Recent changes have substantially broadened the scope of the Research and Development Tax Credit. The Protecting Americans from Tax Hikes (PATH) Act of 2015 has brought permanency to the credit, made it a viable option for high-tech startups and addressed longstanding issues with the alternative minimum tax (AMT).
Meanwhile, new regulations on internal use software development are making it easier than ever for innovative companies to offset their R&D expenses. And yet, many businesses are still failing to maximize their credit due to overlooked areas of opportunity or misinterpretations of the law.
Here are 4 common areas where we see companies missing out on R&D tax credit savings.
1. Overlooking State Opportunities
It’s amazing how many companies claiming the Federal R&D Tax credit have never thought about looking into applicable state credits. Businesses with multi-state operations are especially susceptible to missing out on multiple state credits, many of which follow the same basic eligibility rules as the Federal R&D credit. That said, it’s important to note that calculation methodologies will vary from state-to-state and that some states have specific application requirements and deadlines.
2. Misinterpretation of Qualifying Activities:
Prior to 2004, the IRS required anyone claiming the R&D credit to prove that their efforts were breaking new ground in one of the fundamental “scientific principles,” such as chemistry, engineering or computer science. The legislature eventually realized that such a restrictive interpretation of the rules was not their intent when they signed the credit into law. As such, this so-called “Discovery Test” was eliminated.
Still, many taxpayers continue to use this overly restrictive interpretation of the credit; even though IRS regulations clearly state that improvements to existing products, processes, techniques, formulas and inventions qualify as research and development.
3. Misinterpretation of Qualifying Research Expenditures (QREs):
The R&D credit allows companies to claim three main qualified research expenditures (QREs); wages, supplies and contract research. While it sounds straightforward enough, there is often major confusion around whose wages can be included and what supplies can be pulled in.
For instance, company officers and directors are often intimately involved in R&D efforts, especially at growing companies. Yet, they are often left out of the credit do to a de facto IRS rule that excludes the wages of most highly compensated company leaders. Fortunately, the recent court case Suder v. Commissioner laid this myth to rest, making it clear that the wages of highly compensated employees can qualify for the credit, so long as they are tied to qualifying R&D activities and the wages are in line with industry standards.
As it relates to supply costs, most companies recognize that they can claim the cost of supplies they consume during their research efforts. However, they often do not realize that they can also claim the full cost of their prototypes, even if those prototypes were later sold to a customer.
4. Utilization of the Wrong Credit Methodology:
There are two methodologies that can be used to calculate the credit; the General Method which allows for a 20% rate and the Alternative Simplified Credit (ASC) which allows for 14%. The General Method is older and more established, but many tax preparers prefer the ASC method due to its simplified rules and requirements.
The ASC method is a good option for many taxpayers. However, using this method without considering the General Method can be a costly mistake for some companies—especially startups.
That’s why we always calculate our clients’ R&D credit using both methodologies. Taking the time to do so can and has saved our clients thousands of dollars.
So, before you calculate your next R&D tax credit, ask yourself if you are falling into one of these four common pitfalls.