R&D Tax Credits: Help Your Clients Stay Between the Lines
Do you wish you had a GPS to help navigate the world of R&D tax credits? Here are some of the questions CPAs frequently ask about this valuable, misunderstood and underutilized tax credit.
When helping your clients make the decision to get on the road to tax credit recovery, understanding the rules and what constitutes a moving violation helps you better plan for their journey.
Since the credit is available to all businesses, giving your clients the directions to get where they need to go and the best way to get there is unique to each driver of innovation.
Below, Sanjiv Gaitonde, ADP's director of tax, analyzes questions about the route to help you customize an R&D tax credits trip plan.
How to plan an R&D tax credits road trip
Q: Regarding the new amortization requirement for research and experimental expenditures under IRC Section 174, what is the new versus prior requirement?
- Old route: Based on current guidance, prior to years beginning on or after 1/1/22, taxpayers had the option to either expense IRC Section 174 expenditures in the year paid or incurred, or capitalize the expenditures then amortize.
- New route: Under the new law, taxpayers no longer have the option to expense the expenditures in the current year and are required to capitalize and amortize such expenses.
Q: What is the amortization period?
- Straight ahead: Under current guidelines, five years for domestic and fifteen for foreign expenditures.
Q: Does the IRC Section 174 requirement affect the credit calculation or just when the corresponding amortization deduction is made?
- Straight ahead: Based on current guidance, the IRC Section 174 amortization requirement does not affect the R&D tax credit calculation.
Q: Can taxpayers still go back and amend 2019 through 2021 tax returns if the R&D tax credit has not been previously claimed?
- Green light: Amended tax returns may be filed for three years after the original due date or the date the return was timely filed if extended.
Q: Can the R&D tax credit be carried back?
- Green light: Any unused R&D tax credits for a given tax year must first be carried back one year then carried forward for up to twenty years.
Q: Regarding the Office of Chief Counsel IRS Memorandum Number 20214101F (CCM), released 10/15/2021, for which tax years is the attachment to the tax return required?
- All clear ahead: For all prior tax years that were amended with refund claims on or after January 10, 2022.
Q: When amending, do you need to attach the full study to the return?
- Detour: Taxpayers are not required to attach the full study; however, a statement including the five items of information as set forth in the CCM must be attached to the amended tax return.
Q: Does it matter if the amended tax return was originally filed with an R&D tax credit, but the amount of the credit changed, and that's the reason for the amendment?
If the change in the R&D tax credit results in additional refund amounts above the original amount claimed, the new CCM requirement for documentation does apply.
Q: Is there a particular format for the additional CCM information required for an amended return?
- Passing lane: The CCM does not require a specific format for the required documentation.
Q: Regarding expenses for contractor payments under analysis for inclusion in the R&D Credit calculation, wouldn't a contractor for a nonprofit or government qualify?
- Flashing yellow: The answer will vary on whether your client retains intellectual property rights and financial risks for the contractor services as detailed in the written contract/agreement.
Q: Do wages used in the CARES Act Employee Retention Tax Credit reduce wages allowed in computing the R&D tax credit?
- Under construction: For the 2021 tax year, the same wages of an employee may not be used in both the ERTC and the R&D tax credits. This limitation does not apply for tax year 2020.
Q: Regarding limitations on types of businesses and industries that may qualify for the R&D tax credit, I have had dentist clients asking if they qualify for R&D tax credits. Do they?
- 4-way stop: While no industry is specifically excluded from eligibility for R&D tax credits, certain industries, including dentistry, have been subject to intensified IRS scrutiny. To determine if a dental practice is performing eligible activities, R&D tax credits may be available if the activities meet the following 4-part criteria.
- The activities are new or improved and relate to the functionality, performance, reliability, or quality of a new or improved business component.
- They are based on technological science.
- They have a definable process of experimentation.
- This process eliminates uncertainty regarding the capability, method and/or design of the component.
- Proceed with caution: A dental laboratory, which is developing new or improved products or other types of business components through use of technological science and evaluating multiple alternatives to determine the appropriate business component design may qualify.
- Dead end: However, a dentist molding crowns or designing bridges or performing similar general dentistry activities does not meet the overall requirements.
Q: Most engineering firms are doing work for clients, such as designing a bridge for a state's Department of Transportation. Would this mean they aren't eligible, even if they meet the 4-part test and if the risk/rights are to the client paying them for the work?
- Slippery when wet: Engineering firms can qualify for R&D tax credits if all criteria are met but would not be eligible if the customer agreement stipulates financial risk and/or intellectual property rights remain with the customer.
Q: When is the earliest that the increased threshold can be utilized (2023 or 2024)?
- Odometer reset: The threshold increases to $500,000 from $250,000 of the withholding offset for the R&D tax credit is effective for tax years beginning on or after 1/1/2023.
Q: Regarding the U.S.-based expense requirements, if the U.S. company's software total sales is from the U.S. and part of the cost of sales is out of the U.S. and the rest in the U.S., can the company claim the R&D tax credit?
- Merge with caution: For any expense to be included in the R&D tax credit calculation, the activity and payments to contractors must take place on U.S. soil.
Q: Can we use engineering services as part of our R&D expenses from our U.S. company with a division in India that does most of our engineering work or is this disqualified since the work is done outside of the U.S.?
- Accident ahead: Any work that is not conducted on U.S. soil may not be included in the R&D tax credit, regardless of where the company is based.
Plan the next trip
We hope you got the directions your clients were looking for. If not, ask one of our R&D CPA expert road trip advisors how you can stay safely between the lines.