How to Make Your R&D Tax Credit Defensible

Below are helpful tips to implement to make your R&D Tax Credit Calculation “bulletproof.”

If your company relies on the hard sciences or uses technology to create or improve products or processes, you may be engaging in qualified R&D activities and be eligible for the Research & Development Tax Credit.
Here’s an excerpt from an IRS Field Attorney:

IRS Field Attorney Advice 20171601F (April 2018)

The taxpayer claimed credit for increasing research activities for at least four years. Employees of the taxpayer performed both qualified and nonqualified services. But in short (see end of post), the controller of the company estimated the level of R&D in terms of wages—what percentage of what employees’ salary was devoted to legitimate R&D activities—then took a statistical sample of the projects and multiplied the estimated wages by the estimated R&D project for the year.

Free: R&D Credit Resources
The taxpayer did not use the method provided in Regulation 1.41-2(d)(1), which states:

“If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense. In the absence of another allocation method that a taxpayer can demonstrate to be more appropriate, the amount of in-house research expense shall be determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time spent by the employee in the performance of qualified services for the taxpayer to the total time spent by the employee in the performance of all services for the taxpayer during the taxable year.”

If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expense.

The underlying issue in the case stated by the IRS:

“The taxpayer failed to maintain adequate records reflecting the costs of its qualified research activities and couldn’t determine how much time its employees spent performing qualified services for a particular project.”

Five Steps to Bulletproof Audit Defensibility

- Step 1. Estimate your QREs and complete Form 6765 – you can easily fill that form out by clicking here.

Identify which employees you believe performed qualified research activities in the past tax year.
Then, estimate the percentage of each employee’s total time on the job spent performing these qualified activities.
Next, multiply this percentage by the employee’s W2 wage for the year.
Finally, add the contributions calculated for each employee to determine your total qualified labor costs.
Do the same for each vendor that provided qualified supplies or contracted services.

Step 2. Build nexus at tax time.
Step 3. Build Contemporaneous Nexus throughout the year.
Step 4. Qualify your Research Activities per IRC 41(d)(2).
Step 5. Hire an RCE to review and approve your qualifications’ nexus and computation.

The bottom line, you can receive a research credit reasonably and efficiently. However, if you have concerns about audit defensibility, consider taking baby steps towards building a bulletproof tax position.