Many Texas organizations are surprised to learn that existing business activities may qualify for the federal Research & Development (R&D) credit. Recent changes that have expanded which expenses are eligible and enhanced tax benefits make it an appealing option. However, preparing an R&D credit claim is a complicated process that requires a detailed understanding of allowable expenses and the importance of documentation. Ensuring all eligible expenses are claimed is the key to receiving the maximum possible credit. Concurrently, claiming ineligible expenses may result in unwanted IRS scrutiny. It is essential to understand eligible research and supply expenses clearly. To help clients, prospects, and others, Calvetti Ferguson has provided a summary of the key details below.
The Four-Part Test
Adhering to IRS requirements is the starting point for all successful R&D credit refund claims. Even if certain expenses would otherwise meet eligibility rules, the project itself must first pass the four-part test.
- Qualified activities must have a clearly defined purpose to improve the functionality, performance, reliability, or quality of a new or existing business component.
- Improving or developing said business component must seek to eliminate the uncertainty.
- The activities must be part of a process of experimentation.
- The process must rely on hard sciences (physical or biological science, engineering, or computer science) and be technological.
Generally, the product or business component of the four-part test references can be a formula, invention, technique, process, pilot model, or a patent or similar piece of intellectual property.
Once the four-part test has been met, taxpayers can go one of several routes to make a claim.
- The traditional R&D credit is worth 20 percent of qualified research expenses.
- The alternative R&D credit is worth 14 percent of qualified research expenses.
There are also options to claim the R&D credit against $250,000 in payroll taxes ($500,000 starting in 2023) or the alternative minimum tax.
Most states, including Texas, also have their R&D credit and the federal incentive.
Qualified Research Expenses
The IRS defines qualified research expenses (QREs) as the “sum of in-house and contract research expenses.” These expenses are directly connected to the taxpayer’s trade or business.
In-house research expenses can be employee wages, any amount paid or incurred for supplies used in the conduct of qualified research, or amounts paid to another person for the right to use computers as part of the research process. Wages include bonuses and stock option redemptions but do not include fringe benefits or non-taxable income.
For wages to be eligible, the employee must have been engaged in qualified research or directly supervising or supporting qualified research. Salaries for higher-level managers do not qualify. An employee’s total wages for the year could be considered QREs if at least 80 percent of their services performed for the year are supporting or supervising qualified research.
Contract research expenses are any amounts paid or incurred to anyone other than an employee for qualified research. Sixty-five percent of contract expenses qualify for the R&D credit. These types of expenses must meet a three-part test, which is outlined below.
- The contract is entered into before the research begins.
- The research is performed on the taxpayer’s behalf.
- The taxpayer pays the contract even if the research is unsuccessful.
Taxpayers should note that service contracts and qualified research contracts are different. From the IRS:
“For example, the vendor may be paid by the hour in a service contract, and the research is not specified. In this case, you must look at the work done. Only the amounts paid for qualified research work would be included in QREs (subject to the 65% limitation). In a research contract with an agreed fixed price to perform qualified research, the entire amount would be subject to the 65% limitation and included as a QRE.”
Qualified R&D Supplies
Supplies used in research are tangible property other than land improvements or property subject to depreciation.
R&D supplies should make up a small portion of overall R&D expenses. The cost of equipment and buildings where qualified research is performed must be capitalized and amortized according to the appropriate depreciation schedule.
Generally, the following supply expenses do not qualify for the R&D credit.
- Overhead
- Capital equipment
- Software tools
- Subscriptions and licensing fees
- Rent and lease expenses
- Travel and meal expenses
There could be exceptions if the supply were used during research, however. In those cases, intent matters.
For example, if the supply expense was used to create or test prototypes or as part of an experimental process, it could be considered allowable. The question would be if the outcome was uncertain – which would be allowed – or if the supply expenses were used for a process or prototype where the outcome was predetermined – if the prototype was intended for a product that would go up for sale, as an example.
The process of experimentation and an uncertain outcome are both required if the supply expense is allowable under the R&D credit.
Materials can also be allowable supplies even if they’re sold to a customer if the original outcome was to eliminate the uncertainty. Materials usually allowed in an R&D credit claim are lab supplies, machinery and electrical components, 3D printing equipment, raw material, and hardware.
Certain supplies can be included in an allowable R&D credit claim even if the same materials are used for products that are not part of the process of experimentation or uncertainty. Documentation is critical. Materials or supplies used for product or process improvements should be recorded separately from other expenses.
Typically, the IRS scrutinizes supply expenses more than other allowable expenses, so taxpayers should ensure their documentation is thorough.
Documentation Requirements
For QREs, employees whose wages are included in the refund claim must be substantiated with payroll records, job descriptions, performance evaluations, calendars, and appointment books. According to the IRS, “the goal is to determine what the employee did and how much time they spent doing it.” Using job descriptions or titles isn’t enough.
Contract expenses can be overlooked easily. An excellent place to start is to request the dollar amount of all QREs on contracts, and from there, taxpayers can review specific contracts that may be flagged. If there are only a few allowable contracts, they should all be checked.
Taxpayers need to clearly show that any allowable supplies or materials are directly connected to projects with experimentation or uncertainty components. Documentation should demonstrate the connection between materials or supplies and specific research projects.
It’s also essential to review individual invoices. There could be payments for prototypes and qualified research expenses on the same invoice. Vendors can separate these expenses; otherwise, the taxpayer will need to do this.
Keeping real-time documentation for allowable expenses can go a long way in successful R&D credit refund claims. It’s helpful to establish a documentation policy for R&D expenses so the process is consistent across departments and from one tax year to another.
Contact Us
Claiming the R&D credit can be complicated and time-consuming, and ensuring the correct expenses are accurately reflected is critical. Working with a qualified advisor can help to eliminate uncertainties and streamline the R&D credit claim process. If you have questions about the information outlined above or need assistance with your R&D credit claim, please fill out the contact form below.