Four R&D Tax Credit Documentation Methods

If 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

Solid 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.