Even though many U.S. companies are eligible for the R&D tax credit, they never take advantage of it. The reasons can be multiple: either they aren’t really aware of this possibility, not sure whether their organization qualifies, or simply don’t bother to apply. As a result, they might be missing out on hundreds of thousands of dollars. So what exactly is the R&D tax credit?
The R&D Tax Credit: Overview
Research & Development (R&D) Tax Credit is a tax incentive introduced by the US Government to foster innovation. It started out as a temporary program in 1981, and remained that way until December 2015, when the PATH Act made the R&D Tax Credit permanent. It allows companies to claim between 6 and 14 percent of their eligible R&D expenses. This percentage may vary from state to state.
Who Is Eligible
People often think that only research labs or large corporations qualify for this credit, but this isn’t exactly true. Businesses of all sizes may apply if they carry out research or experimental development provided they can present evidence to support their claims.
Among other misconceptions is the idea that you have to introduce a breakthrough technology to qualify, or at least be successful in your research. Well, neither is actually true. It doesn’t really matter if your research fails, or results in only minor improvements. It is the effort that gets rewarded.
What Expenses Can Be Claimed
According to the U.S. IRS agency, companies can claim credit nearly for all expenditures related to the development or optimization of a product. More specifically, they include:
- Wages paid to the employees who conducted the R&D activities;
- Supply and material costs related to the R&D, including prototype models;
- Contract costs — if a third-party contractor was hired to conduct research for your company;
- Computer leasing — if you have used cloud services to perform research or experiments.
What Activities Qualify
For a business to qualify for the R&D tax credit, its activity must satisfy the criteria listed below:
- Seek to discover new information and eliminate technical uncertainty. In other words, the research should reveal new knowledge about product development or improvement. For example, QA activities or market research will not qualify here.
- Involve experiments.
- Be technological in nature and based on the hard sciences (from physics and chemistry to engineering and computer science).
- Have a qualified purpose, such as creating or improving an existing product or process.
What You Need to Do
As already mentioned, the most important — and challenging! — part is to support your claim with evidence. Sure enough, you will need to have your costs and projects documented. There is no official guidance on the required documentation, but you should do your best to provide accurate, structured and specific information.
By the way, it’s also possible to apply for an R&D tax credit retroactively for at least three past years, so make sure to document everything along the way.
Here are more tips on how to prepare documentation for a tax return:
- Collect records to demonstrate your R&D activities (preferably at the time when they are carried out). This documentation might include lab reports, patent claims, experiment descriptions, protocols and logs, etc. Relevant internal emails could also be useful here.
- Implement employee timesheet to facilitate project time tracking. Since wages constitute the largest part of most tax claims, it would be a good idea to pay extra attention to this type of documentation. Standard payrolls is not enough: you will need to demonstrate how your labor costs are connected to the R&D activities. That’s where a detailed breakdown of working hours by projects could come in really handy.
- Keep your contract agreements. If you appoint subcontractors to perform the R&D for you, contract papers will be necessary to acknowledge your rights to the intellectual property. Other good examples of supporting documentation are invoices and 1099 forms.
- Structure your general ledger so that you can easily find supply costs associated with the R&D. Ideally, this information should be backed up by relevant invoices.
While there is no explicit guidance on how much documentation is enough, you should focus on providing quality rather than excessive information. According to the IRS, records should be presented in usable form and sufficient detail.
What Further Steps You Need to Take
Companies who want to claim R&D tax credit have to submit their applications to the IRS (Internal Revenue Service). Apart from supporting documentation, you need to provide Form 6765 (as well as form 3800 for small businesses and several other categories of taxpayers). During the audit, the IRS might conduct interviews with technical or financial staff to clarify certain questions. Many businesses prefer to appoint a tax advisor to guide them through the application process.
Besides, most U.S. states offer their own R&D tax incentives. Since state requirements might be different from the federal ones, it makes sense to clarify them with the local tax authorities.
If a company conducts experiments or tests while developing a product or improving a service, their activities might qualify as R&D under the U.S. federal tax incentive. This opens up an attractive opportunity to claim a part of your research expenses and use it to fuel future projects. Just keep in mind the most important part of the process — collecting the supporting documentation: lab reports, invoices, payrolls, and, of course, employee timesheets.