By Jacob Wood, JD, and Terri S. Johnson, CRE

Over the years, we’ve talked to a lot of professionals about leveraging the federal R&D tax credit. Most understand the basics, but we’ve noticed that there are some things that consistently surprise people about this credit.

Surprises are great for things like birthday parties. Less so for tax planning. As such, we’ve compiled these 10 points that even some pros don’t know about the R&D tax credit.

The R&D Tax Credit May Be Claimed by Taxpayers in Virtually Any Industry

This is the No. 1 misconception about the R&D credit. People hear “R&D” and envision white lab coats and test tubes. They just assume they don’t qualify. Virtually any industry may qualify for the credit – manufacturing, architecture, food and beverage, engineering, software design, etc.

The R&D credit is tremendously underutilized. Less than 30% of eligible businesses claim it, and it is mostly smaller businesses that are missing out. Review the eligibility criteria and you might be pleasantly surprised.

Tracking Time Is Not Required, but You Do Have to Record the Work Done

This is another myth that often stops people before they start. People imagine they need copies of every timesheet ever logged to support a claim.

Yes, documentation is crucial to successfully claiming the credit, but specifics are not spelled out in the law. Taxpayers simply need to provide “sufficient documentation.” This might include the following:

• Payroll information for employees directly involved in R&D and for employees or managers supervising them.
• General ledger reports indicating which costs and supplies were related to R&D activity.
• Copies of contracts and invoices paid to third-party contractors.
• General documents that demonstrate the research process and progress (test results, blueprints, drawings, emails, meeting minutes, etc.).
• Credible testimony.

You Can Amend Returns to Take the Credit Retroactively

There is no missing the boat here. If you engaged in qualified research activity in the past three open tax years, but didn’t claim the credit, you still may do so by filing an amended return with Form 6765.

Bear in mind, the IRS requires extensive supporting information for a retroactive claim to be considered valid. Taxpayers are required to provide the following:

• Identification of all business components for the relevant tax year.
• For each business component:
  -- Identification of each research activity performed.
  -- Name of each individual who performed the activity.
  -- Description of what each individual was hoping to discover.
• The total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for that tax year.

Sorry, on an Amended Return You Cannot Elect 280C

If you file an original return in a timely fashion, you can take a 280C election, which permits you to take an automatically reduced credit and apply it directly toward your tax liability. This can be particularly significant for pass-through entities and should be discussed with your tax professional.

However, this election may not be taken on amended returns. Instead, the full credit amount must be added back into taxable income before tax liability is calculated.

There is one caveat: if you are amortizing Section 174 expenses according to Notice 2023-63, the adjustment to reduce expenses is only required if the amount of the gross credit exceeds the current year deduction for the Section 174 credit-eligible capitalized expenses. This only applies for tax years starting after Dec. 31, 2021.

Sometimes the Credit May Be Used to Offset Payroll Tax

Small businesses that don’t yet have tax liability may claim the Payroll R&D Tax Credit, a modified version of the federal credit. The Payroll R&D Tax Credit permits “qualified small businesses” to claim up to $500,000 annually for tax years beginning after Dec. 31, 2022, and to use that credit to offset the 6.2% employer portion of the Social Security payroll tax under the Federal Insurance Contributions Act (FICA) as well as the 1.45% employer portion of the Medicare payroll tax liability.

For tax years prior to Dec. 31, 2022, the maximum claim is $250,000 and the credit only applies to the Social Security tax.

The Payroll R&D Tax Credit can be taken for up to five years, resulting in a potential total credit of $2.5 million to apply against payroll taxes. This is a huge boon to startups and smaller businesses because the Payroll R&D Tax Credit can free up crucial capital needed to continue research.

To be considered a qualified small business:

• You must have less than $5 million in gross receipts for the year in which you wish to claim the credit.
• You must have no gross receipts for any tax year more than five years prior to the claim year.

The R&D Credit Can Open a “Closed” Return for Purposes of Carryback Refunds

In general, a taxpayer can claim R&D tax credits retroactively by filing amended returns for the previous three years. For example, in 2023 a taxpayer could go back and amend a return from 2022, 2021, or 2020. Prior tax years would be considered closed.

Interestingly, the R&D tax credit can “open” a return beyond the statute of limitations for claims of refund. In the above example, even though 2019 is technically closed, the R&D credit can open the return and a 2020 credit can be used to offset 2019’s tax.

The Credit May Be Carried Forward for 20 Years … After You Carry It Back for One Year

Many people are aware of the R&D tax credit “carryforward” provision, which allows businesses to take unused R&D tax credits generated from a given year’s qualified research expenses and apply them to future tax liabilities. This is a boon to companies that didn’t turn a profit in a given year or earned a credit that exceeded the tax owed in that year.

What many don’t realize is that the credit must first be carried back one year. Only then can any remaining credit carry forward for a maximum of 20 years. There’s no skipping the carry back.

Even with Losses or No Taxable Income, the Credit Still Brings Benefits

There are ways to take advantage of an R&D credit even if you don’t have profit. As mentioned above, the credit can be carried backward and forward into a year of tax liability, or you can use the credit against payroll taxes. But what may go unnoticed is that you might be able to use the credits against capital gains or built-in-gain taxes and that the credit may make your company an attractive acquisition target since the credits add value.

Sometimes Research Paid for by Others Is Eligible for the Credit

“Funded” research is generally not considered credit-eligible. However, this is not the same as being paid for the work. A taxpayer being paid for a research activity can qualify for the credit under certain circumstances, and it’s worthwhile to be aware of this possibility.

To qualify under these circumstances, the taxpayer must have “economic risk” and “substantial rights”:

• Economic Risk – The taxpayer’s payment for the research activity is contingent on success. If the contract requires the taxpayer to return the funding if he or she is not successful, then the taxpayer is assuming financial risk.
• Substantial Rights – The taxpayer retains “substantial” rights in the results of the research activity. This is not an exclusive right. Many times both parties can have “substantial” rights to the results of the research.

Discussing your contractual payment provisions with a tax professional is highly recommended.

Taking the Credit Does Not Increase Your Audit Risk

Filing for the R&D tax credit does not increase the likelihood of an audit. That said, it is critical to thoroughly document qualified research activities and costs in the unlikely event of IRS scrutiny.

As discussed above, there is no specific type of documentation required, but the documentation must be “sufficient” (Section 6001).

An object lesson took place in April 2019 that should remind taxpayers of the consequences of insufficient documentation. In Siemer Milling Company v. Commissioner of Internal Revenue, the court ruled that Siemer Milling lacked sufficient documentation to support their claimed credits, and subsequently disallowed over $235,000 in credits. The court held that Siemer Milling did not provide sufficient documentation to demonstrate that their business activity had met all parts of the four-part test, particularly Part 3 – Process of Experimentation.

Learn more from Jacob Wood and Terri Johnson at PICPA’s 2024 Annual Meeting and Celebration. Wood and Johnson are scheduled to speak on value added services and much more. Sign up today and join us May 13-15 in Lancaster, Pa. 

Jacob Wood, JD, is a regional director at Capstan Tax Strategies. He works closely with taxpayers and accounting firms to provide practical, creative, and customized engineering-based tax solutions. Wood can be reached at jwood@capstantax.com.

Terri S. Johnson, CRE, is a partner at Capstan Tax Strategies. She enjoys helping entrepreneurs and tax professionals benefit from cost segregation, R&D tax credits, and federal energy incentives. She can be reached at tjohnson@capstantax.com.

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^{Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.}