The Research & Development (R&D) tax credit provides competitive incentives and extensive cash-flow opportunities for U.S. business owners. However, as with many government programs, receiving the benefit heavily relies on one major component: the documentation
Understanding these important terms is critical to R&D tax-program compliance:
Qualified Research Activities (QRAs): includes both internal and external contracted activities undergone during an experimental process to discover or improve products, processes, or formulae.
Qualified Research Expenses (i.e., Qualified Research Expenditures or QREs): eligible expenses, incurred during qualified R&D activities, used to calculate the tax-credit value.
R&D Tax-Credit Documentation Plays a Vital Role in Program Participation
R&D tax-credit documentation requires verification of all QREs to maintain compliance. Consistent and complete documentation minimizes a company’s risk during IRS audits. Furthermore, sufficient documentation is described in Internal Revenue Code (IRC) section 41, which states that “the taxpayer must retain detailed records to substantiate that the expenditures claimed are eligible for the R&D tax credit calculation.”
For many business owners, hearing these words alone – documentation, tracking, compliance, audit — sufficiently deters them from pursuing R&D tax credits. As a result, each year, organizations of diverse size and scope miss out on this highly rewarding program simply because they don’t want to deal with the documentation.
Use Our Documentation Checklist
At Acena Consulting, we understand that no one (besides our team, of course) enjoys chasing tax paperwork. We offer an easy-to-follow R&D Tax Credit Checklist to focus our clients on the essential documentation that facilitates filing for the R&D tax credit. Key considerations include:
Understanding the Required Documentation Framework
The first step is building the basic documentation framework associated with your business’ operations and internal processes.
The system should capture both quantitative and qualitative components because claiming the R&D tax credit requires both types of evidence to be documented and evaluated.
Contemporaneous documentation: The IRS requires that all records must be kept to prove the actual use of funds for qualified research. To document research activities "contemporaneously," businesses must maintain and include information that explains the nature, conducting, or purpose of the research activity, as well as documents that show the amount of direct and indirect expenses.
Qualified Research Expenditures (QREs)
The quantitative component of the R&D tax credit encompasses qualifying research expenses (QRE) directly incurred during qualified R&D activities. Documentation related to these items is critical to making the credit calculation and supporting it, in the event of an audit.
Many executives don’t realize that QREs can be either contracted or internally incurred expenditures. Furthermore, If you are new to research credits, it can be a worthwhile exercise to delineate both qualified and nonqualified activities as part of the overall research tax credit calculation, to ensure that there are no "blind spots" in the overall analysis.
Some of the most common and significant QREs include:
- Qualified Wage Expenses: Salaries or wages of staff and supervisors working on eligible initiatives.
- Qualified Supply Expenses: Non-depreciable equipment, materials, and supplies used during R&D initiatives. This can also include rental or lease costs of supplies.
- Qualified Computer Rental Costs: rental or lease costs of computers under Sec. 41(b)(2)(A)(iii), which provides that “any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.”
- Qualified Contract Research Expenses: Payments to contractors for time spent performing qualified tasks.
Other Limiting Rules: What doesn't qualify as QREs?
- Non-Taxable items connected to employee wages, like 401(k) contributions, health insurance contributions, pre-tax benefit deductions, and other pre-tax benefit deductions must be omitted from the calculation.
- Items related to marketing activities, business acquisitions, or stock options don’t qualify.
- Any expenses relating to maintenance and repairs of tangible property don’t qualify as QREs.
It is next necessary to evaluate development efforts conducted during the tax year. This evaluation includes documenting all potential efforts that may qualify under IRS guidelines.
Identify Eligible Activities for R&D Documentation
For development efforts to qualify, they must pass a four-part test, demonstrating:
- Permitted Purpose
- Elimination of Technical Uncertainty
- Process of Experimentation
- Technological Nature
Each development activity must pass all four tests to be included among development-associated expenses. Documentation showing how the project satisfies each test should be created and maintained in your documentation system.
Consistency Requirement for the R&D Tax Credit
The consistency requirement for research and development tax credit refers to the need for businesses to uphold consistent treatment of their qualified research expenses when claiming the tax credit. This requirement ensures that businesses both accurately and consistently calculate eligible R&D expenses and claim the corresponding tax credits.
To meet the R&D tax credit’s consistency requirement, businesses must use a reasonable method for determining their QREs and must also apply this method consistently from year to year. Put simply, companies are expected to utilize the same principles, criteria, and calculations to identify and track qualified expenses throughout the entire duration of the project or research.
One thing that’s important to note: Yes, consistency is required when calculating and claiming the R&D tax credit. However, the consistency requirement does not mean that companies must use the same accounting method for determining QREs each year. The current legislation allows for flexibility in selecting the best or most appropriate method for the given circumstances as long as the selected method remains consistently applied over time. Should there be changes in the accounting method, businesses should ensure they are well-documented and supported by valid reasons.
Key components of your documentation system to support consistency include:
- Maintaining accurate and detailed records of all project QRAs and QREs on an annual basis.
- Keeping copies of tax returns during base years.
- Hiring an outside consulting firm (like Acena Consulting!) to perform a full R&D study.
Failure to adhere to the Consistency Requirement can result in significant penalties from the IRS, so take this requirement seriously.
Maintain Audit Compliant Documentation
When evaluating documentation for audit protection, you must confirm that all QRA-related expenses are captured in your documentation system. This measure ensures the IRS can easily verify these expenses and decreases the risk of an audit.
Tracking time spent on development efforts also provides protection against adjustments if audited.
All taxpayers filing for the R&D tax credit should maintain easily accessible documentation to support QRE designations. Account ledgers, accounting approaches used, expensed supplies, fixed based percentage calculations, org charts, and wages paid are examples of documentation that may be required to file for the R&D tax credit.
Acena Consulting Streamlines R&D Tax Credit Documentation