Moore Colson :: News & Resource Center

Obtaining Research-Related Tax Savings Without an R&D Department

Mike Anderson - Tax Manager

Tucked away in remote corners of tax laws, you'll find opportunities for businesses like yours to reap significant savings. They're not shady shelters that stay one step ahead of the law. Instead, they're little known, legitimate provisions that were put in place to help businesses grow and stay financially healthy.

A great example is something called the Research & Experimentation Credit, which you'll find in Section 41 of the Internal Revenue Code. Congress established the credit to reward companies for investments in innovation and improvements. Over the years, the credit has been renewed and expanded - but surprisingly few companies actually take advantage of it.

While you may not believe that your company's activities include research and experimentation, you probably perform activities that the government places in those categories. Unlike typical tax deductions, the credit involves a direct reduction of income taxes, so the potential for savings is dramatic.

It allows you to claim a tax credit for a percentage of what the IRS refers to as ¿qualified research expendituresî (QREs). These are costs associated with investments in innovation and improvements, particularly the salaries and wages paid to employees with direct involvement in those areas.

Even companies that are aware of the credit often overlook costs that are eligible. That's because the scope of legitimate QREs goes far beyond what most businesses would consider as research-related costs. For example, investments made in process improvements typically qualify for credits. Another example is the wages paid to line employees who participate in experimentation.

Identifying a company's Research & Experimentation Credit opportunities demands going well beneath the surface and developing a complete understanding of the business. Process improvement costs are typically buried deep within production, and probably won't be found without that understanding. Other areas in which QREs often lurk include quality assurance engineering, product design and in-house software development.

In determining whether an activity's cost is a QRE, the IRS expects it to meet the overall research and development deductibility rules, as well as stand up to three tests:

The goal has to be to discover some technological information that doesn't already exist.
That information must be intended for use in developing something new or improved to benefit your business.
Finally, any costs must be directly attributable to what the IRS calls a ¿process of experimentation,î with no assurance that you'd succeed.

Having QREs is only part of the picture. The IRS subjects the credit to far greater scrutiny than most matters. That doesn't mean you shouldn't claim what you've earned, but the way you document your claim is critical. First, you need to be aware that the IRS usually challenges the qualification of the QRE, rather than the amount itself, so you should create detailed documentation that demonstrates that each QRE meets the Section 41criteria.

After your company identifies its QREs, structure your procedures to make sure that you continue to capture those credits in the future. That way, you won't have to pay taxes you really don't owe.

Is it realistic to expect that pursuing the Research & Experimentation credit will pay off for your company? A great deal depends upon your business philosophy and what you do for your customers. If you handle the same things year in and year out with few changes, you probably won't see much in the way of benefit. But if you invest a great deal into improving products and processes, you have significantly greater potential for a credit. More than 90 percent of the companies undergoing closer investigation had some unclaimed QREs.

Companies are usually able to receive retroactive benefits, too. Once you're able to establish that your QREs are solid and that you're entitled to the credit, the law generally allows you to file amended federal and state income tax returns for the prior three years, which means you'll probably be entitled to substantial prior-year refunds.

So how do you begin the process of obtaining the credit to which you're entitled? A good place to start is by asking your CPA about their experience with the credit and the process for claiming it. If they've handled the process for other companies, ask about how they work and request samples of their documentation to ensure that you're comfortable. If they haven't had experience with the process, ask them to contact a firm that has a thorough understanding of the Research & Experimentation Credit. After all, you shouldn't pay more than your fair share.

For more information, call Moore Colson at 770-989-0028