For many businesses, the end of the year is a time to review performance, analyze results, and assess strategic goals. Unlike other years, 2020 featured a once in a lifetime pandemic that challenged businesses to adjust to changing government orders and manage through the resulting financial and operational consequences. These unexpected conditions meant that most, if not all, 2020 plans were put aside to deal with the crisis. As the end of the year quickly approaches, many are making strategic moves to leverage investments, bolster finances, and reduce taxes. While there are plenty of year-end actions that can create savings, it is often difficult to find a single strategy that can “bury the needle”. However, the Research & Development (R&D) Tax Credit represents an opportunity for many Los Angeles and Orange County companies to realize significant savings. In part, the amount of savings depends on the amount of Qualified Research Expenses (QRE) incurred.
What are Qualified Research Expenses?
QREs are the expenses incurred when conducting Qualifying Research Activities. They are classified into one of three categories, including:
- Compensation paid to employees for performing “qualified services”. This includes all taxable wages, such as bonuses and stock options.
- Supplies and materials necessary to conduct qualified research and development.
- Payments made for contract research expenses.
Employee Compensation Expenses
The amount of compensation eligible for the R&D tax credit depends on a variety of factors, including job description, job title, and even credentials and qualifications. However, the main determinant is whether qualified services were performed. According to the IRS, this includes:
- Engagement in actual research activities.
- Direct supervision of research activities.
- Direct support of research activities.
Supplies and Material Expenses
Broadly speaking, only tangible personal property used for qualifying research activities can be claimed as a supply expense. The IRS rules are rather complex for determining these expenses, but they have explicitly stated the following do not qualify.
- Land or improvements to land
- Travel, meals, or entertainment
- Telephone expenses of researchers
- Relocation or rental/lease expense
- Professional dues or royalty/license expenses
The IRS Audit Technique Guide states that material and supply expenses should make up a small amount of the QREs. When it does not, they carefully review this area to determine if credit calculation errors have occurred.
Contract Research Expenses
From time to time, a business will elect to outsource a portion of research activities due to a lack of necessary resources to complete the tasks internally. In these circumstances, contract research expenses are calculated as 65% of any expense paid to a third party. For these expenses to qualify, there must be an agreement in writing that meets the following:
- Entered into prior to the commencement of research activity.
- Provides that research be performed on behalf of the taxpayer.
- Requires the taxpayer to bear the expense in the event the research does not produce the desired outcome.
The R&D tax credit can open the door to significant tax savings greater than is usually experienced with other tax credits. Since determining qualification can be a complex process, 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 a tax or accounting 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.