The research and development (R&D) tax credit is available to many organizations to help reduce their tax liability and overall financial expenditures. Unfortunately, many organizations don’t know everything they need to know to fully take advantage of the credit. To help educate these organizations, as well as the CPAs who represent them, we spoke with Ashley Chikes, director of operations for R&D experts EPSA USA, about steps CPAs can take when advising a client about the R&D credit, the ins and outs of the Pennsylvania R&D credit, and more.

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By Bill Hayes, Pennsylvania CPA Journal Managing Editor

Podcast Transcript

In a complicated, costly tax structure, the research and development, or R&D, tax credit is a prominent way for organizations to reduce their tax liability. However, many organizations are not aware of the best ways to fully optimize the credit. Today's guest, Ashley Chikes, director of operations for EPSA USA, will discuss steps CPAs should take to help their clients fully substantiate R&D credit claims, explain the two base methodologies for calculating the R&D, and much more.

Can you give us an idea of how full optimization of the R&D tax credit reduces the tax liability of an organization?

[Chikes] This is definitely a great time of year. Obviously, a lot of companies are getting ready to file their tax returns here in March or April. So excited to be able to talk about this and hopefully companies can pay less taxes.

Basically the way that it works is claiming the credit allows a company or an individual, depending on the entity type, to offset their tax liability for a given tax year. The great thing about the R&D tax credit is it is a credit, not a deduction. It's a dollar-for-dollar reduction in your tax liability.

That's how most of our clients and the companies that I work with claim the credit. There is also an interesting thing that I don't feel like is really well known in the tax world. In 2015, with the passing of the PASS Act, companies that are five years old or less, with less than $5 million in gross receipts, can actually use the R&D credit to offset payroll tax.

This is incredibly valuable for a lot of the startup companies who maybe don't have tax liability to offset. The normal way of offsetting your tax liability wouldn't benefit them, but they can use it to offset a portion of their Social Security tax that they pay for all of their employees. That's another way: in addition to the normal way that companies and CPAs understand – offsetting tax liability with a credit –you can also use it to offset that payroll tax.

What would be the ideal steps CPAs should be advising their clients to take in order to fully substantiate R&D credit claims?

[Chikes]  Substantiation is definitely a hot topic with the IRS right now. Some of the CPAs with the PICPA that I've spoken with are aware, but some people may not be. The IRS issued some new guidance at the end of last year that's required when you're filing the R&D tax credit on an amended return. As of right now, it's supposed to go through on January 10th, but you never know. With the IRS, that could definitely change. But there is now a reporting requirement that's required when you file the R&D tax credit on an amended return.

Typically, in years past, all that was required was a Form 6765. The CPAs just prepare the returns as normal and include that form and kind of go on their merry, little way. But now, with this reporting requirement, it's going to be a lot more difficult and you want to make sure that you have everything set forth. There is a four-part test that's required with the R&D tax credit and things like that, but you've got to make sure that you're documenting and every expense that you're qualifying is substantiated at the end of the day.

Typically what we do is experts in this industry draft up a report that walks through everything that qualifies. But it can be time-consuming, and sometimes CPAs are responsible for the entire report and then the entire return. It can be definitely challenging. That's where they need to lean on their clients to make sure that they're keeping their normal documentation for a certain period of time and things like that.

I think if CPAs are calculating the credit for their clients, the biggest thing is making sure that you're talking to someone that's knowledgeable about the technical activities of the company, to make sure that they're doing R&D. There's a lot of case law in this area, specifically relating to ensuring that the individual's giving the qualified expenses and stating that they are knowledgeable.

It's really important that the CPAs are talking to people at their companies, with their clients, that know what's happening. Can't just be a CFO. The individual needs to know what's happening at the company. They have to look at the activities of the employees. They have to look at the projects of their clients and review contracts to make sure that they comply with the R&D tax credit.

There's a lot. I can go on for hours in this particular area. But I think the biggest thing that I would say in substantiation is making sure that they keep documents and document their process and who they spoke to, and that they're looking at projects on an individual basis instead of just taking a holistic approach.

One of the steps I've heard and read you talk about is investigating relevant buckets of R&D expenses. Can you tell us what sort of buckets expenses can usually fall to?

[Chikes] The R&D tax credit allows four buckets of cost. That's what I call them. Four buckets of cost that can be captured toward the R&D tax credit. The first one, and I would say 99% of our clients have this expense, would be wages. That's going to be employees of the company. Most of the time when we're working with clients, individuals directly engaged in R&D, it’s kind of a slam dunk. No-brainer. Obviously, that can be captured toward the R&D tax credit.

There are two other levels though that can be included. So that would be directly supervising R&D activities. I have a lot of companies, it's kind of a mom-and-pop shop that they've got, but the CEO and the president are heavily involved. They're meeting with a sales team. They're meeting with a client. They're meeting with a testing team. They're meeting with everyone. A lot of times those expenses aren't included. If a CPA is calculating the credit or if a client is doing it themselves. You can take those activities if they're directly supervising R&D.

