What is the R&D tax credit?

The R&D tax credit is available to companies developing new or improved business components, including products, processes, computer software, techniques, formulas or inventions, that result in new or improved functionality, performance, reliability, or quality. It’s available at the federal and state level, with over 30 states offering a credit to offset state tax liability.

How does your company know if it’s eligible for the R&D tax credit?

R&D credit eligibility is much broader than many companies realize, applying not only to product development, but also activities and operations, such as new manufacturing processes, software development, and quality enhancements. Start-ups may also be eligible to apply the R&D tax credit against their payroll tax for up to five years. Your organization could be eligible for the R&D tax credit if it: Devotes time and resources to creating new or innovative products Improves existing products Develops processes, patents, prototypes, or software Hires designers, engineers, or scientists R&D tax credits can also be retroactive. Depending on when your tax return was filed, you may be able to claim R&D credits for three prior open tax years. Loss companies may be able to go back even further; some states also allow more than three years for retrospective claims.

How could your company benefit from the R&D tax credit?

It’s a dollar-for-dollar tax savings that directly reduces a company’s tax liability. There’s no limitation on the amount of expenses and credit that can be claimed each year. If the federal R&D credit can’t be used immediately or completely, then any unused credit can be carried back one year or carried forward for up to 20 years. Each state has its own carryover rules. The R&D tax credit regularly provides a wide range of businesses with a source of extra cash — up to 10% of annual R&D costs for federal purposes and much more when state credits are factored in.

How did the R&D tax credit change in 2015?

The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D credit permanent and expanded its application to create a potential tax benefit for small businesses and start-up companies. The TCJA retained these provisions. Because of the permanency of the R&D credit, companies can now rely on and incorporate it into their annual tax-planning strategy.

How can my organization claim the credit?

The amount of R&D tax credit a company can claim will depend on many factors, but the potential tax savings make it worth the time to investigate. For example, R&D tax credits have the potential to offset income tax, which can reduce a company’s tax burden in the years qualified activities occur. Companies that haven’t previously taken advantage of the credit also have the option to look back at all open tax years — typically three to four years, depending on when tax returns were filed — to claim the missed opportunity. If a company doesn’t currently have taxable income or is otherwise limited in how much tax credit it can use, the federal tax credit can be carried forward for 20 years or potentially applied to offset the company’s federal payroll tax under the newly expanded rules. State credits may also be carried forward for a length of time determined by the state.

What documentation is necessary to claim the credit?

Because R&D tax credits may be claimed for both current and prior tax years, companies can benefit from documenting their R&D activities, so they’re well positioned to increase the amount of credits claimed. To claim this credit, taxpayers must evaluate and document their research activities contemporaneously to establish the amount of qualified research expenses paid for each qualified research activity. While taxpayers may estimate some research expenses, they must have a factual basis for the assumptions used to create the estimates. Examples of contemporaneous documentation include these items: Payroll records General ledger expense detail Project lists Project notes Lab results Emails and other documents a company produces throughout the regular course of business These records combined with credible employee testimony can form the basis of a successful R&D credit claim.

Does the R&D credit bring increased IRS scrutiny?

For taxpayers already claiming the credit and those who may want to determine eligibility, it’s critical to be thorough when calculating and documenting qualified research activities for R&D credit claims. A possible consequence is increased IRS scrutiny and disallowance of credits claimed. The ruling in Siemer Milling Company (Siemer Milling) v. Commissioner of Internal Revenue is a reminder of those consequences. On April 15, 2019, the U.S. Tax Court ruled in favor of the commissioner in finding that Siemer Milling lacked sufficient documentation to support the R&D credits claimed. The importance of proper reporting when claiming R&D tax credits In the case, the court disallowed over $235,000 dollars in R&D credits claimed by Siemer Milling during tax years 2010 and 2011. This disallowance was due in large part to the taxpayer’s failure to retain and provide supporting documentation demonstrating how the company’s activities met all four tests necessary to constitute qualified research expenses. Siemer Milling claimed that expenses from activities related to development of new flour products and improvements to its production line qualified for the R&D credit. However, the company offered no documentation to demonstrate how the activities constitute experimentation in the scientific sense. The court found the taxpayer simply stated that it was involved in new product development involving technical activities, but these conclusory statements were insufficient evidence on their own. Simply reciting the steps undertaken wasn’t enough to conclude the company had undertaken a methodical plan involving a series of trials to test a hypothesis to develop new processes or products. Other clarifications This case did provide a few taxpayer-friendly facts on eligibility for qualified research expenditures: Technical uncertainties don’t need to be solved in the credit year but can span more than one year. To establish that a company participated in technical activities, it doesn’t necessarily have to employ individuals with specialized degrees. The U.S. Tax Court discussed what types of documentation or support of estimates would be useful to properly support credits claimed.

Article

Five common misconceptions about the R&D tax credit — and whether you qualify

March 11, 2021 · Authored by Star Fischer, Tom Sanger, Travis Riley

While tax reform, often referred to as the Tax Cuts and Jobs Act (TCJA), introduced many new changes for businesses, the R&D tax credit continues to provide reliable opportunities for reducing income tax liabilities — often saving companies hundreds of thousands of dollars.

However, many companies aren’t fully benefiting from the R&D credit because of common misconceptions about its applicability to their operations.

Businesses that fail to claim the R&D credit often do so because of confusion around documentation, qualifying activities and expenditures, and how the credit can be used.

Gaining clarity around these topics can provide the foundation for identifying and claiming the R&D credit — and lowering a company’s tax burden.

The following will be addressed and answered in the article below:

What is the R&D tax credit?
How does your company know if it’s eligible for the R&D tax credit?
How could your company benefit from the R&D tax credit?
How did the R&D tax credit change in 2015?
Common misconceptions: Five reasons companies don’t think they qualify
How to determine R&D eligibility: The four-part test
How can my organization claim the credit?
What documentation is necessary to claim the credit?
Does the R&D credit bring increased IRS scrutiny?
How tax reform changed the R&D credit
What’s next for the R&D tax credit: Amortization of R&D expenses starting in tax year 2022

Star Fischer

Principal

Tom Sanger

Principal

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Five common misconceptions about the R&D tax credit — and whether you qualify

Star Fischer

Tom Sanger

New revenue recognition standard for hospitals

What is the R&D tax credit?

How does your company know if it’s eligible for the R&D tax credit?

How could your company benefit from the R&D tax credit?

How did the R&D tax credit change in 2015?

Common misconceptions: Five reasons companies don’t think they qualify

1. The organization isn’t paying federal income tax

2. The company isn’t focused on R&D

3. Employees aren’t degree-holding engineers or scientists

4. The company isn’t developing anything new

5. The company is subject to alternative minimum tax (AMT)

How to determine R&D eligibility: The four-part test

Four-part test

How can my organization claim the credit?

What documentation is necessary to claim the credit?

Does the R&D credit bring increased IRS scrutiny?

The importance of proper reporting when claiming R&D tax credits

Other clarifications

The importance of proper reporting when claiming R&D tax credits

Other clarifications

How tax reform changed the R&D credit

Increase in credit from decrease in tax rates

Retention of eligible small business credits

Retention of qualified small business payroll credits

Increased usability for individual taxpayers

What’s next for the R&D tax credit: Amortization of R&D expenses starting in tax year 2022

Have questions? Baker Tilly can help.