If your business engages in any research and development to improve its processes, products or services, it likely qualifies for the federal R&D Tax Credit. This credit – not a deduction, but a dollar-for-dollar reduction in taxes. can create immediate cash flow by reducing current-year tax liability for a broad range of business activities in a wide variety of industries.
The U.S. Chamber of Commerce reports that fewer than three in 10 businesses that would qualify for the Research and Development Tax Credit apply, and most of those are large businesses.
Small businesses are leaving many millions of dollars on the table, in part because they believe the documentation requirements are too onerous. While everything in a credit claim must be documented, the paperwork is already gathered by businesses that would be claiming the credit.
With the help of a tax advisory firm like National Tax Group, businesses seeking to claim the credit should have no trouble gathering the documentation, particularly if they begin the process at the beginning of their R&D efforts.
Businesses that claim the R&D Tax Credit quickly become familiar with a variety of terms unique to the IRS. They include Internal Revenue Code (IRC) Section 41(b); Qualified Research Activities (QRAs); Qualified Research Expenses (QREs); Form 6765, and improved products, processes, software, techniques, inventions or formulas.
Qualified Research Activities (QRAs)
Qualified research activities are those involved in improving products, processes, software, techniques, inventions or formulas.
They must meet a four-part test: their aim is to improve function, performance, reliability or quality; they are designed to eliminate uncertainty about the development or improvement of a business component; experimentation has been based on the scientific method; and research was based hard sciences – biology, chemistry, physics, engineering or computer science.
To demonstrate to the IRS that your business is engaged in QRAs, the first step is to document everything and carefully track all documentation.
The requirements are nebulous and uncertain, so National Tax Group recommends its clients document err on the side of over-documenting. Saving blueprints, patents, designs, drawings, and prototypes, project notes and meeting minutes related to research help establish the R&D efforts in a business are QRAs.
Qualified Research Expenses (QREs)
Once R&D efforts are established as QRAs, the next step requires documentation that delineate QREs – qualified research expenses.
These expenses include the cost of tangible supplies used in research and development; employee wages and salaries of all employees engaged in, directly supervising and directly supporting research and development; up to 65% of contract research expenses paid by the business; and up to 75% of payments to tax-exempt scientific research organizations and educational institutions involved in outside research.
Documenting R&D Expenses
To establish the legitimacy of QREs, every contract and employee record must be saved, along with all receipts for tangible supplies. For employees, that might include W-2s, payroll documentation, time studies and meeting minutes. For supplies it might include invoices, purchase orders, receipts, bills of lading and the company’s the general ledger.
According to Treasury Regulation Sections 1.41-2(e), contracts with outside vendors must stipulate that payment is for work and not results, research is performed for the use and ownership of the claiming business and all economic risk is accepted by the claiming business.
For both employees and outside contractors, only wages may be claimed as part of the tax credit, not ancillary benefits like health insurance, or non-taxed income. Along with the general ledger, service contracts, purchase orders, invoices and 1099-NEC forms should be saved.
Eventually, any business seeking the R&D Tax Credit must file IRS Form 6765 and submit it with its federal income tax return.
A tax specialist can help you with the form filing, expense calculations, and qualification determinations, increasing the likelihood of a successful tax credit and significant sums flowing back into your business. Contact National Tax Group for a free consultation to determine if your business qualifies for the R&D Tax Credit.
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