The R&D Tax Credit provides tax incentives for innovative US-based companies. Your company may not qualify for the R&D tax credit right now, but there are steps you can take to qualify in the near future. Whether your business is newly formed or well established, it’s possible to plan ahead to make sure you can claim your credit down the line.
Here are some best practices for preparing your company to claim the R&D Tax Credit.
What is Research and Development?
The goal of the R&D Tax Credit is to incentivize American companies to invest in innovation. (We’ve written a great article that explains the R&D Tax Credit in greater detail) Not all companies that innovate qualify for the R&D Tax Credit. However, many companies that think they don’t innovate actually do qualify for the credit. There’s a misconception that this tax credit is reserved for large corporations with teams of white coats or rocket scientists— but that’s not the case. Many small and growing businesses can qualify. The key is understanding how the IRS defines qualifying research activities. The IRS designed a four-part test to determine which activities qualify for the credit.
To qualify for the R&D Tax Credit, research activities must:
- be technological in nature (must fundamentally rely on a hard science, like engineering, physical sciences or computer science)
- eliminate uncertainty (eliminate uncertainty related to the capability, method or design of developing / improving a product or process)
- involve a process of experimentation (identify and evaluate more than one alternative to achieve a result)
- Have a permitted purpose (provide new or improved functionality, performance, reliability or quality for a business component)
Of course, the four-part test is far more complex and nuanced than this simplified summary. Reading the linked articles above will help give you a better understanding, but you may want to schedule a call with an expert for your specific tax situation.
Now that you have some background on whether your company qualifies or not, here are some practical tips on how to best prepare your company to claim the R&D credit, as well as strategic ways you can adjust your planning in order to qualify.
Avoid the 5 Common Pitfalls
The best way to prepare your company to qualify for the R&D Tax Credit is to avoid these common pitfalls.
1. Your company is conducting R&D activities outside of the US
The goal of the R&D Tax Credit is to support US innovation – so any work done outside the US doesn’t count towards the credit. We get it – offshoring software development or other related research activities can reduce costs and increase runway for both startups and larger established companies. But many startups don’t account for the tradeoff in quality, communication issues, time zone differences, data security and other factors that increase the risk of timely delivery within budget.
Here’s what to do: Consider moving some of those overseas research activities to the US. If you do the math, the R&D Tax Credit provides a huge incentive to do the work in the US. And you can always find regions in the US with lower cost of living that provide quality software development services for at lower costs.
Don’t forget that even if you’re offshoring development, the resources you have in the US that are providing direct support or supervision for the offshore activities can still qualify.
2. You’re not categorizing your books correctly
We see this countless times – companies that pass the 4 part test and qualify for R&D tax credits but mis-classify R&D expenses in their general ledger. These R&D expenses are often mis-classified and buried under “Cost of Goods” and this is a big red flag to the IRS. So companies will often have to “clean up” their books to re-classify R&D expenses correctly. This is a time consuming process and could be avoided if only some thought and consideration were made when starting R&D activities.
Here’s what to do: Talk to your bookkeeper and make sure you have an “R&D” category for your expenses. As you start paying for supplies, consultants, marketing samples, prototypes, patents, focus groups, etc that are related to your R&D, make sure these expenses are properly classified as such. If you’ve already begun R&D activities but don’t have them classified correctly, now is the time to correct any past misclassifications and ensure expenses are classified correctly moving forward.
3. You’re not keeping a list of supporting documentation
Businesses need to continually evaluate and document R&D activities to substantiate R&D Tax Credit claims on an annual basis. In case of an audit, the IRS will require evidence that shows not only how you calculated the credit amount, but why the wages and expenses qualify. A good tax provider will have prepared documentation that substantiates your R&D credit claim on your behalf, but part of the evidence is based on the documentation you created for your R&D activities. Tax filing season is stressful enough — you don’t want to be looking for supporting documentation during this time.
Here’s what to do: Keep a running list of documentation related to your R&D activities. This will make it easier for you to provide documentation to your tax provider so they can calculate and substantiate your R&D Tax Credit.
Be prepared to provide the following documentation:
- Project plans and proposals
- Project meeting minutes
- Marketing materials and publications
- Technical documentation
- Experimentation results
- Both successful and failed
- Other related documents you produce throughout the regular course of your business related R&D activities
4. You’ve determined you don’t qualify because you’re performing the research activities on behalf of another company
Many consulting companies and agencies perform R&D activities on behalf of their customers who pay for the research. This often leads to confusion about who can claim the R&D tax credit – the business that funded the R&D activities, or the company who performed the R&D activities.
The IRS allows companies who perform and are paid for R&D activities to qualify for the credit if they meet two criteria:
- Payment to the company that performs the work is contingent on the success of the research
- The company retains “substantial” rights to the research
In other words, the IRS checks to see if the company was “at risk” of bearing the research costs in case of project failure. For “substantial” rights, the IRS checks to see if the company can use the research results without having to pay for it.
Here’s what to do: Check the conditions of the contract with your customer to see if you are at risk of bearing some of the costs if the project fails. For example, if your contract is fixed-price, there’s a good chance you are at risk. You can also check the representation and warranty section of your contract for any conditions of remedy.
You should also check for “substantial” rights – the right to use the research results without paying for it.
If you’re a consulting company or agency that does a significant amount of R&D activities for your customers, take the time to thoughtfully negotiate the conditions of your contracts. You can often use the risk for the failure of the research (skin in the game) as leverage for a non-exclusive right to use the research results.
If you have any questions about your existing contracts and whether you can claim the R&D tax credit, schedule a call with an R&D tax expert.
5. You’re not meeting one of the four parts
Based on our experience, the technological in nature requirement of the four part is often the one that businesses fail to meet. There are many businesses that are innovating by “building a better mousetrap”, but their activities are not technological in nature (based on a hard science).
Here’s what to do: Consider investing in software development that supports your innovation so you can meet the technological in nature requirement. We find that innovative entrepreneurs often have future plans to enhance their product or processes to improve customer service or automate and digitize operational processes that were once manual. Accelerating these plans will help you qualify for the R&D tax credit that will subsidize a significant amount of the costs for software development while giving your business a competitive advantage sooner.
Please consult with a R&D tax credit expert before starting your software development investment, as there are certain conditions that may impact your ability to claim the credit. For example, using off-the-shelf software to build a mobile app or website may not qualify as R&D in the eyes of the IRS.
Taking these steps can help ensure your business is on its way to passing the four part test and qualifying for the R&D Tax Credit. Many companies don’t realize they can qualify for the tax credit by avoiding a few common pitfalls. If you have more questions about your eligibility, make sure to read about the common myths many businesses have about qualification.