Best Practices for Claiming the R&D Tax Incentive

The Research and Development (R&D) tax credit is an incentive that can generate cash flow for businesses in a vast array of industries.  Companies that develop new or improved products processes, and software could be eligible for the R&D credit even if the project ultimately fails and the research is unsuccessful.

Through the R&D tax incentive, qualified companies can gain immediate cash benefits to offset both income taxes and payroll taxes in certain instances and, as a result, reduce tax liability dollar-for-dollar. However, the R&D tax credit does not benefit only large companies with dedicated R&D departments. Small and medium-sized companies are also eligible for significant savings through the R&D tax incentive.

How to Qualify for the R&D Tax Credit?

The goal of the R&D tax credit is to incentivize American companies to invest in innovation. Given that supporting new technologies, products and services is key to the health of the economy, it is in the interest of the US government to invest in these types of projects. As a result, the R&D tax incentive consistently ranks as one of the most valuable credits used by companies to reap big savings when filing their taxes.  In addition, over 30 states offer similar R&D tax credits, many of which piggyback off the federal calculation.  The combined potential federal and state benefit is between 12 and 16 cents for every qualifying R&D dollar depending on the type of calculation method used, and the state(s) where the benefit is being claimed.

The key step for claiming the R&D tax credit is understanding how the IRS defines qualifying research activities. To do so, the IRS designed a four-part test. Accordingly, to qualify for the R&D Tax Credit, research activities have to:

  1. Be technological in nature and rely on principles of the hard science, like engineering, physical sciences, or computer science,
  2. Eliminate uncertainty related to the capability, method, or design of developing and improving a product or process,
  3. Involve a process of experimentation to identify and evaluate more than one alternative to achieve a result, and
  4. Have a permitted purpose and provide new or improved functionality, performance, reliability, or quality for a business component.

Overcoming R&D Tax Credit Challenges

While the steps to claim the credit may seem straightforward, tax laws around R&D are highly complex and constantly changing. Claiming the R&D tax credit requires a deep understanding of the tax credit process, so companies should establish and apply best practices, such as:

Establishing a Documentation Process Early

Documentation is the most important step for claiming the R&D tax credit and should begin as soon as possible. Preparing to record the right information early on helps companies eliminate the need to go back retroactively to find the necessary information and helps avoid common documentation errors.

Collecting the Necessary Documentation

Another important step is to evaluate any potential activities a business is currently performing or planning to perform that might be eligible for the R&D tax incentive. Once companies identify potentially eligible activities, they can begin recording qualifying expenses and start documenting the necessary information.

The main goal of collecting documentation is to prove that a company’s activities qualify for the credit. Even though the IRS has not established a clear definition of what documentation is required to claim the R&D tax credit, any relevant supporting documentation is key to maximizing the credit benefit.

Understanding Form 6765

Once businesses develop a documentation process and collect the necessary information to support an R&D claim, it is necessary to complete the IRS Form 6765, Credit for Increasing Research Activities.

Form 6765 is used to calculate and claim the R&D tax credit. Form 6765 has four distinct sections: Sections A, B, C, and D. The IRS provides instructions for using the form, but they often make references to relevant sections of the Internal Revenue Code that can prove difficult and time-consuming to follow.

Preparing for Possible IRS Examinations

While the R&D credit is the most lucrative domestic tax credit available, if the IRS finds the credit a company is filing does not meet the R&D requirements, the credit will be disallowed either partially or completely. In addition to this, if the IRS finds that the credit was either claimed through negligence or did not meet the eligibility requirements, there may be penalties involved. Therefore, businesses should take the proper steps to document information that will help them support their claim to prevent risks associated with the R&D tax credit and stay prepared for possible examinations.

Maximizing Tax Savings with the R&D Tax Incentive

While lucrative, the R&D tax incentive is complex, and each company’s process can be different from another’s. Therefore, establishing best practices can make all the difference when it comes to claiming the tax credit. This is especially important in areas where issues commonly arise and can lead to missed opportunities and create problems should the company be selected for an IRS audit.

Another solution that can help companies claim the R&D tax incentive successfully is outsourcing the entire process. Such an approach allows them to rely on experts who help companies determine eligibility and provide assistance with every step of the R&D process, including project initiation, data collection, identifying qualified projects and expenses, documentation, credit calculation, and completing the necessary forms.

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