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Best Practices for R&D Tax Credit Documentation

Protecting the bottom line is essential for long-term success in the ever-evolving business landscape. One often overlooked avenue for achieving this is leveraging available tax credits and incentives. The Research and Development (R&D) Tax Credit is the most powerful permanent tax credit available to businesses today to invest in innovation, ultimately strengthening their competitive edge.

However, claiming this credit can be complex and tedious without expert assistance. Businesses that invest in R&D and want to reduce their tax liability via the federal R&D tax credit must be able to show Qualified Research Activities (QRAs) and substantiate Qualified Research Expenses (QREs), but it’s not always easy to make sense of exactly what type of evidence and paperwork is needed. This article explores the key aspects of R&D tax credits, vital recordkeeping requirements, and examples of required documentation.

Understanding R&D Tax Credits

The R&D Tax Credit is a dollar-for-dollar credit that directly reduces the tax liability of a business for designing, developing, or improving products, processes, formulas, inventions, techniques, or software. It was designed to incentivize businesses to invest in innovation and technology and keep high-paying technical jobs within the US. This credit is available at the federal level and in almost 40 states, making it one of the most lucrative business incentives available to U.S. taxpayers.

Qualified Research Activities

To claim the R&D tax credit, a business must engage in “qualified research activities.” These activities typically include experiments, tests, and systematic investigation to develop new products, processes, or software. For example, developing new or improving existing software, developing or enhancing existing manufacturing processes, experimenting with new product prototypes, and more.

A research activity must meet the four-part test to be a QRA, and taxpayers must be able to document that an activity passes all the elements of the test:

  1. Permitted Purpose – The business must show that the activity is intended to create new or improved business components to increase performance, functionality, reliability, and quality.
  2. Elimination of Uncertainty – The business must show its intent to discover information that eliminates uncertainty concerning the capability, methodology, or appropriateness of the development or improvement in the business component.
  3. Process of Experimentation – The business must demonstrate that it utilized a systematic process to evaluate one or more alternatives to achieve the desired results.
  4. Technological in Nature – The business must show that the research activity must rely on physical or biological sciences, engineering, or computer science principles.

Qualified Research Expenditure

The QRE is a critical component of R&D tax credit calculations. QREs include employee wages, contract research expenses, supplies, and rental or lease costs of computers. Businesses need to keep in mind that the expenditure incurred should be directly tied to the specific research project.

  1. Employee Wages: The R&D tax credit covers employee wages for services directly involved in, supervising, or supporting research. This includes federal taxable wages reported on Form W-2, including bonuses and stock option redemptions.

    Documentation for qualified employee expenses
    • Employee Forms W-2
    • Payroll registers
    • Timesheets
    • Oral testimony
    • Meeting minutes
  1. Contract Research Expenses: Contract research expenses refer to the applicable percentage, typically 65%, of amounts paid or incurred by the taxpayer to third parties (NOT taxpayer’s employees) for qualified research.

    Documentation for qualified contractor expenses
    • Chart of accounts
    • General ledger
    • Service contracts
    • Purchase orders
    • Invoices
    • Forms 1099-NEC (for individual contractors)
  1. Supplies: The IRS defines qualified R&D supplies as any tangible personal property, excluding land, improvements to land, and depreciable property. To qualify as a QRE, a supply must be directly related to the performance of qualified services.

    Documentation for qualified supply expenses
    • Chart of accounts
    • General ledger
    • Purchase orders
    • Invoices/Receipts
    • Bills of lading
  1. Rental/Lease Costs of Computers: Rental or lease expenses for computers or cloud computing can be considered QREs if they are directly associated with qualified research activities. This can include expenses for renting or leasing computers, laboratories or research facilities, and other equipment used directly in the R&D activity.

    Documentation for qualified computer rental or lease expenses
    • Lease agreements or rental contracts
    • Logs & schedules documenting rental usage
    • Invoices/receipts

The above lists will give you an idea of what you might need to claim this credit but are by no means a definitive checklist. Required documentation may differ from one project to another. This is why you must consult a tax provider with expertise in R&D tax credit requirements in relation to your specific industry.

How to Claim the R&D Tax Credit

Businesses benefiting from R&D tax credits must file Form 6765 (Credit for Increasing Research Activities) as part of their income tax return. This form is where you report the details of your qualified research activities and expenditures, and it plays a pivotal role in the credit application process. Completing Form 6765 accurately is vital, as errors or omissions can lead to delays or disqualification.

Moreover, recent guidelines released by the IRS require businesses to provide the following information using Form 6765:

  • Identify all the business components to which the Section 41 research credit claim relates for that year.
  • For each business component, identify all research activities performed and name the individuals who performed each research activity and the information each individual sought to discover.
  • Provide the total qualified employee wage expenses, qualified supply expenses, qualified contract research, and qualified lease or rental expenses for the claim year.

How alliantgroup Can Help You Maximize Your R&D Tax Credit

R&D tax credits present a compelling opportunity for businesses to invest in innovation and enhance competitiveness. However, claiming these credits requires a thorough understanding of qualified research activities and qualified research expenditures.

At alliantgroup, with our two decades of experience in tax credits and incentives, technology, and a team of former IRS commissioners, policymakers, and 800+ industry-specific experts, we’re well-equipped to assist businesses with R&D tax credit documentation, calculations, and reporting. We are at the forefront of changes in regulations impacting tax credits. This gives us deeper insight into industry-specific activities that may qualify a business for this credit.

Contact us to discuss R&D tax credits for your business. Reach us today at 844.524.0077.

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Mark W. Everson

The Honorable Mark W. Everson was the nation’s 46th Commissioner of Internal Revenue Service serving from 2003 until 2007. Prior to joining the IRS, Everson held Bush administration posts as Deputy Director for Management at the Office of Management and Budget and Controller of the Office of Federal Financial Management. Everson also served in the Reagan administration, holding several positions at the United States Information Agency and the Department of Justice, where his assignments included Deputy Commissioner of the Immigration and Naturalization Service. At the state level, Everson oversaw the Indiana Workforce and Unemployment Insurance Systems under Governor Mitch Daniels.