Preface: Researching and developing can be hard work, and proper documentation can be hard work too. When applicable, hopefully, the research and development projects yield improvements to your products or processes, and the documentation yields a tax credit.
Tax Credit for Research or Development (Segment II of II)
Credit: Jacob M. Dietz, CPA
Sufficiently document in the records what the original problem was to solve, the steps in the process, and what was finally created. The IRS wants documentation, although it does not specify in exactly how to document. This article gives some ideas. Consider grouping records by project for recordkeeping. Examples of this documentation could be: notes from meetings, drawings, blue prints, notes of tests, etc.
There are some exclusions for activities. Below is a partial list of the excluded activities that do not qualify for the credit:
- Research after the product is being produced commercially
- Adapting a product for a specific customer
- Duplicating (reverse engineering)
- Studies and surveys
- Funded by others.
If the project is not a qualifying project, then do not include expenses for that project for a research credit.
If, however, the project does qualify, then make sure you have substantiated by documentation how it qualified, and then track the expenses and indicate how they are qualifying expenses.
For each period, track how many hours of each employee was for each activity. Keep records that show the employee name, the employee hours, the day, and the activity
Track and Document Expenditures
Labor is likely a significant amount of the research expense. Carefully substantiate labor costs. For each period, track how many hours of each employee was for each activity. Keep records that show the employee name, the employee hours, the day, and the activity. Also, indicate what the employee did for the project. For example, was the employee creating drawings, or sawing, or testing, etc. Include labor for the actual research, and first-line management supervision of those employees.
At the end of the project, be prepared to substantiate how many hours each employee put into the project. At the end of the year, be prepared to substantiate the ratio of qualified research hours to nonqualified hours for each employee.
If you are buying supplies, and you know they will all be used for research and development, code them immediately to that research and development supplies account.
Track the supplies that are used in research and development. Consider creating a separate general ledger account, and record your supplies expense in that account. If you are buying supplies, and you know they will all be used for research and development, code them immediately to that research and development supplies account.
Alternatively, some supplies that you buy may be used for both qualified research expenses, as well as other expenses. In this situation, consider keeping a usage log that tracks how many of each supply is used in a specific project. Every month, this log can be entered in your books and records, and the expense can be taken from the account that the supply was originally purchased in and moved to the research and development supplies expense account.
If you have multiple projects, then try to document which project consumed the supplies.
If using the usage log to move expenses from their original expense account to a research and development supplies account, document how the price per each is computed. For example, perhaps it is pulled periodically from a catalog or an invoice.
Save documentation that shows how the supplies are being used. For example, suppose that you are using metal to create a piece, and subjecting it to tests to see if it will break. Try to have some documentation that would indicate why all this metal is being used, such as notes from the tests or some other substantiation. If you have multiple projects, then try to document which project consumed the supplies.
If subcontractors are paid to do any research, consider creating a separate general ledger account for subcontractor research expense. Keep copies of the contract on file. It should be clearly documented how they fit into the overall project. There are various qualifications for the subcontract expense to qualify. Here are some of them:
- The work is of a nature that would qualify if it were performed in-house by an employee.
- There should be an agreement with the subcontractor before the subcontracted work was accomplished.
- The agreement should explain that the work is being done for your company
- The agreement should indicate that you must pay for the research even if the project fails
- The agreement should indicate that your company should own the rights, although not necessarily exclusively, to the research being subcontracted.
Before taking the tax credit, however, consider if you have qualifying activities and qualifying expenses. Also, make sure you have documentation to prove them.
If your business is spending significant money to research and develop, smile and consider the tax credit. Before taking the tax credit, however, consider if you have qualifying activities and qualifying expenses. Also, make sure you have documentation to prove them. Researching and developing can be hard work, and proper documentation can be hard work. Hopefully, the research and development yields improvements to your products or processes, and the documentation yields a tax credit. Taking the credit can be complex, so consult with your tax advisor if you are interested in applying to your business research or development activities.