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Many Los Angeles and Dallas businesses conduct activities that qualify for the Research & Development (R&D) tax credit. Although traditionally thought to be only for large companies with established R&D departments, the truth is the credit can be claimed by many small to mid-size businesses as well. Unlike other federal tax credits, precise rules govern what research activities qualify and how employee wages, contractor expenses, and supply costs are determined. Although the topic is complicated, and the application of rules varies based on specific circumstances, there are broad guidelines that businesses should be aware of when it comes to documentation and recordkeeping. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
Contract Research Expenses
Contract research expenses are those amounts paid to any person or agency, other than any taxpayer’s employee, engaged in conducting research activities. There are two primary issues to consider when collecting and maintaining documentation, including where the research is performed and the amount of qualified expenses incurred.
The contractor’s location is important because only those research activities conducted within the U.S. are eligible for the federal tax credit. Similar requirements may exist for the Texas and California state R&D tax credit as well. In terms of expense documentation, it is recommended to retain the following:
- Company Chart of Accounts
- General Ledger
- Copies of Relevant Service Contracts
- Purchase Orders
- Form 1099s Issued to Individual Contractors
Material & Supply Expenses
Qualified supplies are defined as any tangible personal property used in an R&D project. This may include components used to create prototypes, product designs, or items used in testing. It is important to note the IRS has stated that costs related to land, land improvements, travel, meals, entertainment, telephone expenses of researchers, and any royalty or licensing fees are not eligible to be claimed. When tracking and documenting these expenses, it is essential to retain the general ledger, chart of accounts, purchase orders, and invoices for any materials or supplies purchased.
Employee Wage Expenses
Any wages paid to an employee for services provided as part of a research project may be included when claiming wage expenses. A common challenge faced is how to allocate wages based on employee activities. The best way to accomplish this is through detailed time tracking, but many do not have the system and structure to automatically capture the needed information. As a result, it is common to rely on estimates determined through oral testimony or checklists. The process for determining the exact amount of qualified wages can be complicated, but there is an IRS rule which permits a business to include 100% of the wages for any employee that spends at least 80% of their time on research projects.
Remember that only taxable wages should be included in the credit calculation. This means items such as 401(k) contributions, health insurance contributions, and other pre-tax benefits should be excluded. In terms of documentation, it is recommended to retain the following:
- Employee W-2s
- Time tracking details
- Interview notes
- Job descriptions
- Meeting notes
These are records that provide additional support and outline how a company appropriated resources, or details of the research project, in a specific year. Since this information is outlined in the IRS Audit Technique Guide, it is important for businesses to ensure they compile such documentation as well. Examples of this type of documentation include:
- Materials explaining research activities, including brochures, pamphlets, press releases, and other similar documents.
- Submissions to management, the board of directors, review committees, or other similar groups regarding research projects, activities, expenditures, and the research credit.
- Documents prepared by, or on behalf of, internal audit, including quarterly and annual reports that refer in any manner to research activities.
- Minutes, notes, or other similar recordings from the budget, board of directors, managerial, or other similar meetings concerning research activities.
- Project authorizations, budgets, or work orders that initiates a research project.
- The internal authorization policies for approving a research project.
- Project summaries and/or progress reports and project meeting minutes.
- Field and lab verification data/summary data.
- Research credit studies conducted by outside consultants.
- Papers, treatises, or other published documents regarding the taxpayer’s research.
- Complete copies of contracts (including all modifications), letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party.
We’re here to help
Ensuring the proper records and documentation are collected during the research project is essential to maximizing the credit amount and satisfying the IRS should an audit occur. Due to the complexities involved in recordkeeping, it is important to consult with a qualified tax advisor to guide you through the process. If you have questions about the information outlined above or need assistance with another tax credit, planning, or compliance issue, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.