How many balls in the air?
Your world includes designing and manufacturing your product AND selling and marketing it. We wouldn’t want to forget those other minor responsibilities like accounting, administration, HR, maintenance, purchasing, and oh yeah, taxes.
Here is one item you can take off your plate while learning enough to feel comfortable that it will benefit you: The Research Tax Credit.
Today we will take a complex tax credit and simplify it down to its core. Facts presented in a way to help you understand if this tax credit may lower your federal income taxes.
The “simple” 4-part test
Your development activity must pass a set of tests commonly known as the 4-part test. While we could go into the very depths of each test, here are the basics:
Business Component Test: Are you developing a business component (a short way of saying a product OR process OR software OR technique OR formula OR an invention) for sale or use by a customer. We stress the word OR because the test applies individually to each business component.
Example: A small business designs a new product for use in the grocery industry (I picked the grocery industry because it’s almost lunchtime). The effort to develop this new product would be one business component. After design is complete, the small business also develops a process to manufacture the new product. The design and development of the process would be a second business component.
Elimination of Technical Uncertainty: At the beginning of the development process, uncertainty related to capability (Can we develop this?), Process (How do we develop this?) OR appropriate design (What is the correct design?) must be present (we will talk shortly about documenting the technical uncertainties).
Example: Our small business owner recognizes that this new product idea for the grocery industry could be made using plastics or metals and the actual design may not be known until they build and teste a few prototypes. These uncertainties qualify for this second test.
Process of Experimentation: In order to alleviate technical uncertainties, a development team must evaluate one or more alternatives or conduct a process of trial and error. This iterative effort around eliminating technical uncertainties is important to the process. If there is no iteration or evaluation of alternatives, then it would follow that there was no technical uncertainty.
Example: Small business development team recognizes their new product may take several forms and evaluates (through various designs on their CAD system) a number of different designs. The process of developing and evaluating various alternative designs would satisfy this test. If, in addition to this evaluation process, the development team then built one or more prototypes in order to test their new design(s), this process would also be considered part of the Process of Experimentation.
Scientific Principles: Embedded in the Process of Experimentation is the requirement that principles of hard science are used to alleviate the technical uncertainties. The principles of hard sciences are defined as principles of the physical or biological sciences, engineering or computer science.
Example: The development team, during their design phase and again during the prototype development recognize that principles of engineering are required in order to evaluate and determine the correct materials, width, length and thickness of the product given the anticipated use of the product (durability, strength, etc.). The use of these engineering and physical science principles would satisfy the test.
No such thing as “perfect” documentation
Every company uses a different approach to keeping documentation relative to product development. The larger the company, typically, the better the potential for documentation. I say, potential, because larger companies may use a standardized process and have systems in place tracking project-level costs and activities. However, some larger companies have so many projects that move through their manufacturing operation that keeping detailed records is neither cost effective nor efficient (depending on the complexity of the development effort).
The IRS, on the other hand, requires that records be kept in a form that will substantiate claims made on a tax return. The bad news is that because each business is different (as is their development process, product, approach, etc.), specific documents are not easily identified and guidance from an IRS agent that is conducting your audit can be nebulous.
So how do we guide a small business owner and their team to develop documentation that will support their efforts to stay innovative and competitive?
Here are some basic items that should be not only considered but developed to support your research tax credit claim:
Project-based time tracking: Completed by the employees conducting the development activities. Ideally, this tracking would be completed weekly but if necessary, bi-monthly and at worst, monthly. Time tracking should also include specific tasks completed within the project (concept development, testing, design, prototype development, beta-testing, etc.).
Development process: The development process used (each development process) for the specific project should be detailed in a way that shows the steps from concept inception through to completion. Ideally, each step would include a short description of the types of activities completed within each step (for example, if the step was testing, a description might include the tests conducted).
Project Description and Detail: Each project should have a document attached that includes a project description, break down of the project into the 4-part test and discussion on technical uncertainties, alternatives evaluated, etc.
Expenses are the easy part: In order to substantiate the amount of expense taken, employee W2s, account details of supplies costs included and 1099s for contractors used in the development project should be kept in the event of an audit.
Other Documents: Other documents needed in the event of an audit could include emails, iterations of CAD drawings, meeting notes, etc. Because every company is different, the documents to keep also vary.
Example: CEO of a small but fast growing technology company is very involved in the development cycle and is not only the creative mind behind the development efforts but attends weekly engineering meetings, approves and monitors progress on all projects and spends the majority of his time helping to bring the products to completion. Under audit, the development team had no meeting notes, little documentation tying the CEO to the projects other than their testimony. While the truth may be that the CEO should be credited for a very high percentage of his time spent in qualified R&D, it is an uphill struggle due to the lack of quality documentation. As he is the highest paid individual in the company, his hours and wages are critical and a large part of the expenses used to determine the research credit.
At Acena Consulting, we recognize that you, the small business owner, have a lot more on your plate than worrying about a tax credit. Our role is to bring strong tax technical knowledge, ability to build efficient processes, answer the questions you may not know that need to be asked and take this concern off your list so you can focus on your core business. Let us help you lower your taxes, increase cash flow and document your activities in a way that will secure your R&D tax credit.
Want to learn more about the magic of our approach?