When most people hear research and development (R&D), they think of scientists and large corporations working to bring new products to the market. However, businesses of all sizes can engage in R&D, and this is made easier by the R&D tax credit. Although it used to be limited to larger companies in the past, congress has recently expanded the credit to allow small and medium-sized businesses to participate. For businesses that want to participate, their owners and leaders must first understand what the R&D tax credit is and the mistakes to avoid to ensure they can take advantage of it.
Businesses engage in research and development in different ways. The activities that they engage in while doing their R&D can be eligible for a tax credit. Before we look at these activities, we have to ask, what is R&D tax? R&D tax is an amount businesses can claim as credit after the business has invested in qualified R&D activities that lead to innovations and growth in the business and other sectors.
These qualified activities must meet four criteria:
- They must have a permitted purpose – This means they must be tied to the development or improvement of reliability, performance, or quality of an important business component. This can be an invention, software, technique, process, or product.
- Be technological – The development of the component has to be based on hard science. This can be physics and chemistry, engineering, computer science, or biology.
- They must eliminate uncertainty – The business should have faced uncertainty in the past when designing or developing a business component. This uncertainty is what led to the need for research and development in the first place.
- They must be involved in the process of experimentation – The business must demonstrate that each activity was part of a systematic trial and error approach that helped overcome the uncertainties described above. Alternatively, the business must demonstrate that it evaluated multiple alternatives during the research and development process.
Avoiding issues with your R&D tax credit claims means getting things right. Here are the most common mistakes businesses make that you should know about so that you do not make them too.
Many business owners do not know they can make R&D tax credit claims unless they are advised by a professional. Some think that even though they know they can qualify, it is not worth pursuing the credits. Both of these are grave mistakes that mean businesses miss out on offsetting some of their R&D costs.
A successful R&D tax credit claim means businesses pay less tax on their income which means they get to put that money back into the business or their R&D if they like. The amount credited can be thousands or even tens of thousands of dollars, making it imperative that business owners look into making R&D tax credit claims.
The most important thing about R&D tax credits is that the business needs to create a new product from scratch to claim associated activities. There has to be scientific, technological, or biological innovation that involves risk to the business. This provision means that the businesses that make such claims have developed new products.
However, this is not the only way the credit is awarded. Some companies create new services, systems, and processes that require a lot of R&D investment. Some companies take existing products, whether from their existing catalog or their competitors, and do enough R&D to come up with a different product and product line.
All of these are different ways of developing something new that becomes eligible for R&D tax credits.
It is easy for businesses to prove that every activity they have included in their claim qualifies for credit. They can do this using project-documentation solutions and time-tracking software, for example. There are many other ways to show that work was done under an R&D umbrella. Such documentation makes it easy to back up related expenses.
When providing this proof, it is important to understand that not everything done under this umbrella qualifies for credit. Costs associated with things like routine testing, maintenance, market research, and various commercial activities cannot be claimed.
Compiling and making R&D claims is an incredibly complex process that is easy to get wrong. Businesses can file claims on their own, but they risk not unearthing all costs they can claim when they do this. Missing some of this data can mean you are not claiming everything you should be.
It is, therefore, a good idea to hire a company that specializes in creating engineering-based R&D case studies. Such companies can unearth product development, manufacturing, and engineering data that you may have overlooked and that is critical to your claim.
They also simplify the complex process and let you know the potential credit you could receive, how to support your credit claim so it stands up to scrutiny, and how usable your credits are.
Another common mistake businesses make, especially when they do not hire a company to help them with their R&D tax credits, is not having a formal documentation process. Many of these companies do not have a single person responsible for documenting. They do not know what the person should be documenting, or when the process should be taking place.
This leads to companies leaving the documentation to the end of the year when the assigned person has to go through hundreds or thousands of documents trying to find qualifying activities and expenses. Such a massive workload increases the chance that the person assigned will miss something and this leads to lower credits.
Having a formal process not only simplifies this process, but it can also help a business find more qualifying expenses thus increasing its credit.