Recently, research and development (R&D) received widespread media attention. Headlines over the past year have revealed new legislation and guidance for this incentive, which is a tax credit provided to companies that perform qualifying research and development activities in the United States.

For example, the Inflation Reduction Act of 2022 doubled the amount of R&D tax credit allowed for startups who elect to use the credit against their payroll tax from $250,000 to $500,000; the credit is available to small-business startups meeting specific criteria. R&D tax credit changes have also taken the form of new IRS guidance regarding required documentation for amended returns that claim R&D tax credits resulting in a refund. And for tax purposes under Section 174 of the tax code, companies can no longer immediately expense R&D expenses for tax purposes. They must now capitalize and amortize R&D expenses over five years for research performed in the U.S. and over 15 years for research outside of the U.S.

With all of attention surrounding the tax credit, it should be no surprise that many businesses are now taking a closer look at the development efforts they undertake to stay competitive. After all, the R&D tax credit can be a great way to pursue new opportunities and reinvest in efforts that help a company get ahead of its competition. However, the process of properly assessing, calculating and documenting the credit can be complex, with many moving parts.

In this article, we'll look at four areas your organization may not even know to consider when pursuing the tax credit.

Your Organization May Already Qualify

Many organizations can benefit from the R&D tax credit but are often unaware they qualify. Before pursuing any new projects, your organization should identify if any recent projects already qualify for the credit.

Just because your organization doesn't have an engineering team or isn't developing a new product doesn't mean it isn't participating in qualifying R&D. The credit can apply to a wide range of activities, including improving existing products or processes. To qualify for the tax credit, a project must involve some level of risk and uncertainty and result in a new or improved product or process.

For example, a manufacturing company buys a new piece of equipment but, after getting it running, discovers that the production process isn't as good as originally hoped. The company may have qualifying process development efforts by undertaking a project to modify the equipment on the line to become more efficient and improve reliability. The key is not that they modified their machine to get it running but that they modified it to work better within their process.

If your organization has installed new equipment or incorporated new technology recently and had to make changes uniquely to your process, you may examine whether your situation qualifies.

Employees are the Bread and Butter

Since the R&D tax credit is wage-based, your employees' salaries are critical to the amount your organization will receive. If your employees working on an R&D project are low-paid, your credit will not be as significant, and vice-versa.

The number of people working on the project is also an essential factor. If you have many employees working on a particular R&D project, that's where you get the most benefit. But which employees qualify?

Qualified research and development wages go beyond just employees wearing lab coats or the lead engineers. Every employee who spent time performing qualified research or spent time directly supporting or supervising the research should be included.

These workers include:

• Employees performing direct research
• Employees reviewing the research
• Any employee directly supporting R&D efforts (i.e., an assistant who transcribes test results).
• Organizations must identify all the business components to which the research credit claim relates in a given year.
• For each business component, you must identify all research activities performed and name the individuals who performed each research activity – and the information each individual sought to discover.
• You must provide the total qualified employee wage expenses, total qualified supply expenses and total contract research expenses for the claim year.

R&D Project Qualification is a Gray Area

One of the most confusing — and riskiest — aspects of R&D is that there is a fine line between requirements and qualifications. Just because you are doing an activity required to comply with the R&D tax credit doesn't necessarily mean it will qualify. Many gray areas need to be scrutinized due to the complex nature of the rules and regulations. Some organizations may unknowingly take an incorrect position that is aggressive and not realize the risk they are putting themselves in.

That is why working with professionals who can guide you through the process is essential. A professional can not only help you understand the rules and regulations, but they can also help you better identify which activities will qualify for the credit. In addition, a professional can help you document your activities and expenses to maximize your credit. By working with specialists, you can ensure that your R&D activities comply with the law and that you receive the maximum benefit from the tax credit.

Always Be Prepared for an Audit

As the R&D tax credit continues to make headlines and gathers more scrutiny, the IRS is simultaneously amping up its auditing efforts across the board. With the expectation that the IRS will increase its population of auditors, it's essential for organizations performing R&D to be fully above board with their details.

As mentioned, the IRS recently stated that it now requires specific information to be provided by taxpayers for a research credit claim in order for a refund to be considered valid on an amended return.

That information includes:

In addition, if you are seeking the R&D tax credit, you should gather detailed documentation to support your stance; that way, you can be fully prepared should an audit occur. This documentation should include items such as design drawings and iterations; emails regarding the projects; applicable dates and times employees performed qualifying activities; and other pieces of evidence validating the qualifying nature of the development effort and the personnel involved.

It's crucial that your organization keep track of and store all of this information for each R&D project for at least three years due to the statute of limitations associated with federal tax returns.

Next Steps

The R&D tax credit can be a valuable asset for your organization by helping to reduce taxes and improve your bottom line. However, it can be tricky to navigate the process and ensure you're claiming the credit correctly. Working with a tax expert can help ease the burden and optimize the credit for your organization.

If you're interested in learning more about the R&D tax credit and seeing if your business qualifies, please contact us.