Common Misconceptions About R&D Tax Credits: Debunking Myths and Clearing Up Confusion
The R&D credit refers to tax-saving opportunities for companies that invest in research and development. The R&D tax credit incentivizes businesses of all sizes to develop or improve products and processes within their industry. Unfortunately, many misconceptions may unnecessarily stop a company from claiming the credits it deserves. The following are just a few examples.
Thinking a lack of exhaustive documentation prevents claiming a credit
While comprehensive documentation of a company’s R&D activities will certainly bolster its credit claims, there is no strict list of specific documents required to claim credit. The IRS does, however, expect the records that are retained to be sufficient to substantiate that the expenses claimed are eligible for the credit. Some documents that can be used in this manner are:
- Payroll registers
- Project lists
- Project notes
- Time tracking data
- General ledgers/trial balances
- Design drawings/blueprints
To supplement the documentation, oral testimony from employees can also be helpful.
R&D isn't the company's sole focus; therefore, it wouldn't qualify for a credit
A business doesn’t have to be a life sciences or high-tech company with a dedicated research department to qualify for the R&D tax credit. Qualification for the R&D credit is quite broad and applies to various industries. A company needs to commit resources to developing new products or processes, or enhancing existing ones even if it is not the focus of their business.
The company doesn't pay federal income tax
Startups may be able to apply up to $500,000 of the federal R&D credit to offset the FICA portion of their payroll taxes. To be eligible, a company should have less than $5 million in gross receipts and have no gross receipts or interest income older than five years.
R&D is calculated on the federal income tax return and can be applied against payroll taxes starting the quarter after the company claims the credit.
The employees don't hold degrees in engineering or science
While companies with scientists and engineers on the payroll may be obvious candidates for the R&D tax credit, no rules require your company to employ scientists or engineers. Instead, employees can perform research and development activities regardless of job title or degree. Even if you only have third-party contractors performing research activities, you may still be able to claim R&D credit.
The company is subject to AMT
In the past, companies may not have benefited from the credit because of the alternative minimum tax amount. However, beginning in 2016, small businesses can offset regular taxes and AMT by utilizing the R&D credit.
The company doesn't develop new products or techniques
A business’s research and development does not have to be new to the industry. Instead, it can simply be new to the company. While developing new techniques and products can qualify a company, companies that pursue innovation without creating anything new can still be eligible.
Four-part test to determine R&D eligibility
To determine R&D eligibility, companies can use a four-part test developed by the IRC and Treasury Regulations.
Qualified Purpose
Research and development must be for a qualified purpose, including creating a new or improved business component. Business components may include software, techniques, processes, products, and more. Qualified purpose is broad because it applies to many industries.
Elimination of Uncertainty
A company must show that it attempted to eliminate uncertainty when developing or improving a business component. Uncertainty exists when companies do not have proof of a new product or method’s capabilities. Generally, you will not have evidence or lack of uncertainty when you start the development process, but you should be able to show that you’re looking for real solutions.
Experimentation
During the R&D phase, companies must demonstrate through simulation, trial and error, or modeling that they have evaluated multiple methods for achieving their results. For instance, the R&D department must consider numerous alternatives in clinical research before claiming the R&D tax credit.
Technological
When experimenting, businesses should rely on hard sciences. While companies do not need to expand, refine, or exceed scientific principles, they should depend on sciences like engineering, biology, computer science, and chemistry for innovation.