The other level of R&D expense that you can take to would be directly supporting activities. The internal revenue code regulations specifically state this: If you have a secretary typing up lab notes related to R&D activities, you can include those expenses as well. Those often get left off the table. So those are kind of the three buckets of costs or that's the three levels of wage expenses.

The next bucket of cost would be contractors. Typically, these are individuals who are performing the same activities of employees. They're just paid on a 1099 or through another company.

They do have to be in the United States though. I have a lot of companies who have overseas contractors that they're working with. The IRS doesn't like that. They need to be in the United States if you're going to include it in the R&D credit.

The other two buckets of costs that you can include: supply costs with manufacturers. This can be a big thing. It needs to be tangible, and it needs to be directly tied to R&D. While I'd love to say we could take pens and pencils, the IRS says that's general administrative, so that can't be included. But if you're building prototypes, things like that, you can include the supply cost related to those.

Then the final one, me being kind of a software and technology expert, this is one a lot of my software companies are taking advantage of, especially now with the remote world, is cloud hosting.

It's technically, the way it's written up in the code, rental or lease of computers, but the way it's been interpreted recently, including cloud-hosting expenses. The big ones like Google Cloud and Microsoft Azure, things like that. But there's hundreds of cloud-hosting companies out there now, and you can include that as well.

So, to recap: wages, contractors, supplies, and cloud-hosting expenses are the four main buckets of cost.

Can you explain to us the two different base methodologies that are used to calculate the R&D credit?

[Chikes] Before we get into the specific base methodology, because this is a question I get probably nine times out of 10 when I'm doing kickoff calls with my clients, is “We're doing an R&D credit for 2018 to 2020. Why do you need information back to 2015?” And that's a great question.

The formal need of the credit is actually the credit for increasing research activities. That's a mouthful so we normally just call it the R&D tax credit. But it is a credit for increasing research activities and the actual calculation requires a historical base period review. You have to calculate a base amount to know what you're overcoming to calculate the actual credit for the credit years.

There's two methodologies. Typically, most professionals and clients that I've worked with who've done it themselves in the past follow the alternative simplified credit methodology. That just requires a three-year lookback. You have your study period, to say we're reviewing the credit for 2018 through 2020, I guess 2021 now that we're in tax year 2022. Then that would require then, for 2018, you need to go back to 2015. You'd have to go back to 2015, gather documentation, do all of that for 2015, if you're using the alternative simplified, or ASC, to gather the information. This is the easiest. Normally, with documentation-retention policies and things like that, they normally have documentation going back to 2015 and that can definitely be advantageous.

The other methodology that I think is definitely underutilized is the regular methodology. There's two kind of subparts within the regular methodology, depending on when the company started performing R&D. You either look at the 1980s or if they weren't around in the eighties, then you look at the first several years that they were in business.

You'd be surprised at who has documentation going back that far. I just met with a client before the holiday break and they have a warehouse full of their documentation from the 1980s, which me being an attorney was like music to my years. I just picture them digging through boxes to find me this financial information. Not everyone has that. That's why the IRS has that alternative simplified credit methodology as an option.

If they do have documentation, if they were in the 80s and they have documentation for the 80s, or if they started in '95, '96, and they have information from those early years, that can be really advantageous because the way the credit works is you have your expenses for the current years and you're comparing it to that base period. If you've had really big years in the last several years, that base period is pretty large. Whereas if you can go back to the 80s or the early 90s or whenever you started, a lot of times that was much smaller. That can result in a larger credit.

Both methodologies are permitted. It's not like the IRS prefers one over the other. But it can really be advantageous if they have the documentation. I'm not expecting everyone to have that kind of documentation, so reasonable estimates are permitted. You can interview people. We can definitely get creative and the IRS permits that. If people don't have warehouses and warehouses full of information from the 80s, that's quite all right. But it's definitely advantageous to take a look at both methodologies and see which one results in a better credit.

As we talk about determining both state and federal R&D credits, our CPAs – our audience – they're going to have a lot of clients in Pennsylvania. What is Pennsylvania's status as far as having a state R&D credit and how would that affect planning?

[Chikes] I'm going to be honest, and I love my great state of Pennsylvania: The R&D credit is not that great. Hopefully, the Department of Revenue isn't listening here, but they do have an R&D credit. It is an application-based credit. You can't actually go back and amend for it. It's due 9/15 via the online portal, which I would think the majority of the CPAs that are listening are familiar with the Department of Revenue online portal. It's just a section of that portal where they go online and submit the application.

The way that it works is you go in by 9/15. It's not first-in, first-out. They wait until 9/16 in theory and they review all the applications at once. It's not a first-in, first-out.

