post), the controller of the company simply estimated the level of R&D in terms of wages—what percentage of what employees’ salary was devoted to legitimate R&D activities—then took a statistical sample of the projects and multiplied the estimated wages by the estimated R&D project for the year.

The taxpayer did not use the method provided in Regulation 1.41-2(d)(1), which states:

“If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expenses. In the absence of another allocation method that a taxpayer can demonstrate to be more appropriate, the amount of in-house research expense shall be determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the taxpayer to the total time spent by the employee in the performance of all services for the taxpayer during the taxable year.”

The underlying issue in the case related by the IRS: The taxpayer failed to maintain adequate records reflecting the costs of its qualified research activities and couldn’t determine how much time its employees spent performing qualified services with respect to a particular project.

Five Good Moves[1]

It seems the taxpayer described above was “penny-wise and pound-foolish,” as it appears they didn’t hire a qualified professional to help them pay attention to the methods to claim the R&D tax credit. The following are five things our firm would have advised this company to do when substantiating the wages allocable for the R&D credit:

  • Don’t go it alone. Get experienced help in claiming the R&D tax credit.
  • Don’t have just your controller do the claim work. You need an in-house subject matter expert who was involved in the actual R&D to work with your accounting personnel and R&D consultants.
  • Make every effort to maintain documentation to back up claiming the credit. Look for the historical data that will support the claim and qualitatively discusses the nature of the project: timecards, reports, minutes, even promotional brochures. Anything that points to the innovation or the challenges in creating it helps to support the claim for the credit.
  • Look for needed improvements in your internal recordkeeping to make it more efficient to claim the R&D credit in future years.
  • We have the necessary experience to help you efficiently claim all the R&D tax credit you are entitled to. Contact us at any time to discuss your particular facts and circumstances so that we can help you maximize and substantiate the credits you are entitled to.[2]

The Wrong Approach: One Taxpayer’s Made-Up Two-Step Process

  • The taxpayer’s controller identified which employees were believed to have performed qualified services at any time during the taxable year. They estimated the fraction of each employee’s time spent performing qualified services, then multiplied this fraction by the employee’s total wages for the year. The controller then added the amounts calculated for each employee to calculate the initial estimate of total wages incurred for qualified services.
  • The taxpayer multiplied this estimate by a fraction, based on a statistical sample. The denominator was the number of projects that the taxpayer believed to involve 50+ hours of work by employees and that might have involved at least one employee who conducted qualified research during some part of the project. The numerator was a subset of the projects in the denominator, with respect to which the taxpayer (after investigating a random sample of the projects) determined that an employee performed qualified research during some part of the project.

The Biggest Reasons the Methodology is Not Appropriate:

The taxpayer only considered whether the project involved qualified research at some point and did not determine what percentage of total project costs were attributable to the performance of qualified services, such as wages. The taxpayer provided no reasonable basis to apply their methodology, and the process looked at no detail of how the employees’ work time actually contributed to the R&D.  Thus, taxpayer’s methodology is not more appropriate than the method provided by Treasury Regulation 1.41-2(d) and was rejected by IRS.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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

consistency-rule.jpg

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

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

Boosting Your R&D Tax Credit

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

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

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

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

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

Calculations

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

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

Outside Contractors

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

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

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

Benefit of Better Tracking

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

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

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

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

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

Outside Contractors

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

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

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

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

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

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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

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

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

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

Do Your QRAs Back Your QREs?

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

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

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

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

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

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

Burden of Proof

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

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

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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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.

New call-to-actionLarge 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.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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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.

New call-to-actionf 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.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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