Research and Development (R&D) is integral to the business ecosystem as it spurs invention, innovation, and progress. R&D is perhaps one of the main drivers of business efficiency and growth since it allows improvements to existing processes, the creation of new services and products, and cost reductions in existing systems.
The IRS has long recognized the importance of R&D and provides tax incentives to businesses to encourage them to engage in R&D activities. These tax incentives take the form of the R&D Tax Credit, which allows businesses to deduct a portion of their R&D expenses from their taxes.
In October 2021, the IRS introduced additional guidance for documentation of R&D tax credit refund claims, requiring businesses to provide extra information, not just what was provided in form 6765.
Here’s a rundown of what changed with the new regulations and what it means for businesses claiming the R&D tax credit.
What Is The Research And Development Tax Credit Program?
The R&D tax credit is part of the U.S. tax code meant to stimulate economic growth by encouraging businesses to invest in research and innovation to increase their competitiveness. The credit is available to businesses of all sizes, from startups to large corporations, and can be used to offset both federal and state taxes.
To be eligible for the credit, a business must have been engaged in qualified research activities during the tax year. These activities must seek to create or improve a product, process, technique, software, formula, or invention and meet certain requirements set by the IRS, including:
- Be for the purpose of discovering information that’s technological in nature
- Be intended to develop or improve a product or process
- Require significant experimentation and involve trial and error
- Be innovative
- Have technological uncertainty.
- Resulting in a significant increase in knowledge, capability, or speed and a cost reduction
Excluded activities include:
- Market research
- Research conducted outside the U.S.
- Research funded by an unrelated 3rd party
- Routine data collection and testing for quality control of existing components
- Consumer preference testing
The R&D tax credit can offset up to 20% of a business’s qualified research expenses and up to $250,000 in startup R&D expenses.
These expenses are categorized as qualified research expenses (QREs) and basic research payments (BRPs and may include wages paid to employees working on research projects, the cost of materials used in research, and contract research expenses.
The new IRS guidance doesn’t change the definition of qualified research activities or the eligibility requirements for the credit. However, it does impose additional documentation requirements for businesses claiming the credit.
What’s New on The Reinforced documentation Requirements for the R&D Tax Credit?
The new IRS R&D tax credit documentation requirements state that businesses must provide the following materials:
- Identification of all business components that form the factual basis for the Research and Development claim
- A description of all research activities performed by all identified business components
- A list of individuals who worked on the R&D project
- A description of the information each individual sought to fix or discover and the challenges experienced thereof
- Total qualified research expenses including the employee wages, supply expenses, payments for outsourced services, and contract research expenses
These requirements point to one thing: IRS wants more documentation to support R&D claims.
The idea behind these changes is for the taxman to understand how businesses conduct their research so that the tax credit can be better utilized.
The new regulations also aim to improve transparency and reduce the likelihood of fraudulent claims. By providing more information on the R&D process, businesses can build a stronger case for their credit claims and avoid any potential audits.
What Does This Mean for Businesses?
The new IRS regulations on R&D tax credit refund claims will require businesses to invest more time and resources in documenting their research activities. However, this should not deter businesses from claiming the credit as it can still provide significant tax savings.
To make the claim process smoother, businesses should keep track of their research activities from the beginning. This will make it easier to compile the required documentation when it comes time to file for the credit.
Businesses should also consider working with a tax advisor or R&D tax specialist to ensure they are taking advantage of all the available tax incentives. These professionals will help businesses navigate the new regulations and take advantage of all the available opportunities.
To comply with the new documentation requirements, the IRS has provided businesses with a grace period from Jan. 10, 2022. However, it’s in businesses best interest to start preparing for these changes as soon as possible to take advantage of the R&D tax credit.
Related: Check out our article discussing the 4-part R&D test.
What Next For Businesses
Once a business files for a tax credit and the IRS determines that the credit is allowable, the business will receive a refund of any overpaid taxes. This refund can be used to invest back into the business, which will help it grow and create new jobs.
Other benefits of the credit include:
- Reduced effective tax rate
- Increased earnings per share
- Increased cash flow
- Reduced federal and state tax liability
- Increased return on investment
NOTE: If all requirements are not met, you will be notified and given 45 days to make corrections and refile.
The Bottom Line
The R&D tax credit is a valuable tool that businesses can use to offset the cost of their research activities. It’s also a great service for accounting firms, adding a new revenue stream to your business.
While this credit is a fantastic way to help clients, there is a lot of work in complying with the new IRS regulations. This is why many firms partner with Tri-Merit.
If you have any questions about how this service will affect your firm or your business needs help to claim the credit, our experienced tax experts can help. We offer the technical expertise and flexibility clients want, making complex R&D tax credit claims simple.
Schedule a time to learn more about R&D tax credit claims and how we can help you take advantage of this valuable tax incentive.