For a company’s activities to meet the requirement to be considered qualified research activities (QRAs) it has to fulfill the “IRS Four-Part Test”. The “IRS Four-Part Test” has four requisites:

1. New or Improved Business Component: The QRAs must result in a new or improved level of function, performance, reliability or quality. A simple change in the product’s aesthetics doesn’t fulfill this criterion. The candidates need to design, develop or improve products, processes, techniques, inventions, formulations or software to qualify for the Research and Development Tax Credit.
2. Technological in Nature: The research and activities must be based on one or more of the following sciences: engineering, software, manufacturing and design, environmental and life sciences, etc.
3. Elimination of Uncertainty: The QRAs must intend to eliminate uncertainties concerning the development or improvement of a product, process, technique, invention, formulation, or software.
4. Process of Experimentation: The process of experimentation is identifying and evaluating alternatives, performing trial and error experiments, and testing results. The IRS also considers “process of experimentation” when a candidate creates prototypes, models and simulations. Any failed projects, technological in nature, are also considered part of the process of experimentation.

In the case of an IRS audit, a company must be able to present documentation that will support the activities the taxpayer has cataloged as QRAs. To prove that the company conducts research activity, the company must present an R&D project list to the R&D tax consultant. The project list must include any R&D project the company has conducted in the past tax year. The project list needs to include a technical explanatory narrative that addresses the “IRS Four-Part Test” requirements. The project narrative will explain how the company’s projects meet the eligibility requirement and ultimately prove that qualified research activities were conducted by the taxpayer.

The R&D tax consultant will also need other documentation to further support its R&D Tax Credit calculation. Supporting documentation is any record that proves the company’s research activities fulfill the “IRS Four-Part Test”. The following supporting documentation reinforces the existence of a company’s QRAs:

1. Testing protocols
2. Sketches and design drawings
3. Intellectual property documentation
4. Photographs
5. Prototypes
6. Project schedules and status updates
7. Laboratory records
8. Job descriptions
9. Product development procedures

A few of the documents listed above will suffice as evidence of the company’s QRAs in the case of an IRS audit.

The IRS defines Qualified Research Expenses (QREs) as the sum of “in-house research expenses” and “contract research expenses”. Those in-house research expenses include:

1. Wages – Taxable or subject to self-employment tax of individuals performing, directly supervising or supporting the qualified research.
2. Supplies – Amount paid or incurred for materials used in the conduct of qualified research.
3. Contract Research – Payments for the conduct of research. The taxpayer must be at risk when conducting the research.

Wages

Wages are often the largest component of the qualified research expense in an R&D Tax Credit Study. Wages will constitute as an “in-house research” expense if employees were paid for “qualified services”. Wages mean all taxable wages as reported on a W-2 form. It also includes bonuses, stock option redemption and any wages subject to withholding.

The references used to check a company’s wages include W-2s, payroll records, personnel interviews or any other document that tracks employee costs. If a company or a company’s department specifically specializes in R&D activity, then W-2s will be the best document to refer to. If an employee or a company only does partial R&D activity payroll records and personnel interviews will be the best evidence to determine their wages as qualified expenses.

Supplies

Supplies are any materials used in the conduct of qualified research. Supplies are qualified if they are used by employees conducting “qualified services”. The supply must be directly related to the “qualified services” conducted by the employee.

A company’s general ledger or trial balance are the best documents an R&D tax consultant could use to check a company’s supplies. A general ledger may contain entries of supplies the company incurred for R&D projects. If the client is a company that consistently conducts R&D, they will have a designated account within the general ledger where all the R&D supplies are allocated. Since all general ledger entries are backed by an invoice, this document is the most detailed reference to check if the company has incurred in any qualified research expenses (QREs).

Contract Research

The IRS defines a contract research expense as 65% of any expense paid for the performance of qualified research on behalf of the taxpayer. The IRS provides a three-part test which determines what is considered a contract research expense. The contract research agreement with a third party:

1. Must be agreed on prior to the performance of the qualified research.
2. States that the research is being performed on the taxpayer’s behalf.
3. Requires the taxpayer to bear the expense of any risk involved with the research.

The best source to confirm a company’s contract research expense is 1099 documentation or vendor invoices. The 1099 will give a more detailed account of what a specific vendor worked on throughout the year, by summarizing all the payments incurred within that tax year. If an outside contractor worked on R&D and non-R&D projects, the R&D tax consultant can use 1099 or vendor invoices to allocate which costs are considered QREs and can be used for the R&D Tax Credit Study.

