As many companies know, the federal R&D Tax Credit can be a significant tax incentive and provide substantial benefit in terms of annual tax reduction. However, there is a cost associated with properly documenting R&D activities in a way that will stand up under IRS scrutiny.
What issues arise and how can a company best protect themselves from an adjustment if their research tax credit is audited? Today, we will begin with the business component test and discuss the specifics as well as ways to document it properly.
Let’s take a look:
The Business Component Test
At its simplest point, the R&D tax credit is given for the development or improvement of a business component that is to be held for sale, lease or license or used in the taxpayer’s business.
What is a business component?
You can find the definition in the Internal Revenue Code under Section 41(d)(2)(B) as a product, process, computer software, technique, formula or invention.
So it begs the question, what types of improvements qualify and is there a standard that taxpayers can rely upon?
Well, yes and no.
The Internal Revenue Code and Regulations do specify some efforts that are directly excluded from qualified R&D such as adaptations, duplications, reverse engineering and market studies.
However, how do you determine if your efforts (or your client’s efforts) for improving a business component would qualify?
Again, there are no magic bullets but some direction in terms of congressional intent and the regulations.
Specifically, Congress specified that both evolutionary research as well as research aimed at achieving a result that has already been achieved by other persons (Conference Report to accompany H.R. 4328, Report 105-825, 105th Congress, 2d Session) qualify as research and development activities under IRC Section 41.
What does that mean for the efforts expended on an improvement to a business component?
It appears that the types of activities that would qualify (provided they meet all parts of the four part test) as an improvement would be relatively broad and inclusive so long as the improvements were functional in nature.
Documenting the Business Component Test
The IRS Audit Techniques Guide suggests agents review a taxpayers research activities and make sure they have tied the research to a specific business component. While this is a relatively easy step in the process, it is important.
In a case where the relevant business component is an improvement, it would be advisable to identify the functional improvement directly (increase in throughput, speed, quality, strength, etc.).
It is important that each research effort be segregated and tied to a project and its related business components be identified.
How can the documentation be completed efficiently?
As we have discussed in the past, an efficient documentation process is critical to the overall value of the R&D tax credit. If employees are taken away from their primary responsibilities for too long, it negatively impacts productivity. Documenting the business component would best be completed as part of an overall project documentation approach and would ideally be completed by the Project Manager early in the project.
In our next article on Problems and Solutions
Next week, we will be reviewing the issue of documenting the technical uncertainty that must be identified at the onset of the research activity.
What say you my friends?
Are you currently tracking each research activity separately?
Can you identify the business component being developed and when research starts and ends?
Is your internal documentation process adequate, efficient and streamlined?
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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.