New Documentation Requirements Shed Light on Underutilized Incentive

The research and development (R&D) tax credit may be one of the most underutilized business tax incentives available to U.S. taxpayers. It is estimated that as many as two-thirds of businesses that might qualify to take this tax credit don’t take it, either because they don’t know it exists or they don’t believe they have expenses that would qualify.

Documentation is Key

Taking the R&D tax credit requires an understanding of which expenses and activities qualify, along with careful documentation of those expenses. As of January 2022, claiming the R&D tax credit on amended tax returns became more difficult, as the IRS started requiring more stringent documentation. The change cast a light on the tax credit and prompts discussions between business owners and their advisors about recapturing some of their tax costs from previous years.

If you think your business may qualify to recover past taxes by identifying and documenting R&D activities, now is the time to have a discussion with your tax advisor. Generally, to claim a refund, you must file within 3 years after the date you filed your original return or within 2 years after the date you paid the tax, whichever is later.

Ask the Right Questions

Many times companies don’t realize they have Qualified Research Expenditures (QRE’s), or there has not been enough activity in the past to undergo through the analysis necessary. Sometimes a change in ownership, or change in accounting firms, or someone asking the right questions stimulates the conversation to realize that there may be a host of activities that add up to valuable tax savings

Broadly speaking, an activity may qualify for the R&D credit if it drives innovation for the company, or if it is involved in developing new products, improving existing products, developing software, improving processes or techniques.

A sample of activities that can qualify for the R&D tax credit are costs related to:

  • Hiring outside labor with experts in a specific field, like a certain type of engineer that is not available in house.
  • Scrap materials, prototypes and expenditures related to testing.
  • Labor costs of people facilitating, testing or helping on new products or systems.
  • Computer aided drafting.
  • Experimenting on designs, inputs or raw materials, through multiple iterations, finding ways that didn’t work, going back to the drawing board and working on the project again.
  • Uncertainties in developing a product, processes, or material
  • Innovating software, as long as there is risk of failure, and the outcome is unknown.

While the term “research and development” is often associated with the technology, manufacturing and science environments, businesses in just about any industry can qualify to receive the tax credit. For instance, farmers who experiment with a different type of corn seed on one field or with a new feed mixture for their cattle, may qualify.

Some of the industries that typically qualify are aerospace, agriculture, automotive, biotech, construction, financial services, insurance, material fabrication, medical research, software development and technology.

Activities can qualify, as long as you have each of the following: 

  • A qualified purpose, defined as relating to performance, quality, reliability or a new or improved function of a business component of the taxpayer. In other words, you want to see if the new feed mixture results in a certain percentage weight gain in your cattle.
  • Technical uncertainty.
  • Process of experimentation.
  • Discovery of technological information by using principles of the physical or biological sciences, engineering or computer science.

The new documentation required to claim the R&D tax credit on amended returns, recently released by the IRS, includes:

  • Identify all business components for which there are research credit claims for that year.
  • Identify all research activities performed for each business component.
  • Identify all individuals who performed each research activity.
  • Identify all information each individual sought to discover.
  • Provide the total qualified employee wage expenses, total qualified supply expenses and total qualified contract research expenses for the claim year.

Typically, all this information is gathered during an R&D tax credit study, but now the IRS wants this detail included with an amended return. With research claims coming under high levels of IRS scrutiny, properly substantiating claims for R&D credits are now more important than ever.

The more rigorous documentation standards are an additional challenge when combined with new law contained in the Tax Cuts and Jobs Act (TCJA) of 2017. This legislation provided that, starting in 2022, R&D costs can no longer be expensed immediately but must be capitalized and amortized over at least five years. The impact includes higher immediate tax liability for companies with R&D expenditures.

But for many business taxpayers who have R&D expenses but have never taken the tax credit, it still represents a significant opportunity to save on taxes.

R&D Tax Credit Study

All of this may sound complex, but an R&D tax credit study by qualified advisors can help identify the processes in your business that may help you recoup past taxes and save on future taxes.

R&D tax credit studies can be beneficial in all industries, but especially in manufacturing, where taxpayers are innovating to make a part, product, or process faster, stronger and better. A company may have a new part design that they designed, fabricated, and tested by starting with a model or prototype, then checked for fit, form, and function until satisfactory results were achieved.

If you would like to discuss your company’s potential for saving on taxes through the R&D tax credit, contact your Adams Brown advisor.