Cracking the Code to Qualified Research Expenses for the R&D Tax Credit

Cracking the Code to Qualified Research Expenses for the R&D Tax Credit

Discover the keys to tax-saving success! Our guide reveals why mastering qualified expenses is crucial for unlocking R&D Tax Credits.

By Matthew Bechtold ・ 6 min read
Tax and Credits

If you're here and familiar with our blog, at this point you probably know a bit about what R&D Tax Credits are.

Now, we want to dive a little deeper on the subject. So in this article, we’re here to chat about what makes certain expenses count and what doesn't for those R&D credit calculations.

If you can figure out which expenses qualify for the R&D Credit, you’re well on your way to snagging a sweet dollar-for-dollar cut in your tax bill.

Let's dive in…

Qualified expenses for the R&D tax credit

To qualify for R&D credits, you need to incur certain qualified costs - or expenses- as per IRS requirements listed in Form 6765.

These costs revolve around the development or improvement of products, processes, or software meeting IRS criteria. Think employee wages, contract research expenses, supply costs, or cloud costs.

But hold up, before we get into the nitty-gritty of wages, supplies, and all that, let's nail down what exactly makes research "qualified.”

Oh, and quick side note — the IRS is shaking up Form 6765 in 2024. Changes might be on the horizon for the R&D credit so it’s important to educate yourself!

Now, back to the main topic —

What's Qualified Research, you ask?

Qualified research is an activity that meets something called the four-part test under section 41 (d) of the tax code. The IRS uses the four-part test to determine if your company’s activities qualify for the R&D Tax Credit.

Let's break each part down in simple terms:

Part 1: Permitted Purpose

  • This is like asking, "Is your work trying to create something new or improve an existing product, process, or software?"
  • If your answer is "yes," then you pass this part of the test.
  • It's all about having a clear goal to make things better or come up with something new.

Part 2: Technological in Nature

  • Imagine you're using science, engineering, or computer science to solve a problem or make something new.
  • If you are, then you pass this part of the test.
  • Basically, it's about using technical knowledge to work on your project.

Part 3: Elimination of Uncertainty

  • Think of this as asking, "Were there unknowns or uncertainties when you started?"
  • If there were, and you had to experiment, test, or figure things out to solve those uncertainties, you pass this part.
  • It's about showing that you didn't have all the answers from the beginning.

Part 4: Process of Experimentation

  • This part is like asking, "Did you test different things, make prototypes, or try different approaches to figure out the best way to reach your goal?"
  • If you did, then you pass this part of the test.
  • It's about showing that you learned through trial and error.

If you can answer "yes" to all four parts of this test, then your activities likely qualify for the R&D Tax Credit. It's like the IRS's way of saying, "Your work is creative, technical, and involves problem-solving, so you can get a tax credit for it!

What expenses qualify for R&D Tax Credit?

QREs, or Qualified Research Expenditures, are the real heroes. For the R&D tax credit calculation for your company, you need to know what expenses go into the R&D credit.

Qualified Research Expenditures:

  1. W2 Wages: Paying your internal peeps for "qualified services" tied to research.
  2. Contractor (1099) expenses: US based contractor or consulting expenses related to product development.
  3. Supplies: Costs for materials used in the course of building prototypes
  4. Cloud Expenses: Specific to SaaS companies - any costs related to your pre-production and staging environments.

To be clear, if an expense doesn't fit into these categories, it can't be claimed as a QRE.

Let’s understand each in a little more detail –

Qualified Employee Wages (W2s)

When it comes to calculating the R&D Tax Credit, you need to consider the wages you pay to your employees.

These wages include the money they earn that's reported on their W-2 forms, like regular pay, bonuses, and stock options. However, it doesn't include any non-taxable perks or benefits.

Now, there are three types of services that qualify for W2 wages, but there are some conditions to keep in mind:

  • Engaging in Qualified Research: This means your employees are directly involved in doing the research work. They're hands-on with the research tasks.
  • Direct Supervision: This is when certain managers closely oversee the research activities. It's not the big bosses; it's more like the first-line managers who make sure everything is going smoothly. They don't do general administrative tasks that only indirectly help with the research.
  • Direct Support: This involves providing services that help the people doing the research or overseeing it. For example, if you're making parts that are needed for experimental models, that counts as direct support.

In most cases, you can include in your calculation the wages your employees earn for the time they spend on these qualified services. And there's a special rule: If at least 80% of their work is related to qualified services, you can include 100% of their wages. On the other hand, if less than 80% of their time is spent on qualified services, you can only include the hours they actually worked on those services.

