Many business owners, manufacturers and software designers believe the process of documenting project expenses that qualify for research and development (R&D) tax credits is onerous and time-consuming. However, the effort is well worth it as their qualified projects can yield beneficial tax savings, increase their cash flow and give them a competitive advantage. Although setting up a system to capture acceptable expenses for a claim may seem daunting, qualified R&D tax credit professionals can make the process painless.
The first step is to determine which activities and processes may qualify for R&D tax credits according to a simple four-part test established by the IRS:
- Permitted purpose/business component – Must relate to creating new or improved business components that result in improved function, performance, reliability or quality.
- Technological in nature – Must rely on the principles of physical or biological science, engineering or computer science. These principles can cross into many industries including manufacturing, software design, device and component development, and engineering.
- Elimination of uncertainty – Must be intended to discover information to eliminate uncertainty regarding the capacity, method or design for developing or improving a product or process.
- Process of experimentation – Should include the evaluation of different alternatives to resolve or eliminate a technical uncertainty. This evaluation may involve modeling, systematic trial and error, simulation or other methods.
Once you know your activities qualify under the four-part test, the next step is to capture and document key information related to the project such as labor costs, supplies and payments made to third parties for performing qualifying research.
Although the IRS and state governments do not have specific requirements for the documentation needed to request the R&D tax credit, the IRS recommends keeping records in sufficient form and detail to substantiate the expenses that are being claimed.
Qualifying Labor Expenses
Because employees may work on several projects at once and perform different types of duties, it is important to segment qualified R&D activities from all other work performed. Many payroll systems can be programmed to track qualified research wages to qualified research projects.
The types of documentation that can be used to substantiate R&D labor expenses include:
- Time tracking data
- Employee W-2 forms
- Payroll registers
- Time questionnaires
- Job descriptions
- Meeting minutes
- Interview notes provided for oral testimony
Qualifying Supply Expenses
Expenditures for qualifying supplies and materials used on projects often are more straightforward and easier to track. Accounting and purchasing systems can be programmed to flag qualifying expenses on projects. What qualifies for the R&D tax credit calculation can be surprising at times. For example, the supplies used to build prototypes used in research and development and later sold to customers may qualify.
Typical sources for documentation of supply expenses include:
- General ledger
- Chart of accounts
- Purchase orders
- Invoices
Payments Made to Third-Party Contractors
If a third-party contractor or firm provides research, design, engineering or other services on a qualified project, those expenses also may qualify for the R&D tax credit. Proper documentation and segmentation of qualified expenses is vitally important because contractors often comingle expenses on their invoices.
Documentation to qualify third-party expenses may include:
- Third-party work contracts
- Form 1099 for individual contractors
- Purchase orders
- Invoices
- General ledger
- Chart of accounts
Seek the Advice of Experts to Streamline Documentation and Claims
Claiming R&D tax credits requires a fair amount of documentation to satisfy the IRS and state governments. That’s why it is important to seek professional help from a tax consultant with substantial expertise in helping companies like yours successfully claim these valuable tax credits.
Engineered Tax Services can conduct a tax credit study which provides a comprehensive analysis of your business’ R&D activities. With this analysis, we can prepare a detailed claim package of expenses that qualify for R&D tax credits, and our professional tax experts will document your activities and expenditures. We will be prepared to defend your claims should state or federal tax authorities initiate an audit.
To learn more about claiming R&D tax credits for your company’s projects, visit our R&D tax credit page for more information and complete the form at the bottom of this page. If you have immediate questions about tax deductions for your business, please call Engineered Tax Services at (800) 236-6519.
