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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.