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The Research and Development Tax Credit

R&D team contemplates the tax credits that may be available

Does Your Business Qualify?

In an effort to incentivize innovation, the federal government provides a tax benefit to businesses engaged in research and development (R&D) efforts to design, create and improve products, services and software. This dollar-for-dollar credit can play a key role in allowing your business to introduce new products and processes, expand its operations, hire new employees, increase R&D efforts and remain competitive within its industry.

However, like most tax benefits, the qualification requirements can be complex. Following are four tips to help you take advantage of any R&D tax credits available to your business.

#1 – Understand what activities and expenses qualify for the credit.

Eligible activities typically include those that require some type of research, experimentation or trial-and-error in order to improve products, services and processes. The credit is available to businesses across all industries and business types; however, some types of businesses are more likely to qualify based on the nature of their operations.

In order to qualify for the credit, a business’ activities must meet four tests:

  • Permitted purpose – The business function must be performed with an intention to develop a new process or product or improve the performance, functionality, reliability and/or quality of a process or product.
  • Technological in nature – The activity must be technological in nature and guided by sound principals of engineering or physical, biological or computer science.
  • Element of uncertainty – There must be some technical uncertainty involved in the process. Is it even possible to improve this process or product?
  • Experimentation – Because there’s a level of uncertainty involved, there must be some type of experimentation to evaluate possible alternatives and/or improvements.

Specific expenses that typically qualify for the business tax credit include:

  • Qualified labor – Labor expenses that qualify for the tax credit include taxable wages for employees who are directly involved in or responsible for supervising, or supporting, functions such as technical spec development, testing, design, prototyping, technical design requirement definitions, etc.
  • Qualified contract research expenses – These include research expenses the business must bear, regardless of whether its research efforts are successful. For example, expenses related to prototype fabrication, engineering efforts, software development, etc.
  • Qualified supplies – Supplies covered by the tax credit include any raw materials or components used in R&D efforts that weren’t capitalized or depreciated. These can include materials used to develop and test prototypes as well as materials used for product design or testing purposes.

#2 – Understand what expenses and activities don’t qualify for the credit.

R&D tax credits aren’t available for:

  • Projects conducted outside the United States
  • Surveys, polls, etc.
  • Social science or economic research
  • Functions related to quality control and/or routine maintenance
  • Duplication or reverse engineering of an existing product or process

#3 – Maintain appropriate documentation.

As with any federal tax incentive, it’s important to maintain supporting documentation of your business’ eligibility for the tax credit. While it’s acceptable to estimate certain research expenses, you must be able to document a factual basis for any assumptions used in the estimation process.

At a minimum, be sure to maintain the following documents.

  • Payroll records
  • Project lists
  • Project notes
  • Lab results
  • Emails and other documents produced during the regular course of business

#4 – Conduct an R&D study.

With all the variability surrounding the R&D tax credit, it can be difficult to determine whether your business qualifies. A great way to determine your company’s eligibility for tax credits is by engaging a qualified, independent third-party advisor to review your business and determine what activities and functions may qualify for the credit.

At Creative Planning Business Services, we work with business owners to evaluate their company’s structure and core functions and help determine whether they qualify for a wide range of tax incentives, including the R&D credit. Our experienced tax professionals can help you optimize your tax planning strategy and perform tax compliance work so that you’re free to focus on more pressing business needs.

To learn more about how to utilize tax incentives as part of your overall business strategy, schedule a call with a member of our team.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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