Documentation: Essential to the R&D Tax Credit

Documentation is the key component of claiming the Research and Development Tax Credit. Here at Swanson Reed, we see a large amount of companies not taking advantage of the R&D credit because they are unclear on the documentation and substantiation requirements. Here is what needs to be documented.

Qualified Research Expenditures (QRE’s) :

Wages: Any payment to a staff member for qualified R&D work that they conducted.

Eligible documentation for payroll includes W2’s, payroll register, interviews, work schedules, morning minutes or other tracking documents that associate the labor costs to the R&D project.

A payroll register is likely the best reference. If an entire year was spent on the R&D project, an employee’s W2 will be easier to extract. If a worker’s time was split with other activities, devise and write down a means of allocating time to the R&D work. Written, summarized and signed results of interviews with employees partially involved in R&D are a reliable backup.

Payroll is typically the largest component of an R&D claim, so this is not the place to get slack on documentation.

*Note that only direct labor and first-line supervisors are eligible.

Supplies: The purchase of any necessary supplies being used in the qualified research activities.

A general ledger is likely the best reference. Each general ledger entry should be supportable by an invoice. Sorting the general ledger entries or loose invoices by vendors that typically support the R&D project will typically surface the R&D costs more quickly. If the R&D project has its own cost center, sorting the general ledger by cost centers will yield results quickly as well.

Contracted Research Services : The payments made to a third party for conducting qualified research activities.

Invoices and 1099’s are good sources of documentation for contracted research services.

If invoices are filed by vendors, identify the ones that typically support the R&D projects.

1099’s summarize all payments to a vendor during a year. If a vendor worked on other jobs beyond the R&D project, a written-down means of allocating the costs to the R&D projects is needed.

Qualified Research Activities:

Taxpayers must have hard evidence of how and why the qualified research activities meet the criteria of the IRS’ Four-Part Test:

  1. Permitted Purpose: The purpose of the activity or project must be to create new (or improve existing) functionality, performance, reliability, or quality of a business component.
  2. Elimination of Uncertainty: The taxpayer must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability of development or improvement, method of development, or the appropriateness of the business component’s design.
  3. Process of Experimentation: The taxpayer must undergo a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result is uncertain at the beginning of the taxpayer’s research activities.
  4. Technological in Nature: The process of experimentation used to discover information must fundamentally rely on principles of hard science such as physical or biological sciences, chemistry, engineering or computer science.

The Consistency Rule:

According to the Internal Revenue Code, in order to accurately calculate the credit, the taxpayer is required to define QRE’s the same from year to year. If a taxpayer changes their definition of QRE’s for the current year, he or she must change the definition for prior years that will affect the result of one of the three calculation methods. Documentation of this must be provided.

Audit Documentation:

In the case of an audit, every company needs to be able to present documentation that illustrates the progression of its R&D activity and can ultimately prove its R&D eligibility. Along with the above sources of documentations, here are some other records that would be beneficial to keep:

  • Project records/ lab notes
  • Conceptual sketches
  • Design drawings
  • Photographs/videos of various stages of build/ assembly/ testing
  • Prototypes
  • Testing protocols
  • Patent application number

Essentials of Data Collection: CORRECT AND COMPLETE!

Information and data must be supportable, above reproach, and related to the R&D performed. Pretend that an IRS auditor is looking over your shoulder while  compiling the information.

The size of the credit is directly proportional to the amount of substantiated expenses that are claimed.

Swanson Reed understands the importance of data collection, but knows it can be a time-consuming process. We are here to help you each step of the way. Click here to check out our substantiation checklist or contact one of our Swanson Reed specialists.

The Government’s Role in Facilitating Research & Development in the US

In the US the government, through the decades, has always played an active role in facilitating Research & Development, both in the private and the public sectors. This is only natural, considering the government’s priority in furthering economic growth. And economic growth and R&D go hand in hand, as innovation and changes in technology are integral to any country’s growth process.

As such, the government has come up with certain policies that directly encourage R&D activities. Government support for R&D is such that it has created agencies which provide grants, such as the National Science Foundation, and it has also developed various tax incentives such as the Research & Development tax credit which various firms can avail of.

The support of the government has proven effective for furthering R&D. In the early part of the 20th century, for instance, government support enabled the emergence of new technologies related to agriculture, health care, information technology, and chemicals. One particular case in point is the development of the lithium-ion battery, which was brought about with the help of materials research which was sponsored by the federal government.

In recent years, it can be said that the total R&D spending by the government has remained stable, making up approximately 2.5% of the GDP, or the gross domestic product. However, there are two main pointers related to this which may need further measures from the government. One is that the government’s R&D spending has gone down compared to private sector spending, and another is that the share of the government’s R&D spending on basic research has also declined. These issues need to be addressed, because the basic or fundamental research is the basis for most innovations. Therefore, certain economists have recommended that government support for basic R&D be increased in order to improve economic growth.

The government is therefore encouraged to create more positive policy instruments, especially when it comes to tax incentives. The government was already made aware of this more than two years ago, when in a speech by Ben Bernanke, he stated, “The challenge to policymakers is to encourage experimentation and a greater diversity of approaches while simultaneously ensuring that an effective peer-review process is in place to guide funding toward high quality science.”

The setting of clear-cut policies for R&D tax incentives, however, may be well under way. Recently, the IRS issued a series of proposals that seek to be more beneficial to firms engaged in the development of new products. These proposals eliminate any gray areas associated with R&D incentives, therefore encouraging firms to move forward with their research and experimentation activities with more stable and solid backing from the government.

If your firm is engaged in R&D and would like to know more about how you can qualify for government tax incentives, we at Swanson Reed can help you. Our company has been involved in R&D for more than 30 years, and we have assisted various firms with all their R&D tax incentive needs and requirements.