R&D Tax Credits: Section 41 Overview and New Refund Claim Requirements
The Research and Development (R&D) tax credit is a powerful federal tax savings opportunity available to those conducting qualified research activities. Many businesses do not consider the credit because of the various misconceptions about what specific activities may qualify. In fact, qualified research activities may include a broader spectrum of activities than most think. Getting a tax refund for work that is already being done might seem like it’s too easy, and while the process of getting the refund has changed, qualifying is more accessible than many might believe. The IRC Section 41 research tax credit is designed to reward taxpayers who create, experiment, improve, and innovate, in whatever form and in whatever business or industry where that process happens. Despite the broad application, there are important eligibility, calculation, expense tracking, and documentation requirements that must be followed. In addition, recently released IRS guidance has added an additional layer of complexity. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
About IRC Section 41
The Section 41 research tax credit is permanent, thanks to a 2015 legislative change. It’s a generous tax incentive for any type of business that engages in qualified research activities, which must meet the four-part test.
An activity satisfies the test criteria if the following conditions are met;
- Permitted Purpose – The purpose of the research must be towards the creation of a new or improved product, process, technique, invention, software, or formulation (or “business component”) resulting in increased performance, quality, or reliability. Concurrently, research activities undertaken for aesthetic reasons (style taste, cosmetics) are not eligible. It is important to note that success in a project is not necessary to meet this criterion.
- Uncertainty – The research must eliminate uncertainty about the capability, design, or method related to the development of a new/improved product, process, or component. Since regulations do not require that the taxpayer be successful in eliminating the uncertainty, proof of resolution is not required to meet this test. Concurrently, it can be demonstrated uncertainty existed if the information available to the taxpayer did not establish the method for developing an improved business component. Finally, it is important to remember the Patent Safe Harbor rule, which states the issuance of a patent means information that is technological in nature, and the elimination of uncertainty relating to a new business component has occurred.
- Technological in Nature – Essentially this requires that the process of experimentation was founded in, or fundamentally relies on, hard science principles. Examples include those found in engineering, physics, chemistry, biology, or computer science.
- Process of Experimentation – Requires that uncertainty must be eliminated through a process of experimentation which may include an iterative process, trial, and error, use of the scientific method, simulation, modeling, or any approach that involved the analysis of alternatives. The process is not required to be completely academic, but documentation on the alternatives considered, testing methodology, and results, must be performed and documented to satisfy this requirement.
It is important to note there are situations when a business passes the 4-part test but may still not be eligible. This includes research conducted after commercial production has started, adaption or duplication of an existing business component, surveys focused on market research, foreign research, and funded research. Practical examples include market research, efficiency studies, management functions, routine data collection, or standardized quality control testing or inspection.
The most common stumbling blocks encountered by businesses include the exception for foreign research or funded research. The former requires evidence that research took place in the U.S. The latter requires the taxpayer to illustrate that payments made as part of a contract were not dependent on any outcome, and substantial rights to the research must be retained.
There is often confusion about which project expenses qualify as part of an R&D tax credit claim. Typically, a business can claim the expenses related to wages, supplies, and certain third-party research expenses.
The wages paid to employees participating in or directly supporting/supervising R&D activities can be claimed. This means employers can capture a portion of the (W-2 Box 1) wages for the time spent on qualifying activities. There are a few important points to keep in mind:
- If 80% or more of an employee’s time is deemed qualified, then substantially all test is met.
- Rigid time tracking is not required as estimates are permitted but must be made on a reasonable basis.
- Reasonableness may be demonstrated in many ways including oral testimony, written summaries from an individual involved in the project, or contemporaneous documentation.
The supplies used in qualified research not related to land or other depreciable assets can often be claimed. When demonstrating that supply expenses are not depreciable in nature it may be necessary to show that it is not attached to the land, not owned by the taxpayer, and has a useful life of less than one year.
The opportunity to claim partial supply expenses is also available. This occurs when a portion of the costs, but not the entire expense, meets established requirements, the taxpayer is permitted to remove the portion inJUeligible for the credit. For example, a portion of the supplies associated with a product or machine, such as a casing that has been made before, but the integral components are configured in a new way. The taxpayer would be able to identify the portions which are new and claim it as an eligible supply expense.
There are certain third-party expenses that can also be claimed. For example, tasks completed by a contractor would qualify if conducted by an employee, and activities directly supporting the research would qualify. Concurrently, the taxpayer will be required to prove the research is not funded (and therefore excluded). It is necessary to show evidence that payment was not contingent on the results or outcomes of activities performed and substantial rights to the research and results have been retained. It is important to note that in most cases a taxpayer will be able to claim 65% of the cost of an eligible expense.
Documentation is key. Taxpayers need to keep track of research expenditures, such as payroll records, vendor invoices, and job costing or general ledgers. It is also important to track research activities, including project lists, documentation, contracts, and notes. A rule of thumb is to keep track of all expenses associated with a project as they happen and remove non-qualifying expenses later. This helps to ensure that everything is properly recorded.
Calculating the Research Tax Credit
There are two different calculations available to compute the R&D tax credit, the regular and alternative simplified methods. The regular method uses historical data to compute a base amount. Under this method, the R&D credit for a given year is then 20 percent of the tax year’s qualified research expenses over that base amount. The alternative simplified calculation uses the prior three years as the basis for comparison to current year expenditures.
Section 41 R&D credits can be carried back one year and forward up to 20 years.
New Section 41 Refund Requirements
Starting in 2022, taxpayers claiming a refund for eligible research expenses have a new process to follow. The IRS is requiring five pieces of essential information, which must be submitted along with the tax return.
The essential information consists of:
- Identifying all the business components for which a claim is being made.
- For each business component, identifying all research activities performed
- Name the individuals who performed each research activity.
- List the information that each person sought to discover.
- Provide total qualified expenses for employee wages, supplies, and any third-party contracts.
When deciding which research activities need to be listed, taxpayers should describe what was done and how, by business component. The four-part test doesn’t need to be described in detail and in fact simply restating the language of the four-part test wouldn’t be enough anyway.
Naming the people involved and what information they were looking for can be done in a list, table, or narrative form. Again, by business component. If a group of employees sought to discover the same information for a business component, all the employees can be listed as one group or using job titles/positions. If there is more than one person with the same job title or position in this case, taxpayers would need to indicate how many people hold that position.
Providing total expenses can be completed using Form 6765, Credit for Increasing Research Activities.
One of the biggest takeaways from updated IRS guidance about filing a refund claim is that a formal report isn’t necessary. Taxpayers can largely choose the format they want to best present the required information. When formal reports are used, the taxpayer will need to specify which page(s) the above essential information is on.
During the first year of the new requirements, taxpayers are allowed to correct deficient refund claims. If a refund claim is deficient, the IRS will notify the taxpayer in writing, along with which piece of essential information is missing or otherwise incorrect. From there, the taxpayer will have 45 days to correct the issue, otherwise, the claim will be rejected. After January 2023, deficient refund claims will simply be denied without an opportunity to appeal.
Therefore, it’s imperative now during the transition year for taxpayers to understand how to meet the new refund requirements and provide the necessary documentation to receive the credit.
We’re here to help
The R&D tax credit is a compelling tax savings tool that should not be overlooked. Although some of the regulations have recently changed, businesses should not be discouraged from investigating the credit. If you have questions about the information outlined above or need assistance with an R&D credit claim, JLK Rosenberger can help. For additional information call us at 949-860-9208 or click here to contact us. We look forward to speaking with you soon.