The federal research and development tax credit has been a roller coaster ride since the dynamic changes that came about with the 2001 Temporary Regulations. These regulations relaxed the definition of qualified research and development giving small businesses an opportunity to take advantage of this very lucrative jobs credit. However, the last ten years has seen dramatic pendulum swings in terms of how to document expenses and activities that have left many taxpayers skeptical about their ability to secure an R&D tax credit under audit. While the playing field continues to be litigated and adjusted, there are components of the R&D credit that a taxpayer can and should document if they are going to take advantage of this tax incentive. Here are a few guidelines for the first of five critical items:
Qualified Research Expenses (or QREs).
Today, we will focus on the Wages component followed by Supplies and Contract Research in the coming weeks. Following the expense items allowed for the R&D tax credit, we will move on to discuss documentation related to the projects. The projects will be broken down into four blogs focused on Project Information, Qualification, Effort, and Timing.
Simply, you can include in your QREs those wages paid to employees that are conducting qualified research activities. The wages must be subject to withholding and only those wages that are paid for time spent on qualifying activities may be included. This can include amounts paid for bonuses and other remuneration not paid in cash. The courts have also allowed compensation derived from employees’ exercise of stock options. The IRS, however, doesn’t immediately allow the inclusion of compensation derived from exercising stock options. The IRS has taken the position that these amounts may be included in qualified wages if, when the options were granted, the individual was performing qualified activities. The assumption made by the IRS is that the options are granted for work already performed and, therefore, the decision on whether they can be considered qualified and included in the research expenses should be determined from work performed in the year they were granted.
When documenting your wage QREs it is important to not only document where the gross wages came from (Box 1 of the employee’s W-2) but how the percentage of qualified time was derived. We will explore the percentage of time component in a later blog, but it is critical that this information is captured on a timely basis in the event of an audit.
It is important to focus on documenting the work completed as well as the expenses incurred. While most companies have accounting systems that will accumulate costs and expenses throughout the tax year, it is critical to link those costs to individual R&D projects. Documentation is a key element of any audit by the IRS or state taxing authorities, and it is always best to protect yourself and your business by developing processes to track properly and secure necessary documentation.
Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.