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 claim expenses incurred for research and development activity. 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.
Documentation Proves Mission Critical When Claiming the Innovation Tax Credit
To qualify for the innovation tax credit, business entities must demonstrate 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, making establishing a documentation process as early as possible crucial. Outlining a specific protocol for documenting eligible activities helps ensure that a business doesn't miss out on relevant credits due to insufficient substantiation. 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.
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.
The Process of Experimentation also requires that 80 percent or more of the process of experimentation uses hard science principles to eliminate technical uncertainty. This particular component of the four-part test is defined as the principles of 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.
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.