Every year, the IRS releases the “Dirty Dozen,” a list of tax scams and schemes on which the agency chooses to focus. In the crosshairs this year is the abuse of business tax credits. The IRS explains, “improper claims for the research and experimentation credit generally involve failures to participate in, or substantiate, qualified research activities and/or satisfy the requirements related to qualified research expenses.” So why did the research and experimentation credit, better known as the R&D credit, end up on the “Dirty Dozen” list?
In 2017, the Treasury Office of the Inspector General reviewed $53.8 million worth of R&D tax credit claims. They found that $11.8 million of them were potentially erroneous, a staggering 21% of R&D tax credit claims. Some of them were simply filed improperly, and some did not meet all the requirements for proper claims or didn’t have the proper documentation attached. So how is the R&D credit supposed to work, and what can taxpayers do to ensure their claims are accurate?
The R&D Tax Credit
The R&D tax credit was created in 1981 to incentivize businesses to invest in innovation and stimulate research and development in the United States. The R&D credit applies to any company that spends time and money on developing new products, improves the products it has, improves the processes or software it uses in manufacturing, creates patents or prototypes, or hires researchers, scientists and designers.
The R&D tax credit provides a dollar-for-dollar offset of federal income tax liability as well as payroll tax liability in certain circumstances. Additionally, many states also provide a similar R&D tax credit. Between the federal and state credits, the average potential benefit for the credit may range from 10-20% of qualified spending.
The R&D credit is calculated using the totals of two different kind of research expenses: (1) qualified research expenses (QREs) and (2) basic research expenses (BRPs). Generally, QREs and BRPs relate to activities that advance U.S. technologies and are performed within the U.S.
QREs must be utilized for specific commercial objectives, but they do not have to be for the advancement of scientific knowledge. They can simply be utilized for process, product, or software improvement or development.
In order to qualify for the QRE R&D tax credit, activities need to meet each element of a “four-part test” (qualified purpose, technological uncertainty, process of experimentation, and technological in nature) and aren’t excludable.
Some examples of activities that are excludable and do not qualify for R&D credits include: research conducted outside the U.S., routine data collection or ordinary testing for quality control of existing components, market research, management, consumer preference testing, and research funded by an unrelated third party.
Some examples of activities that don’t qualify because, generally, they don’t meet the four-part test include: administration, training, repairs and maintenance, trial production runs, troubleshooting, and duplicating an existing component via reverse engineering.
BRPs differ from QREs in that they are investigations to obtain scientific knowledge without having a specific objective. Under IRC section 41(a)(2), BRPs must be conducted in the U.S. by qualified organizations and can’t be research for the social sciences, humanities, or the arts.
Things to Consider
If you’re a small-business manager, you know how it is. You try to develop the most efficient processes and the most innovative products, but stopping to reconsider what your company has been doing takes time, people, and money. That gives larger companies an unfair advantage. They have more people, which means they can create greater efficiency and grow even bigger.
But the R&D tax credit can make it possible for smaller companies to invest in research. Even companies with small or no R&D department may benefit from the credit. In fact, most taxpayers who benefit from the R&D credit don’t have departments explicitly named “R&D Department.” Additionally, you may be eligible for R&D credits, whether your activities actually succeeded or not.
A taxpayer claiming an R&D credit must retain records in sufficiently usable form and detail to substantiate that the expenditures and activities claimed are eligible for the credit and are not improper. Improper claims can happen in a number of ways, but the best way to prevent them is to have your claim checked thoroughly by a tax professional whom you trust. Remember that the lowest possible tax bill isn’t the only goal. Accuracy is also important.
Seth Knighton is a senior tax accountant with Dalby, Wendland & Co. in Grand Junction. He mainly serves small businesses, including S corporations and partnerships, and their owners. He attained his public accounting degree from Colorado Mesa University and gives back to the community as a member of Young Professionals Network of Mesa County.