Claiming the R&D tax credit can be an effective way to reduce your federal tax liability if your business engages in research and development. But in order to do this, you need to support the expenses you are claiming properly. Doing so is critical and mandatory to avoid an issue later on.
But what kind of documentation do you need? This article will explain which expenses you can claim, the recordkeeping requirements, and the documentation you need to support the R&D tax credit.
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What Activities and Expenses Qualify for the Credit?
Qualified research activities (QRAs) are those activities that allow you to improve or develop products, techniques, software, processes, formulas, and inventions. The expenses you incur to do these activities are called qualified research expenses (QREs). But not just every expense that allows you to develop a new product counts towards the credit. QRAs must pass a four-part test outlined in IRC Section 41(d) for their associated expenses to apply.
- You need to have intended to develop or improve a product, process, or other technology that is used in a business or trade.
- The activities should have intended to discover something that would get rid of technological uncertainty.
- The activities should be technological in nature. The experimentation should have relied on biological or physical science, engineering, or computer science principles.
- The activity should identify technological uncertainty and produce alternatives to eliminate this uncertainty. There should be a process for evaluating these alternatives.
What Are the Recordkeeping Requirements for the R&D Tax Credit?
Treasury Regulation 1.41-4(d) dictates the recordkeeping requirements for someone claiming a Section 41 credit. Unfortunately, this is unhelpfully vague. The requirement simply states that the records must be detailed to show that the expenses claimed are eligible and that the records are kept in a sufficiently usable form.
There is no direct instruction on what kinds of documents should be kept or how QREs should be recorded. This creates a lot of uncertainty in deciding which types of documents satisfy these requirements. If you are confused and worried, you can look at previous court decisions about the R&D tax credit to see what has worked in the past. However, there are some guidelines you can follow and ways to make it easier.
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What Types of Documentation Should You Keep?
The exact documentation you can keep is quite flexible. However, you should make sure to keep detailed records that will help calculate your credit and substantiate your claims. These documents may be requested during an IRS audit.
Employee wages for qualified services are eligible under Section 174. These wages must meet the requirements of IRC Section 3401(a). You’ll need to show records of federal taxable wages that are reported on Form W-2. This also includes any stock option redemptions and bonuses for these employees.
In general, you’ll want to keep records using the following:
- Employee Form W-2s
- Payroll records and registers
- Time questionnaires
In addition, oral testimony and meeting minutes related to these expenses can be useful.
It’s important to note that nontaxable items are excluded from eligibility even if the compensation was for qualifying services. This means health insurance contributions, 401(k) contributions, non-taxed income, and other pretax benefit deductions do not need to be recorded.
Wages paid for in-house research conducted outside the US. should also be excluded.
Contract Research Expenses
Contract research expenses are those paid to anyone who is not an employee for their services towards the qualified research. Section 41 allows for an applicable percentage, usually 65% of the amount paid or incurred, to be claimed. These expenses are only allowable for the part of the research that was performed within the U.S.
Research funded by another person, government entity, contract, or grant does not qualify. Even if the project fails, the taxpayer must bear the financial burden and keep substantial rights to the research results to qualify. In addition, the contract cannot be contingent on the research being successful. Whether or not the service passes the “risk and rights test” is usually determined by looking at the terms and language of contracts, agreements, and other documents. This includes all forms and attachments and could also include compensation arrangements, warranty terms, IP terms, payment, and nonpayment terms.
To document these kinds of expenses, you can use the following:
- Form 1099-NECs for individual contractors
- Purchase orders
- Service contracts and similar agreements
- General ledger
- Chart of accounts
Since this is one of the more confusing categories of R&D expenses to document, you may want to look at previous court decisions about “funded research” or get assistance from a trusted expert.
The list of qualifying supplies can be quite long. In general, any tangible personal property related to the qualified services counts. The exceptions are for property subject to depreciation and land or improvements to the land.
To document these expenses, you can keep the following:
- Purchase orders
- General ledger
- Chart of accounts
- Bills of lading
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How Can TaxRobot Make Claiming the R&D Tax Credit Easier?
Figuring out exactly what documentation you need to back up your tax credit claims can be confusing. If you end up getting audited, it can even be scary. After all, what happens if you don’t have the right documentation or fill something out wrong? You could be left paying back the credit and possible penalties.
Luckily, TaxRobot’s software can help put your mind at ease. Our software makes it easy to claim the credits you’re eligible for. We use your information to make sure you get the refund you should. But we also ensure you’re taken care of in the event you get audited.
We keep superior, audit-proof paperwork to back up your claim. This follows the IRS recommendation and other statutory requirements. We also offer audit support. If you are audited, we’ll step in and help. Our experts will respond to requests and answer any questions. This means you don’t need to worry about answering something incorrectly. Plus, if you need help along the way, we offer consultations to make sure you fully understand everything that’s happening with your R&D tax credit.
Make Sure You Get the Credits You’re Eligible For
You want to get all of the tax credits you’re eligible for. But figuring out how to document your expenses can be confusing. For the R&D tax credit, the documentation requirements aren’t quite clear-cut. But when you work with TaxRobot, you receive audit support and superior documentation. You can get a bigger refund with less worry.
Related: Form 8974: Complete Guide & FAQs