This is a thought leadership article by Clayton & McKervey and is second in a six part series discussing research and development tax credits. 

The R&D tax credit is one of the most overlooked opportunities to boost your bottom line. Many business owners fail to claim it under the mistaken belief that they’re not eligible. Among the few who do claim it, many are not aware of all the qualifying expenses they’re leaving on the table.

In part two of our six-part series on R&D tax credits, we’ll explore the wide range of qualifying expenses that companies of all types and sizes may be able to claim. As a reminder, it’s a good idea to consult a tax expert before exposing your company to the financial implications of any new tax credit strategy.

Let’s dig into some specifics about the kinds of expenses that qualify for an R&D tax credit.

A quick refresher on the R&D tax credit

The R&D tax credit (as it was originally conceived in the early 1980s) is meant to reward companies for investing in innovation that leads to long term business growth and job creation. When it comes to the question of qualifying expenses, it’s important to remember that the process does not have to lead to a breakthrough discovery that’s new to the world. In fact, there’s no requirement that the experimentation has to be successful in any given tax year – only that it’s properly documented as pursuing some discovery that’s meaningful to your individual business.

Qualifying expenses for the R&D tax credit

First, let’s look at activities, which in general terms must pass a four-part IRS test. They must:

  1. Serve a qualifying purpose for something fundamental to your business
  2. Address an essential technological uncertainty
  3. Be subject to measurement by a hard science of some sort
  4. Follow a documented process of experimentation

The tax credit rules allow you to claim various percentages of labor, supply or outsourcing costs depending on conditions outlined in the corresponding IRS and Treasury codes, and all work must be performed inside the U.S.

  • Taxable wages paid to employees who directly contribute to qualified research activities
  • Taxable wages paid to people who directly assist such employees
  • Taxable wages paid to people who directly supervise such employees
  • Payments to contractors who perform direct services in the U.S. in support of such work
  • Payments to vendors who supply materials consumed in support of such work

By way of example, let’s say that you run a company that manufacturers paint coatings that wants to introduce improved curing additives to the market. A prescribed portion of the taxable wages of the engineer running the test routines qualifies, as do the taxable wages of the engineer’s direct leader or an assistant who may directly support the engineer by maintaining and cleaning the test apparatus.

In this example, the wages of the engineering department’s administrative assistant or the leader of the engineer’s boss are not eligible expenses. Neither are the costs of utilities, IT or phone service connected to the test space, or any rent or capital costs for the space itself.

The scientific-sounding name of the R&D tax credit might create the false impression that only companies like life science, pharmaceutical or microelectronics giants qualify. In fact, many small, medium and even startup business in many markets are likely eligible. Here are just a few:

  • Engineering
  • Software developers
  • Custom Machine builders
  • Plastic Injection molder
  • Tool and Die companies
  • Automation companies
  • Prototype and Precision manufacturing

Expenses that are not eligible for the R&D tax credit

Beyond the three types of expenses described earlier, there are expenses that are unambiguously out of bounds for R&D tax credit qualification.

Capital investments for equipment or property are not eligible. You can’t claim the costs of routine focus group, consumer preference or market research, or testing or quality assurance activities for existing services or products.

The important thing is to keep detailed records. Most of what you need may already be captured in your existing business documentation. This might include:

  • Project budgets, schedules and progress notes
  • Detailed employee assignment and payroll records
  • Experimentation logs and observation notes
  • Supply inventories, purchase orders, receipts and other procurement documentation
  • Contractor bids, proposals and scope documentation

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Clayton & McKervey PC

Headquartered near the international border of the U.S. and Canada, Clayton & McKervey is a Detroit-based, full-service accounting and business advisory firm focused on global business. The firm’s clientele includes closely held, middle-market, growth-oriented companies. Since 1953, Clayton & McKervey has created a strong reputation, both domestically and internationally, with four types of clients, U.S. entities with operations in other countries, foreign entities expanding to the U.S., businesses with international growth plans and clients in need of transfer pricing service.

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