The federal Credit for Increasing Research Activities, more commonly known as the R&D tax credit, is an under-utilized program. There are many companies that would save a significant amount of money if they claimed a credit – but they don’t. While it might not make sense for every organization, it could be the most tax-advantageous domestic program available for many others.
Occasionally, we’ll ask why a company chooses not to pursue an R&D tax credit– not to challenge them but to educate. This is how we’ve come face-to-face with many misconceptions that still exist today about this tax credit program. If you’re not taking advantage of it, consider the reasons why as you read through these common misconceptions. You might just change your mind!
- Our company doesn’t do real research and development.
When we think about research and development, we often envision scientists in white lab coats conducting experiments with test tubes and Bunsen burners or teams in academic institutions competing for the Nobel Prize in Physics. Congress, however, was thinking about research in a much broader sense when it created the tax credit incentive. In fact, the tax credit program is intended to stimulate innovation primarily in commercial companies, not in laboratories and educational institutions.
According to the IRS, the objective of research and development in this context is to create a new or improve upon an existing “business component.” A business component includes a new or improved product, process or software.
Bottom line: If you are a company that develops new products, processes or software, you may be eligible for the credit.
- The research we do isn’t groundbreaking for the industry or the world.
Guess what? It doesn’t have to be! The IRS doesn’t judge a project based on how revolutionary it is. In fact, incremental improvements to existing products may qualify for the credit. And, the project doesn’t even have to be successful to qualify for the tax credit.
What’s important to the IRS is that you’re performing activities in pursuit of technological information that you don’t already know and that you use this information to develop or improve a business component. The product you create or the technological information you discover only has to be new to you, not to the industry.
If you’re creating a business component and you already know the right way to do it, or you already know which technique is going to be selected as the right one to use, then you’re not in pursuit of new information and there is no research.
- We don’t have the required documentation to support a claim.
There is no specific documentation or record-keeping requirement for the R&D credit. However, you must be able to substantiate your entitlement to the credit. And yes, there is a difference between “documenting” and “substantiating” your credits. Usually, a combination of credible employee testimony supported with some documentation will suffice. In fact, when it comes to the R&D credit, testimony may be used to substantiate whether a project qualifies and, if so, to estimate the amount of time and associated costs spent on qualified research versus non-qualified activities. That doesn’t mean you can substantiate your R&D credits with no documentation. After all, it’s an auditor’s job to validate what a taxpayer tells them. As one IRS agent once said, “You can fill the potholes with testimony, but you can’t pave the road with it!”
- Conducting a study to put together a claim would disrupt our business operations too much.
When we conduct a study, there are two areas where we need the assistance of the company’s R&D employees. First, we need to be able to substantiate that a sample set of representative projects meets the IRS definition of R&D. Second, we need to be able to allocate the amount of time employees spend on R&D versus non-R&D activities. Substantiating that certain projects qualify usually requires us to speak to fewer employees but will require a greater commitment of time (typically an hour interview with some follow up to gather relevant project documentation and address any follow up items). Regarding the time allocation process, the time commitment depends on if you have a robust time tracking system. Most companies do not, in which case we will have to allocate time based on employee time surveys. It usually takes employees 45 minutes or less to complete a time survey, and often there is no need to speak to each individual employee – just the department manager. Thus, while there might be some individuals who have more involvement with the study, the impact on the vast majority of the staff is negligible in our experience given the potential benefit.
- Our research is funded by our customer, so it doesn’t qualify.
“Funded research” is a term of art. Just because you get paid for your research activities doesn’t automatically mean your research is “funded.” After all, the purpose of the credit is to incentivize businesses to invest more in developing new products for sale. Thus, you are not automatically ineligible for the tax credit simply because you get paid through a contract. To determine whether you can claim the credit, you must review the terms of the contract to answer these two questions:
- Who has the rights to the research?
- Who has the risk of loss if the research ultimately fails?
If you retain the rights to the research and you have the risk of loss, then you can claim the tax credit even though you might have been paid for some or all of that research through the contract.
- We’re in losses and don’t owe tax. The R&D credit doesn’t benefit us.
Even if you can’t use your credits in the current year, you can usually carry them forward up to 20 years in the future. Also, certain eligible small businesses and startups that are not taxable (pre-revenue, in losses) may be able to use the credit (up to a maximum of $250,000 per year) to offset their payroll tax liability (i.e., FICA taxes).
Every organization involved in product, process or software development, regardless of size, should be evaluating whether it is eligible for the federal R&D tax credit. If you’re not claiming the credit, you might be leaving a significant amount of money on the table. So, if you found your misconception on this list, it’s definitely time to take another look at the R&D tax credit for your company.