Ongoing research and development (R&D) is a cornerstone of a prosperous economy, which is why the IRS provides a federal R&D tax credit under Internal Revenue Code Section 41. But the scope of R&D isn’t limited to large-scale scientific development (such as large pharmaceutical companies working on a new drug); small businesses also can and do conduct R&D activities to develop new products or services or improve their existing offerings.
In a previous blog, we covered how to account for research and development expenses. We get a fair amount of questions about this from our clients because properly recording R&D costs and claiming the associated benefit can be confusing. Part of the problem lies in the vagaries of the way the IRS describes the use of Form 6765 to claim R&D tax credits. For the average business owner, the language is opaque and filled with legalese, which opens the door for misunderstandings and errors.
The history of the R&D tax credit
A few years ago, the R&D tax credit had a reputation for being too complicated and was often ignored by smaller businesses. In 2015, the PATH Act made the R&D credit a permanent fixture of the tax code and established provisions and updated regulations to make it friendlier to small and mid-sized businesses and startups. As a result, more consultants appeared on the scene to help more small and mid-sized businesses from diverse industries take advantage of the uptick in R&D credit interest and availability. Although many of these businesses have indeed used the tax credit as a tool to fund innovation, a large number, often unwittingly, have ended up claiming the credit based on unsound advice.
Like the aggressive advertising offering to get your company ERC credits, numerous companies are on the end of a cold call claiming to help you get R&D tax credits. Indeed, they may be able to help you claim R&D benefits, but some toe a fine line with their interpretation of the regulations. We encourage you to keep at the forefront of your mind the possibility of being challenged by the IRS on the merits of your R&D credit claim. Working with an experienced, reputable firm may lessen or completely eliminate the headaches, time, and tax repercussions of such an audit.
New efforts to police R&D claims
The IRS put into place stringent documentation requirements to police R&D in 2000, and the credit was labeled a Tier 1 issue in 2007. In October 2021, the IRS published a chief counsel memorandum that heightened documentation obligations and spelled out additional reporting responsibilities for R&D tax credit claims.
With the right tax practitioner handling your affairs, you can view these new requirements and efforts to police the R&D credit with relief, rather than anxiety. Make sure to perform your due diligence and consider strongly whether your company is being asked to go beyond reasonable bounds to take advantage of this credit.
Have you been asked to consider an aggressive R&D credit position? Here are some red flags.
The providers work on a contingent fee
Companies that provide an R&D claim service often work on a contingency basis to make their offer more attractive. For example, they’ll charge 25% of the R&D recovery; but if you get nothing, they get nothing too. Barring very specific circumstances, no tax professional works on contingency. In fact, Circular 230 (the set of rules from the IRS that govern CPAs, accounting firms, attorneys, and other tax advisors) prohibits tax preparers from performing R&D tax credit engagements under a contingency fee arrangement.
They market to non-standard R&D industries
Some consultants market R&D credits to non-standard R&D industries, based on stretched interpretations of the laws and regulations. This is not to say that businesses operating in non-standard R&D industries never qualify, but claiming the credit does warrant a serious discussion on the rationale for qualification. As a general rule, if it seems too good to be true, it probably is. Always be honest in your assessment of the specific facts and circumstances of your business activities.
They avoid discussing risk
Any review of a tax claim should include a discussion of the potential risk tied to that position, so beware of any consultant that avoids discussing possible downsides of your claim. Many of these companies provide vague rationales and answers to questions and ultimately try to avoid tough conversations by offering empty assurances.
They promise quick turnaround times
If a consultant promises it will take them a relatively short amount of time to complete the work, proceed with caution. Taking minimal time could mean minimal supporting documentation when providing numbers to the IRS, which is asking for trouble. Conducting a thorough review of R&D eligibility takes time for both the provider and the applicant.
To save on time and costs, some providers may not perform the appropriate due diligence required to conduct a thorough R&D tax credit review. Here are some signs that should prompt you to ask more questions or consult with another professional:
- Using industry averages or other shortcut methods to calculate the credit
- Neglecting to interview and obtain documentation from staff
- Not reviewing areas at high risk of audit
- Failing to evaluate a credit computation method that yields the best possible results
Consult an experienced CPA for R&D tax credit claims
We recommend consulting an experienced business CPA to discuss and plan your entire tax strategy to help you properly account for associated costs and take advantage of possible deductions. Instead of placing your trust (and your reputation) in contingency-based companies, we strongly recommend speaking to a qualified business CPA to ensure your R&D expenses are eligible for the credit. Our business CPAs have experience in helping businesses stay updated with R&D tax credit laws. Send us a message to schedule a consultation today.