Year after year, qualifying businesses leave billions in R&D tax credits unclaimed. This is due to complexity, audit concerns, and misconceptions about applicability.
Your clients can qualify for the credit by conducting internal research to improve product quality, performance, reliability, or functionality. Those activities must have a qualified purpose, address technological uncertainty, and follow a documented process of experimentation.
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Know Your Eligibility
Despite the credit’s lengthy history and multiple extensions, many business owners still need to learn what are R&D tax credits and how they can qualify. And, even for those who do, proper documentation is needed to claim the eligible credits. The first step to determining your qualification is understanding the four-part test for R&D tax credits.
Your research and development activities meet the Four-Part Test if they’re designed to improve existing products or services and aren’t just developing new technology from scratch. You must also attempt to discover technological information that would allow you to create, modify, or enhance your product or service, and the activities must be systematically evaluated for success. Another common misconception is that your research must be in a scientific or technical field to qualify for the credit, which is untrue. The IRS recognizes qualifying industry research activities, including cosmetics, apparel, food and beverage, telecommunications, and software.
You must be able to document your research and experimentation activities with detailed logs of things like your guiding assumptions, testing methodologies and timelines, and iterative changes made on the way to your desired outcome. These can be as simple as your project plans and notes for day-to-day operations. And, if you’re partnering with a qualified tax preparation expert, they can evaluate your documentation and make finding and tracking qualifying expenses easier.
Track Your Activities
The IRS‘ four-part test for R&D credits requires a process of experimentation to resolve technical uncertainty. This includes trial and error, modeling, simulation, or prototyping. In addition to proving that you’re working to improve your business component’s function, speed, quality, or cost-efficiency, the test also demands that you have documented each step of this process.
While many companies have difficulty asking engineers to keep daily time-tracking and activity records, developing a documentation process that effectively captures the relevant information needed to qualify for the credit is possible. This should include payroll and project-based expense records, receipts, and accounts for materials used. It should also incorporate a project-based time-tracking solution that documents the qualifying R&D activities as they are performed. For example, if your engineering team uses a common open-source repository for software development, make sure you have a way to differentiate the code they work on from other contributions in the repo. In the event of an audit, this will help your accountant address claims related to your engineering team’s R&D efforts.
The IRS requires businesses that claim the R&D Tax Credit to maintain documentation of their qualified research activities and related expenses. This isn’t a burdensome requirement but a necessary one to ensure compliance with the program. The good news is that much of the information required for this documentation can be gathered from companies’ records. Time-tracking and expense reporting systems are one source of documentation that can be easily used to demonstrate R&D eligibility. In addition, many projects can be documented through design iterations, CAD drawings, project progress reports, change orders, test results (both successful and failed), marketing materials, and other relevant documents. Distinguishing between direct and indirect costs is often the most critical step in documenting qualified R&D activities. This common mistake leads to missed credits for companies across all industry verticals. For instance, motorsports teams tink with their vehicles daily in the garage. Still, these expenses may be lumped into one general ledger account without clearly labeling them as racing or testing related. This leads to many qualified R&D Credits being left on the table. To avoid this common mistake, your tax advisor can help you create a process to collect the right types of documentation from your engineers and other key staff. Creating a clear, streamlined approach to documenting qualified R&D activities will make it much easier come tax filing season.
Analyze Your Results
Many companies leave credits on the table year after year because they need to learn how to identify, track and support their eligible activities. With the right tools, it’s possible to make claiming the R&D tax credit much easier for your clients. Using dedicated software to survey and gather information can also help avoid mistakes like asking the wrong people the same questions or presenting confusing results. This makes the process much faster, simpler, and less risky for you and your clients. The software also helps you make sense of the complex state, federal and international rules governing credit. It provides a single view of data, showing you the different options and how they apply to your client’s situation so that you can craft an appropriate, unified strategy. Moreover, if your client uses the same payroll and project tracking system, this software can access data from those systems, making the entire process even more seamless and effective. This approach can also eliminate time-consuming manual data transfer steps and reduce the burden on your tax employees.