Claimed correctly, tax credits promote business R&D

Seth Knighton

Every year the Internal Revenue Services releases the “Dirty Dozen,” a list of tax scams and schemes on which the agency focuses. This year, the IRS has put abuse of business tax credits in its crosshairs.

“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,” the IRS stated.

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. A total of $11.8 million of credits were deemed potentially erroneous, 21 percent of all R&D tax credit claims. Some claims were filed improperly. Some didn’t meet all the requirements for proper claims or attach the proper documentation. 

How is the R&D credit supposed to work? What can taxpayers do to make sure their claims are accurate?

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 developing new products; improves products or 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. In addition, many states also provide similar R&D tax credits. Between federal and state credits, the average potential benefit for the credit could range from 10 percent to 20 percent of qualified spending. 

The R&D credit is calculated using the totals of two different kind of research expenses: qualified research expenses (QREs) and basic research expenses (BRPs). QREs and BRPs relate to activities that advance U.S. technologies and are performed within the U.S.

QREs must be used for specific commercial objectives, but don’t have to advance scientific knowledge. QREs  can be used for process, product or software improvements or development. To qualify for the QRE R&D tax credit, activities must meet each element of a four-part test — qualified purpose, technological uncertainty, process of experimentation, and technological in nature. 

Examples of activities that are excludable and don’t 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. 

Examples of activities that don’t qualify because they fail the four-part test include: administration, training, repairs and maintenance, trial production runs, troubleshooting and duplicating an existing component through reverse engineering.

BRPs differ from QREs in that they’re used 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 involve research for social sciences, humanities or the arts.

If you’re a small business owner or manager, you know how it is. You try to come up with the most efficient processes and 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.

R&D tax credits make it possible for smaller companies to invest in research. Even companies with small or no R&D departments could benefit from the credits. In fact, most taxpayers who benefit from R&D credits don’t have explicitly named R&D departments. Moreover, you could be eligible for R&D credits whether your activities succeed or not.

A taxpayer claiming an R&D credit must retain records in sufficiently usable form and detail to substantiate the expenditures and activities claimed are eligible for the credit and aren’t 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 you trust. Remember: The lowest possible tax bill isn’t the only goal. Accuracy also is important.