Qualifying Activities

For an activity to qualify as a qualified research activity (QRA) it has to fulfill the “IRS Four-Part Test”. The “IRS Four-Part Test” has four requisites:

• New or Improved Business Component
• Technological in Nature
• Elimination of Uncertainty
• Process of Experimentation

If the development efforts don’t pass this test the IRS won’t consider the activity qualified for the R&D Tax Credit calculation. The activity doesn’t need to be highly technical, but it does need to be technical in capability, method and design. On the other hand, the development must be technical in nature and have a process of experimentation or it won’t pass the “IRS Four-Part Test” muster.

Non-Qualifying Activities

We often list activities that qualify, but it is equally important to know what does not in the eyes of the IRS. As mentioned above, a company’s activities must pass the “IRS Four Part Test” for it be considered a QRA for the R&D Tax Credit. The list below describes activities that are not considered qualified research:

• Research after commercial production
• Reverse engineering
• Management activities, efficiency surveys and market research
• Routing data collection and quality control
• Internal-use software development that doesn’t meet the “High Threshold of Innovation” test
• Studies related to efficiencies, operations and profitability
• Foreign research
• Research in the social sciences, arts or humanities
• Trial runs that aren’t related to validation
• Debugging flaws in a business component
• Style or consumer taste research
• Training
• Installation
• Funded research (except within a controlled group)
• Duplication of an existing business component

If the taxpayer claims any of the activities listed above as a QRA, the IRS will throw them all out in the case of an audit.

Qualifying Expenses

The IRS defines Qualified Research Expenses (QREs) as the sum of “in-house research expenses” and “contract research expenses”. Those expenses include:

• Wages: Taxable or subject to self-employment tax of individuals performing, directly supervising or supporting the qualified research.
• Supplies: Amount paid or incurred for materials used in the conduct of qualified research.
• Contract Research: Payments for the conduct of research. The taxpayer must be at risk when conducting the research.

Non-Qualifying Expenses

Wage eligibility is based upon what an employee does during a period of time. The taxpayer also has to take into account, but not as conclusive evidence, the employee’s technical and education qualifications. Wages to general support personnel not involved in any experimental or technical projects such as payroll or janitorial staff are generally non-qualifying expenses.

Supplies usually represent a small portion of the total QRE. Thus, a taxpayer should be cautious when claiming supplies as part of their QREs. Ineligible supplies expenses include: travel, meals, entertainment, telephone expenses of researchers, relocation or rental expenses, professional dues or royalty, etc.

Lastly, contract research also makes up a portion of the QRE. However, a taxpayer won’t be able to claim a contract research expense as part of the R&D Tax Credit calculation unless it fulfills a three-part test imposed by the IRS. The IRS provides a three-part test which determines what is considered a contract research expense. The contract research agreement with a third party:

• Must be agreed on prior to the performance of the qualified research.
• States that the research is being performed on the taxpayer’s behalf.
• Requires the taxpayer to bear the expense of any risk involved with the research.

If the taxpayer claims this expense without a contract research agreement as stated above this expense will not pass an IRS audit.

Internal Use Software

This is a category where many technology companies benefit. In today’s age companies develop software that is not commercially available and makes their business run effectively and competitively. The IRS regulations defines the term “non-internal use software” as:

• Software created by the taxpayer for commercial sale, licensing or leasing.
• Software created by the taxpayer to communicate with third parties or have third parties revise their files or documents on the taxpayer’s platform system.

If a company is claiming its internal use software as part of the R&D Tax Credit calculation and it falls into one of these two categories, the software program will be thrown out in the case of an IRS audit.

 

 

It can often come as a big surprise when CPAs and businesses learn how many different industries are eligible for Research & Development Tax Credits (R&D). These federal and state tax credits offer excellent opportunities to convert R&D expenses (developing new or improved products, processes or software) to valuable R&D tax credits. This incentive is the most valuable program an innovative company can claim. It is a dollar-for-dollar offset against previous, current, and future tax year liabilities.

This credit provides a competitive advantage for businesses that develop, design or improve products and techniques. Companies of all industries range between 10-20% ROI for their R&D efforts. For 2016 with the credit’s permanency, we anticipate our client’s benefits to nearly double.

Plus, recent IRS regulations have made it easier to qualify for many businesses. A revised method of computing the R&D Tax Credit and the desire of the US government to increase domestic R&D activity have all made it easier for companies to claim these credits. It is however important to find a provider to help capture and substantiate these credits – that’s where Kuhler Tax Credits comes in.

Check to see if your company’s industry qualifies for the Research and Development Tax Credit:

Kuhler Tax Credits has experience with all of the listed industries, averaging only 4-6 weeks to complete calculations, federal and state forms, and reports. Send us an email at   info@kuhler.com or visit the Kuhler Tax Credits website www.kuhler.com to learn more about the Research and Development Tax Credit and what your tax savings could be today!