Top 10 Things Even Professionals Don’t Know About the R&D Tax Credit

February 9, 2024

Over the years, we’ve talked to a lot of professionals about leveraging the R&D Tax Credit. While most folks understand the basics, we’ve noticed that there are some things that consistently surprise people about this complicated Credit.  

Surprises are great for things like birthday parties. Less so for things like tax planning. As such, we’ve compiled the Top 10 Things Even Professionals Don’t Know About the R&D Tax Credit:  

1. The R&D Tax Credit May Be Claimed by Taxpayers in Virtually Any Industry.  

This is probably the #1 misconception about the R&D Credit – people hear “R&D,” envision white coats and test tubes, and just assume they don’t qualify.  

Activity in virtually any industry may qualify for the Credit – manufacturing, architecture, food and beverage, engineering, software design, etc.  

The Credit is tremendously underutilized – less than 30% of eligible businesses claim it, and it’s mostly smaller businesses that are missing out. Review the eligibility criteria – you might be pleasantly surprised.  

2. Tracking time is not required, though you do have to keep some records of the work done.  

This is another myth that often stops people before they start. People imagine they need copies of every timesheet ever logged to support their claim.  

It’s true that documentation is crucial to successfully claiming the Credit, but nothing specific is actually required by law. Instead, taxpayers need to provide “sufficient documentation” which might include:  

  • Payroll information for employees directly involved in R&D and for employees or managers supervising them 
  • General ledger reports indicating which costs and supplies were related to R&D activity 
  • Copies of contracts and invoices paid to third-party contractors 
  • General documents that demonstrate the research process and progress: test results, blueprints, drawings, emails, meeting minutes, etc. 
  • Credible testimony 

Your R&D provider will start with the documentation you have available and work to ensure that your claim is thoroughly supported. 

3. You can amend an already filed return to take the Credit retroactively.  

There’s no missing the boat here. If you engaged in qualified research activity in the last 3 open tax years, but didn’t claim the Credit, you can do so by filing an amended return with Form 6765. 

Bear in mind that the IRS requires extensive supporting information for the retroactive claim to be considered valid. Taxpayers are required to provide: 

  • Identification of all business components for the relevant TY 
  • For each business component:  
    • Identification of each research activity performed 
    • Name of each individual who performed the activity 
    • Description of what each individual was hoping to discover  
  • The total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for that TY.  

4. One thing you can’t do on an amended return?  Elect 280C…   

If you file an original return in a timely fashion, you can take the 280C Election. This permits you to take an automatically reduced Credit and apply it directly towards your tax liability. This may be particularly significant for pass-through entities and should be discussed with your tax professional.   

However, this Election may not be taken on an amended return. Instead, the full Credit amount must be added back into taxable income before tax liability is calculated.  

One caveat — if you are amortizing Sec. 174 expenses according to Notice 2023-63, the adjustment to reduce expenses is only required if the amount of the gross credit exceeds the current year deduction for the Section 174 credit-eligible capitalized expenses. This only applies for tax years starting after 12/31/2021.   

5. In some instances, the Credit may be used to offset payroll tax liability.  

Small businesses that don’t yet have tax liability may claim the Payroll R&D Tax Credit, a modified version of the Federal Credit. The Payroll R&D Tax Credit permits “Qualified Small Businesses” to claim up to $500,000 annually for tax years beginning after December 31, 2022, and to use that credit to offset the 6.2% employer portion of the Social Security payroll tax under the Federal Insurance Contributions Act (FICA) as well as the 1.45% employer portion of the Medicare payroll tax liability.

For tax years prior to December 31, 2022, the maximum claim is $250,000 and the Credit only applies to the social security tax.

The Payroll R&D Tax Credit can be taken for up to 5 years, resulting in a potential total Credit of $2.5M to apply against payroll taxes. This is a huge boon to start ups and smaller businesses because the Payroll R&D Tax Credit can free up crucial capital needed to continue their research.

To be considered a “Qualified Small Business,” you must:

  • Have less than $5M in gross receipts for the year in which you wish to claim the Credit; and
  • Have no gross receipts for any tax year more than five years prior to the claim year

6. The R&D Credit can open a “closed” return for purposes of carryback refunds. R&D is an exception to the statute of limitations for claims of refund.  

In general, a taxpayer can claim R&D tax Credits retroactively by filing amended returns for the previous three years. For example, in 2023 a taxpayer could go back and amend a return from 2022, 2021, or 2020. Tax years before 2019 would be considered “closed.”    

What’s special about the R&D Tax Credit is that it can “open” a return beyond the statute of limitations for claims of refund. In this example, even though 2019 is technically “closed,” the R&D Credit can “open” the return and the 2020 Credit can be used to offset 2019’s tax.  

7. The Credit may be carried forward for 20 years. But before you can start carrying it forward, you must carry it back for one year.   

Many people are aware of the R&D Tax Credit “carryforward” provision, which allows businesses to take unused R&D tax Credits generated from a given year’s QREs and apply them to future tax liabilities. This is a boon to companies that didn’t turn a profit in a given year, or earned a Credit that exceeded the tax owed in that year.  

What many don’t realize is that the Credit must first be carried back one year. Only then can any remaining Credit carry forward for a maximum of 20 years. There’s no skipping the carry back.   

8. Even if you’re in losses or have no taxable income the R&D Credit can still bring benefit.  

There are ways to utilize an R&D credit even if you don’t have profit. First, the credit can be carried backward and forward into a year of tax liability. Second, you may be able to use the credit against payroll taxes (see #5 above). Third, having the credit may make your company an attractive acquisition target, since the credits have a value. Fourth, you might be able to use the credits against capital gains or built-in-gain taxes.  

9. In certain cases, research paid for by others may be eligible for the R&D Tax Credit.  

“Funded” research is generally not considered Credit-eligible. However, this is not the same as being paid for the work. A taxpayer being paid for a research activity can qualify for the Credit under certain circumstances, and it’s worthwhile to be aware of this possibility.

In order to qualify for the Credit, the taxpayer must have “economic risk” and “substantial rights”:

    • Economic Risk: The taxpayer’s payment for the research activity is contingent on success. If the contract requires the taxpayer to return the funding if he or she is not successful, then the taxpayer is assuming financial risk.
    • Substantial Rights: The taxpayer retains “substantial” rights in the results of the research activity. This is not an exclusive right. Many times both parties can have “substantial” rights to the results of the research.

Discussing your contractual payment provisions with your tax professional is highly recommended.

10. Taking the R&D Tax Credit does not increase your risk of an audit.

Filing for the R&D Tax Credit does not increase the likelihood of an audit. That said, it is critical to thoroughly document qualified research activities and costs in the unlikely event of IRS scrutiny.

As discussed above, there is no specific type of documentation required, but the documentation must be “sufficient” (§ 6001).

An object lesson took place in April of 2019, reminding taxpayers of the consequences of insufficient documentation. In Siemer Milling Company (Siemer Milling) v. Commissioner of Internal Revenue, the Court ruled that Siemer Milling lacked sufficient documentation to support their claimed Credits, and subsequently disallowed over $235,000 in Credits. The Court held that Siemer Milling did not provide sufficient documentation to demonstrate that their business activity had met all parts of the Four-Part Test, particularly Part 3 – Process of Experimentation.

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Over the years, we’ve talked to a lot of professionals about leveraging the R&D Tax Credit. While most folks understand the basics, we’ve noticed that there are some things that consistently surprise people about this complicated Credit.

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