Here's a helpful tip: It's crucial to keep good records of these wages. The IRS likes to see the details. You can use things like payroll records, job descriptions, performance evaluations, and calendars to show what services were performed and how much time you or your staff spent on them. This documentation is important for claiming the R&D Tax Credit.

Contract Research Expenses (1099s)

Contract Research Expenses, often associated with 1099 expenses (referring to payments made to independent contractors), refer to the money you spend on external experts or research firms (they must be based in the US) who are hired to assist with your research and development (R&D) activities.

These expenses can include:

  • Payments to consultants or contractors with specialized knowledge.
  • Fees for research services provided by external experts.
  • Outsourced testing or experimentation services.
  • Any costs related to research work conducted by third-party entities.

To qualify for the R&D Tax Credit, these contract research expenses should meet specific criteria:

  • Directly Related to R&D: The expenses should be directly related to your qualified research activities. They should be payments for services that directly contribute to your R&D projects.
  • Qualified Research: The research conducted by the contractors should meet the IRS definition of qualified research. This means it should satisfy the four-part test.

Quick note: Only contracts where your contractors are paid hourly can be included, In research contracts with a fixed price, this would not be able to be included in the R&D credit calculation.

Qualified Supply Expenses –

R&D supply costs refer to the money you spend on materials and supplies that are used specifically for your research and development (R&D) activities. These can include things like:

  • Laboratory chemicals and equipment.
  • Computer components for software development.
  • Prototyping materials.
  • Specialized tools and instruments.
  • Any materials that directly contribute to your R&D projects.

To qualify for the R&D Tax Credit, these supply costs should meet certain criteria:

  • Directly Used: The supplies must be directly used in the R&D process. In other words, they should be an essential part of your research activities, not just general office supplies.
  • Expendable: Supplies are typically considered consumable, meaning they get used up during the research. They are not items that can be resold.
  • Exclusive to R&D: These supplies are primarily used for your R&D work and not for other general business purposes.

To claim these supply costs for the R&D Tax Credit, it's essential to maintain clear and detailed records. Keep receipts, invoices, and records that show what supplies were purchased, how they were used in the R&D process, and when they were used.

Qualified Cloud Expenses

Cloud costs refer to expenses related to cloud computing services, such as hosting and storage that are used specifically for your research and development (R&D) activities. These can include:

  • Costs associated with cloud servers and infrastructure (think AWS, Google Cloud, Azure)
  • Fees for using cloud-based data storage and processing services.
  • Expenses for cloud-based software development platforms.
  • Any other cloud-related costs directly tied to R&D projects.

To qualify for the R&D Tax Credit, these cloud costs should meet certain criteria:

  • Directly Used in R&D: The cloud services must be directly used in your R&D process. Meaning they are exclusive to your pre-production and staging environments.
  • Exclusive to R&D: The cloud resources should primarily support your R&D work, not be used for unrelated business purposes.

Now let’s understand what doesn't get you that R&D tax credit?

What Things Don’t Qualify For the R&D Credit

Certain research activities don't qualify for the R&D Tax Credit, as outlined in section 41(d)(4). These exclusions include:

  • Activities that simply tailor products for specific customers or involve copying someone else's work.
  • Tasks like efficiency surveys, general management duties, market research, routine data collection, and standard quality control testing are also ineligible for the R&D Tax Credit.

When it comes to expenses:

  • You can't include an employee's wage if their job isn't related to product development.
  • Administrative expenses, like utilities, property depreciation, license fees, meals, overhead costs, land, and land improvements, are not eligible. Stick to the essentials related to R&D.
  • Be mindful of contract research expenses; only include costs that were exclusively used for qualified research and are US based.

Let’s wrap up the QREs –

One thing is clear: getting the R&D tax credit calculation right means having an in-depth understanding of eligible activities and qualified research expenses.

It’s like following a recipe—miss a step, and the dish might not taste as good. But, no worries! TaxTaker's R&D tax credit software are like seasoned chefs. They make it easy, helping you get the most out of your credit without any hassle. Why go solo when you can cook up success with the right team?

About the author

Matthew Bechtold
Head of Accounting

Matt Bechtold heads up TaxTaker's R&D credit practice. He has helped companies claim valuable Federal & State R&D credits for more than 10 years for a wide range of clients and industries, ranging from Fortune 500 companies to startups and medium-sized businesses.

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