Business owners in every vertical continuously strive to decrease their tax obligations. Still, each year, countless organizations that do qualify for the innovation tax credit fail to claim the benefit. Some business owners simply don't know they can use expenses incurred for research and development activity to generate a dollar-for-dollar tax credit that will reduce their federal (and sometimes state) tax obligations. Others may assume the incentive only rewards larger organizations.
It’s true that, initially, R&D tax credit legislation made the benefit more easily accessible to big companies. However, recent updates to the innovation tax credit officially leveled the playing field, enabling companies of every size and in over 40 industries to use their qualifying research and development expenses to reduce the overall tax burden and increase profit margins.
In this article, we want to arm you with the information you need to make sure your company takes full advantage of the research and development tax credit. Specifically, we’ll cover tips for effectively managing qualifying R&D documentation.
Documentation Proves Mission Critical When Claiming the Innovation Tax Credit
To qualify for the innovation tax credit, business entities must demonstrate efforts to develop or improve upon processes, products, software, or formulas that pass the qualification criteria, or four-part test, that includes:
- Elimination of Uncertainty
- Process of Experimentation
- Technological in Nature
- Qualified Purpose
Once an organization determines eligibility for the R&D tax credit, it's critical to start the documentation process to effectively capture relevant information on qualifying expenses, such as salaries, supplies, and materials. Even payments made to third parties that conduct qualifying research activities should be documented.
Documenting Qualifying Research and Development Activities: What You Need to Know
As with most tax incentives, the burden of proof rests firmly on the taxpayer. Developing an efficient, seamless documentation process is a crucial step that should be taken as early in the tax year as possible. Any documentation process that is developed should include tracking time spent by employees on any project that may qualify as well as some information on the tasks being performed.
Additionally, having all proper documentation for each expense makes it easier to support a company's claims. Finally, proper documentation also streamlines the submission of your information to the IRS in the event of an audit.
Proactively gathering essential information as expenses are incurred, instead of reactively attempting to piece it together after an audit request, can save taxpayers an immeasurable amount of time and stress.
When putting together your R&D tax credit documentation, here are a few tips on records and documents you should keep to best support your research and development claims.
Wages paid to employees performing qualified research activities can prove one of the most significant eligible expenses for companies.
Business owners should maintain a record of all financial information that outlines salaries and wages paid to these staff members who conduct qualifying activities themselves or supervise other employees who perform these operations. Examples include the year-end W2 and payroll reports for employees, and K-1s for owners that receive distributions affected by self-employment taxes.
Tracking time spent on qualifying activities is also important when documenting research and development within an organization. Payroll records, meeting minutes, work plans, and any other paperwork that tracks time allocation should always be included in support documentation.
As each company has different internal processes, developing a time-tracking system that efficiently works within your development efforts is critical to both long-term success and employee adoption.
Companies conducting qualifying research and development activities should carefully log all relevant operations, breaking out materials and supplies purchased for R&D purposes from those that don't qualify for the innovation tax credit to make it easier to provide support documentation as needed to the IRS.
What are qualified R&D activities?
Qualified R&D activities include design, testing, and experimentation to develop or improve products, processes, software, formulas, techniques, inventions, models, prototypes, or processes.
80% or more of the effort on each development project must relate to the process of experimentation. This typically includes a trial-and-error process or iterative process to eliminate uncertainties in order to successfully complete the development.
Start at the Beginning
The R&D process begins with concept development efforts. Initial meetings where discussions (both internally and with clients) around new functionality or new products, formulas, etc happen are the beginning of the R&D process. Documenting when, who and what was discussed can add additional qualified time.
One of the most important components of the four-part test is the Process of Experimentation. This test requires that activities conducted rely on the principles of hard science and focus on eliminating uncertainties identified at the beginning of the project. Hard sciences as defined for the R&D tax credit are physical, biological, engineering or computer science.
Always track and manage all design drawings for qualifying R&D activities. Qualifying drawings should include iterations of eligible CAD reports, blueprints, change orders, and progress reports.
Document Successes and Failures!
It's important to note – the research and development tax credit doesn't just reward successful operations. The program also honors qualifying transactions that fail. Always include testing documentation that supports both successes and failures to ensure you're optimizing the tax credit when you file.
Let Acena Manage the R&D Tax Credit Documentation Process for You
At Acena Consulting, our experienced R&D tax credit professionals align with our clients' financial advisors to manage the documentation process. Contact us today to hear more.