Businesses that invest in research and development (R&D) and want to reduce their tax liability via the federal R&D tax credit must be able to properly support claimed, qualified research expenses (QREs). So, how can organizations document the nature of claimed activities and provide a reasonable basis for any estimates, while also reducing the time and effort required to calculate eligible expenses? Although there is no mandated standard for recordkeeping when applying for the R&D tax credit, it may be helpful to establish a methodology for capturing and quantifying QREs.
What are qualified research activities (QRAs) and qualified research expenses (QREs)?
Activities to develop or improve products, processes, software, techniques, inventions or formulas may be considered a QRA. The expenses associated with these activities – employee wages, contractor expenses, supplies and the rental or lease costs of computers – are known as QREs, as long as they meet the IRS requirements under IRC Section 41(b).
The four-part test for determining QRAs under IRC Section 41(d), is as follows:
- Permitted purpose: Was the intent to develop or improve the functionality, performance, reliability or quality of a product, process, software, technique, invention or formula that was sold, leased, licensed or used in a trade or business (aka a “business component”)?
- Eliminating uncertainty: Were activities intended to discover information that would eliminate technological uncertainty – i.e., capability, method or the appropriate design – concerning the development or improvement of a business component?
- Technological in nature: Were activities undertaken for the purpose of discovering information that is technological in nature and where the experimentation fundamentally relied on technological principles of engineering, physical or biological science, or computer sciences?
- Process of experimentation: Did all the activities substantially constitute the core elements of a process of experimentation, i.e., did the activities identify technological uncertainty and one or more alternatives to eliminate it, and was a process of evaluating the alternatives conducted?
What are the IRS recordkeeping requirements for the R&D tax credit?
The recordkeeping requirement in Treasury Regulation 1.41-4(d) states that a taxpayer claiming a credit under Section 41 must retain records in sufficiently usable forms and detail to substantiate that the expenditures claimed are eligible for the credit. This lack of specific guidance with regard to the types of contemporaneous documentation that would satisfy the requirement offers flexibility, but also can create uncertainty. Business owners may find it helpful to refer to previous court decisions regarding the R&D tax credit for additional guidance on recordkeeping.
What types of documentation could be used to support the R&D tax credits claimed?
Businesses claiming the R&D tax credit must retain proper documentation, including contemporaneous books and records, to substantiate eligible QREs. During an IRS exam, auditors typically ask for samples and/or examples of contemporaneous documentation for the following:
R&D tax credit qualified expenses may include employee wages (as defined in IRC Section 3401(a)) that are paid or incurred for qualified services (i.e., deductible expenses under Section 174) that are engaged in, directly supervising or directly supporting qualified research. This includes federal taxable wages reported on Form W-2, including bonuses and stock option redemptions. Nontaxable items – such as 401(k) contributions, health insurance contributions, other pretax benefit deductions and non-taxed income – must be excluded, even if they were compensation for qualified services performed by an employee. In-house research conducted outside the United States (as defined in IRC Section 7701(a)(9)) is also excluded from qualified research (Treasury Regulation Section 1.41-4A(b)).
Contract research expenses
Contract research expenses, as defined in IRC Section 41(b)(3), means the applicable percentage, but generally 65%, of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.
To determine if otherwise eligible contractor costs are considered contract research expenses, employers may refer to Treasury Regulation Section 1.41-2(e), which states that an expense is paid or incurred for the performance of qualified research only to the extent that it is done pursuant to an agreement (in writing or otherwise) that:
- Is entered into prior to the performance of the qualified research (i.e., not contingent upon success of the research)
- Provides that research be performed on behalf of the taxpayer (i.e., the taxpayer has rights to the results)
- Requires the taxpayer to bear the expense, even if the research is not successful (i.e., bears economic risk)
Similar to employee wages, only the portion of the contract amount that is attributable to the qualified research performed within the United States can qualify as a contract research expense (even if 80% or more of the contract amount was for research performed in the United States) (Treasury Regulation Section 1.41-4A(b)).
IRC Section 41(d)(4)(H) further states that any research to the extent funded by a grant, contract or otherwise by another person (or governmental entity) is not qualified research. When considering if the research is funded, the taxpayer must determine if they bear the financial risk of failure (Section 1.41-2(e)) and retain substantial rights (per Section 1.41-4A(d)) to the research. This “risk and rights tests” is often accomplished by examining the specific language and terms of any and all agreements, contracts, etc., written or otherwise (along with forms and attachments). Examples include, but are not limited to compensation arrangements (e.g., fixed-price, cost-plus, cost-plus with a cap, etc.) payment terms, nonpayment terms, IP terms, warranty terms, etc., applied on a separate contract item-by-item basis.
To document contract research expenses claimed as QREs, business owners, after careful review of the language, may use general ledger account details, invoices, purchase orders, work orders or statements of work, master service agreements, etc. They may also find it helpful to refer to previous court decisions regarding “funded research.”
The IRS defines qualified R&D supplies as any tangible personal property other than (1) land or improvements to land, and (2) property of a character subject to the allowance for depreciation. To be a QRE, a supply must be directly related to the performance of qualified services, as defined in IRC Section 41(b). Such expenses can be documented with purchase orders, invoices, receipts or charts depicting account/general ledger records.
Your R&D tax credit documentation checklist options include:
Documentation for qualified employee expenses
- Employee Form W-2s
- Payroll registers
- Time questionnaires
- Oral testimony
- Meeting minutes
Documentation for qualified supply expenses
- Chart of accounts
- General ledger
- Purchase orders
- Bills of lading
Documentation for qualified contracted expenses
- Chart of accounts
- General ledger
- Service contracts
- Purchase orders
- Form 1099-NEC (for individual contractors)
How ADP can help maximize your capture of eligible R&D tax credits
ADP helps make claiming R&D tax credits simple and predictable. With our exceptional experience, technology and resources, we’re well-equipped to assist clients with R&D tax credit documentation and calculations. We also monitor for changes in regulations that could affect tax credits. This allows customers to take a broader, deeper view of incentive opportunities for which they may be eligible, and focus more on potential cost offsets and less on compliance activities.