What is nexus? Sounds like a nerdy scientific term, right? Well, it’s more like a nerdy tax term that is a major component of accurately claiming the R&D Tax Credit.
For the research credit, nexus is defined as the process of providing documentation between Qualified Research Activities (QRAs), also known as R&D Business Components, and their Qualified Research Expenses (QREs), also known as the paid wages, supplies, and third-party contractors associated with your QRAs.
Free: R&D Credit Resources
How to Execute Nexus
To prove nexus during an audit, the IRS will want to see the documentation for each employee and how they spent their time working on QRAs. Without nexus, the chances of disallowance increase.
It is common for businesses to build nexus for credit through different cost accounting methodologies. They are as follows:
- Project Accounting – this is the only method for establishing nexus. Project accounting entails tracking all financial components of QRA. This method is more granular, thus leaving a better audit trail. If in audit, providing proof of project accounting will significantly decrease the risk of disallowance. Project accounting is especially useful when claiming credit for large-scale projects.
- Cost Center Accounting – unlike project accounting, cost center accounting is considered a “higher level” form of tracking project expenses. A cost center is like an ongoing activity or a bucket of a lot of small business components. The risk in utilizing this method is that it is more difficult to link specific projects to expenses. This method does not build nexus. There’s more work and more risk when in the exam.
If a company is already tracking time towards projects, they typically have nexus for the research credit. However, they’re still required to qualify their projects against the 4-Part Test to prove that it’s qualified research.
Companies that don’t track time can still create nexus after the fact (quarterly, bi-annually, or annually). Alternatively, you can use Armor’s timecard module to track time as you go (also known as “contemporaneously”).
Contemporaneous Nexus
Do you want to be even better? Although nexus can be created after the fact, Contemporaneous Nexus is a more “bulletproof” tax position. This method is the most accurate way to ensure that your R&D credit is “audit-proof.” With Contemporaneous Nexus, employees complete and record daily time tracking for work that is considered QRA(s). The key is, you have to prove that you tracked your QREs against QRAs in real-time. In other words, you have to show that you didn’t create nexus after the fact.
The key to Contemporaneous Nexus is that projects and expenses must be accounted for in real-time. By the way, Armor is proficient at providing this service. Now, this doesn’t mean that time must be tracked every hour on the hour. For purposes of the research credit, recording your time at the end of every day is sufficient to build the Contemporaneous Nexus.
As the value of your credit increases, you should consider utilizing Contemporaneous Nexus, as your credits are more vulnerable to audit the larger they get.
Conclusion
As you know, the general rule of thumb when filing taxes is to keep track of all expenses and their related documents in case of an audit. The same goes when filing for the R&D Tax Credit. Being proactive is always better than waiting until the last minute. Better be safe than sorry, right?
With that said, if you’re interested in claiming the R&D Tax Credit, it is crucial to know what nexus is and how your business can create it properly and efficiently. The key to tracking nexus is to know which business components qualify and how qualified their expenses are being paid towards those components.
