Reinvesting your R&D tax credits back into the business is a great way to be more competitive, grow faster and improve profitability.
The R&D expenses that qualify for tax credits can be broken down into three general categories: wages, supply expenses, and contract expenses. Let's look more in depth at each category and what it means for your business.
Your R&D activities are an essential part of your process, and the individuals performing those activities need to get paid. The wages paid as part of your R&D expenses can be included in your tax credit application only if they were paid for "qualified services" performed by the employee. This means you will need to differentiate the time they spend working directly on qualified R&D activities from the time they spend on other non-qualifying activities.
Here, the IRS defines "wages" as all taxable wages including bonuses and stock option redemptions, but not including other fringe benefits. For exact specifications, it's best to consult your R&D tax credit professional.
It's pretty much impossible to conduct research and development without supplies. But how do you know which supplies involved in your R&D expenses meet the tax credit criteria?
There have been several court cases examining this issue, but in general, supplies are defined as any property that does not allow for depreciation. This means that things like fixed assets, and lease expenditures would not qualify. But things like parts, molds, and other base materials would likely meet the requirements so long as they are used for qualified R&D activities.
A fully developed product prototype may or may not qualify depending on the nature of the product. So, it's best to check with your R&D tax credit professional to help determine which supplies meet the IRS' criteria.
Much like the wages paid to your employees, R&D expenses paid to contract workers can also qualify for tax credits. But here, the IRS defines a "contract expense" as only 65% of the actual wages paid to the contractor.
Again, it's important that the services performed meet the specific R&D criteria, and that the wages claimed in your tax credit application were paid only for those services.
Because projects can sometimes take years to complete, it's important to note that "prepaid research expenditures are not eligible for the credit until the services are performed."
Documentation is Vital
For all three categories of R&D expenses, it will be crucial to have the required supporting documentation. In the event of an audit, it's not enough to simply say the parts or personnel are part of the R&D process. You must prove that each expense meets the tax credit requirements by showing how it fits into your overall R&D procedure.
Documenting the time spent by individual employees and showing how supplies were specifically used will be vital to substantiate valuable R&D tax credits.