Then, you apply for your clients. Because there is a finite amount of money set aside for companies that claim the credit, you're then awarded a percentage based on how many other companies kind of apply.

I don't remember offhand, and I don't know if they even release this about the amount of money that the companies is. But I've seen companies get anywhere from 40 cents on the dollar that they claim, all the way up to 70 cents on the dollar that they claim. It just depends on how many companies are claiming the credit at the end of the day.

So, you apply and then the Department of Revenue will send the client … sometimes they send it to the CPA, sometimes they don't … but they send the client basically an award letter, typically around November. Then the way that it works is you're given your award letter: “Company X is awarded $30,000 in R&D tax credit for the commonwealth of Pennsylvania,” and then it's filed on the following year's return.

I have heard rumblings that Pennsylvania's going to look into it and they're talking about expanding it, but that's the way that it works now. Small businesses, they are generally given a larger portion of their credit than companies that aren't considered small, which would be $5 million in assets or less.

I think it's just definitely something that's ... there is a credit. If you're in Pennsylvania and you're paying a lot of tax, it's definitely something to explore.

The other states around us can be more advantageous. New Jersey's a pretty good one, depending on your entity type. There are some other states that are advantageous as well. Pennsylvania just … unfortunately, with being an application state, you can only claim it on a current-year return.

You advise CPAs assisting clients with the R&D credit to conduct a statistical sample to consider all eligible projects and expenses. What does that process entail, and why is that so vital?

[Chikes] I think I'll start with probably the second part of the question: why is it so vital? It's really no extra work on the client's end. There is a revenue procedure, 2011-42, to nerd out on everyone for a minute here. The specific revenue procedure that allows statistical sampling.

Essentially what that means is, and this is sometimes hard to explain so bear with me here for a minute, basically a lot of our manufacturing clients or architectures or engineering firms that we work with, they do hundreds of projects a year. No one's got time to talk about hundreds of projects a year when they're calculating the R&D tax credit. A lot of our clients and CPAs who are doing the R&D credits themselves, or on behalf of their clients, just look at the larger projects, the top five projects or so, and then take expenses associated with those five or so projects. But they're leaving the other 95% of the projects on the table. You can't take expenses associated with those other projects because you didn't technically interview on them and go through the qualification process for the 95% of the other projects.

That can add up at the end of the day. What statistical sampling allows you to do is to – and we have a statistician that we work with who does this for us and who's well versed in Revenue Procedure 2011-42 – but essentially, if you include all of the projects in your statistical sample, you only have to interview on say 20 to 30 or so projects, just depends on how many projects there are. You're eligible to take up to all of the expenses that you included in that original, what we call, sampling frame.

So instead of only being able to take 5%, you can take 97%, 98%. Obviously, if some of the projects don't qualify, you have to remove those expenses. I think that goes without saying. But your starting point is much higher with the statistical sample than if you're not sampling.

For us, at least kind of the way our process works is it's no extra work on the clients or the CPA's end if we're doing it for them, because we're gathering the same kinds of information, the same job costing report or WIP report or getting their GRL logs, whatever the case may be. It's not any more work. They're still sending us the same information. We just have our statistician analyze it and then run the statistical sample. It's definitely easier to do it that way for us and you're able to take a lot more expenses.

I think the other thing about it, too, is you can really dive deep into these projects. One of my favorite parts of my job is getting to hear our clients talk about what they do. CPAs don't have time to sit and talk about 20 to 30 projects in the middle of February when they have hundreds of tax returns piling up behind them. It's something that we're able to do, especially with that statistical sample and dive deep into those projects and how they qualify.

This last question, I'm thinking the answer could come down to just blowing a lot of money, right, but maybe you have more on it: what in general are the negative effects of an organization if they are not taking full advantage of the R&D credit?

[Chikes] Obviously I've done a great job educating you, because that's the number one answer is they are leaving money on the table.

It's decreasing the amount of taxes you have to pay, whether you use it to offset your tax liability, like we talked about earlier, or a portion of your payroll tax, if you can do that. You can then use money to grow your business. I know I just mentioned one of my favorite things is talking about projects. One of my other favorite things about what I get to do is hearing what people are doing with this money that they're getting back either in the form of a refund or offsetting their tax liability on an original return. Hiring more employees, buying equipment, expanding their office space.

There are tons of different ways I've seen companies use their refunds and reduction in tax liability, especially now in this pandemic age where no one knows what’s going to happen tomorrow, right? Companies are struggling, and a lot of the clients that I'm working with the employer retention credit is ending. A lot of this funding that was out there before isn't there anymore. It's trying to figure out ways to keep their business afloat and keep their employees employed and being able to pay the benefits is something that keeps a lot of business owners up at night. The R&D tax credit is something that's out there, that if people aren't claiming it they're just leaving money on the table at the end of the day.