Funded R&D Project Documentation is Essential to Claim Credits

The R&D federal tax credit is a lucrative benefit for small and large businesses across industries. But if you don’t have the right documentation to support your claim, you could wind up missing out on your hard-earned dollars.

Case in point: In a 2019 ruling, the IRS denied R&D tax credits to 12 individuals who worked for an S corporation, after determining the group failed to adequately prove they retained the necessary intellectual property rights and financial risk as dictated by the tax code.

This new ruling highlights the importance of ensuring you retain and document your company’s rights and risks to development work if you want to claim the R&D tax credit. Below, we take a closer look at the case, what the individuals in question missed and how you can avoid making the same mistake.

Why were the individuals in the case denied the R&D credit?

The S corporation designed and produced innovative technology for the power industry and was hired by another entity to develop a new enclosure for turbine power generation. In other words, the company was doing highly technical work that clearly met the thresholds for the R&D credit; however, companies must also retain substantial rights to the development work to benefit from the credit.

While the S corporation and third-party entity negotiated a detailed set of contract terms for the project, those contracts failed to demonstrate the S corporation’s rights to the research they performed. When the case went to trial, the court ruled that the S corporation’s research was completely funded by the third-party entity, which disqualified the company from claiming any rights to the research it performed.

Is all funded research disqualified from the R&D credit?

Although companies do not need to retain exclusive rights to their research and development activities, they must retain substantial rights to the completed research activities in order to qualify for the R&D credit. In order to retain the substantial rights to a development project, a company must retain all risk for development activities performed during a study year by bearing the expense of development even if the research is unsuccessful.

Because the S corporation could not demonstrate through their contracts or other documentation that they retained the substantial rights to the research they performed, the IRS disallowed all credits.

The bottom line

This case illustrates the importance of maintaining quality documentation for the R&D tax credit, especially if your company works on any projects that might be considered funded research. Companies can document their rights to intellectual property and financial risk by maintaining contracts, invoices and purchase orders that show  your company would bear the financial risk if the development project was unsuccessful.

If you think you may qualify for the R&D tax credit, Aprio can assess your eligibility  and work with you to determine which research projects may qualify. Aprio’s R&D Tax Credit specialists also have the experience to help you document research and development projects and maximize your overall benefit. If you’re interested in learning more about the R&D tax credit, please contact Carli Huband, Managing Partner of Aprio Specialty Tax Services, or Meredith Kowal, Partner, Aprio R&D Tax Services.