Fortunately, recent tax changes should make it easier for them to do so, with new IRS regulations allowing more companies to qualify for the federal research and experimentation (R&E) tax credit. To take advantage of this credit, it's critical to understand the law and document your R&E activities thoroughly.
The R&E credit
Under Internal Revenue Code Section 41, companies can take a credit equal to the sum of 20 percent of the excess of "qualified research expenditures" for the tax year over a base amount, plus 20 percent of basic research payments. Qualifying activities include:
- Product development or improvement
- Prototype, patent, trade secret or proprietary information development
- Production process enhancement or improvement
- Process automation
- Internal engineering department operations
- Employment of technical personnel (as employees or contractors)
Broader research definition adopted
Until recently, a narrow definition of "qualified research" under the regulations meant that many companies could not claim the R&E credit. However, the latest rules have liberalized this definition. Now, research must meet the following requirements.
It must be intended to eliminate uncertainty regarding the development or improvement of a business component.
- It must be undertaken to discover information of a technical nature, relying on principles of physical or biological sciences, engineering or computer science.
- Its application must be intended to be useful in the development of a new or improved business component.
- Substantially all of the research activities must constitute elements of a process of experimentation relating to a new or improved function, reliability, performance or quality. The solution should not be readily known at the outset of the research.
Certain activities are excluded from the definition of qualified research, and more stringent regulations apply to internal-use software.
It's important to note that, between the tax credit and the deductions for R&E expenses, there is an interplay that reduces the actual tax benefit to less than 20 percent. To guard against double deductions, the IRS stipulates a formula that reduces the amount of the credit.
If you do not take the reduced credit, you must reduce your otherwise deductible research costs by the credit amount. Taking the reduced credit allows you to deduct the credit while still receiving a 13 percent reduced credit.
Complete, real-time documentation
The IRS aggressively audits R&E claims. And should you be audited, it may require you to produce items such as meeting minutes, engineering drawings, test results, patent and copyright applications, and management reports.
The agency's Research Credit Audit Techniques Guide defines the documentation that companies must have to support R&E claims.
Collecting the required documentation after research activities are completed (for example, in the face of an audit) can be burdensome. It may also result in less accurate or complete records. If you plan to take the R&E credit, it's wise to establish ongoing documentation.
It's also a good idea to maintain research logs. These logs should document:
- Each research approach applied
- Any revisions, tests and rejections
- New alternatives and uncertainties about their outcomes
- Any new information, products or functionality resulting from the research
- Research completion dates
The broadened R&E tax credit can provide significant benefits to innovating mid-market companies. But to take full advantage of this credit, plan carefully to avoid costly and time-consuming audit headaches down the road.
Lou Miller is an executive with the accounting firm Crowe Chizek and Co. LLC. Reach him at (574) 236-8661 or email@example.com.