How to Track Expenses for the R&D Tax Credit

R&D tax credits can help companies minimize their tax bill, yet many companies may not be fully exploiting this opportunity. Moreover, many small businesses may have trouble deciding how to track R&D expenses. It is important for companies to stay compliant and keep accurate records when they claim Qualified Research Expenses (QRE) on their tax returns.

What are Qualified Research Expenses?

Qualified research expenses are any type of research expense that a company claims under the R&D tax credit. Some examples of eligible expenses include employee wages, money spent on supplies, and payments to third-party research companies. In order for an expense to be a qualified research expense, it needs to meet a four-part test to determine whether the process helps create a new product or process or if it improves an existing one. Companies also need to prove that the development was technical and experimental in nature. On the other hand, other costs, such as general and administrative expenses, are not eligible.

The Best Way to Track QREs

It is crucial for companies to carefully track all of their expenses to ensure that all of the QREs that they list are correct. For example, if you are listing employee wages, you will need to show that the individual was conducting or supervising this qualified research. If you use a contractor or research consortium, the process is different, as you are not eligible to include the total amount.

Small businesses will likely need to rely on an accountant’s expertise in this area to ensure they reap the full benefits and do not accidentally overstate their QREs. Before using an accountant, it may be helpful for companies to utilize accounting systems and software throughout the year to organize all of their information accurately and separate QREs from regular expenses.

Project-based tracking software is an excellent way to monitor your employee’s work activities and determine which activities are related to QREs. Companies can also use integrated timekeeping to keep track of the total hours that someone works. Both of these tools can help companies quantify and qualify employees’ activities and more accurately calculate the time they spend on qualified research activities.

Once you have figured out a way to accurately track your employees’ work, the next step is to come up with a detailed expense categorization system. Some of your QREs will not only include payroll expenses but may also include other expenses like supplies and payments made to independent contractors. Moreover, there may be other closely related expenses that still do not qualify as QREs. It is important for businesses to be able to keep track of all of these expenses and accurately identify which expenses are QREs.

How to Stay Compliant with R&D Expense Tracking

Small businesses will need to track all expenses associated with research and development activities. Some of these expenses can include salaries, materials, and other research costs. Not all research-related costs can be included, so it is important for companies to consult with an accountant before filing and claiming QREs. It is also very important for companies to keep track of various types of documentation in case they are audited by the IRS.

If you plan to include employee expenses as a QRE, you will need to keep W2 forms, payroll registers, time tracking logs, and other employment information to verify that this employee’s job was to conduct or supervise research. This process can be confusing if your employer does not focus 100% of his efforts on these qualified research activities. If you hire a contractor or third-party research company, you will need to provide documentation showing that your company maintains its rights to this research.

Common Pitfalls in Tracking QREs

There are many common mistakes that businesses can make when filing their taxes and claiming QREs. These misclassifications can cause issues if you are audited and could result in penalties and fines. Small businesses can make many common mistakes in various categories if they are not careful.

Employees need to perform the qualified research or directly supervise this research. The most important thing to note is that you need to track the amount of hours they spend on this research if it is not their full-time job. It is also important to remember that only 65-75% of the expenses are eligible if you use an independent contractor or research consortium.

It is also important that the supplies you use are directly related to the research conducted if you want to count them as a QRE. It is crucial to note that costs like land, property, and certain intangibles are not eligible expenses. The IRS may also be more likely to scrutinize your filing if your supply expenses represent a high percentage of your total QREs.

There are other types of costs that are not eligible, including marketing and advertising costs, international research, HR expenses, customer service expenses, indirect research costs, and employee training.

Closing Thoughts on Tracking R&D Expenses

If you are unsure how to track R&D expenses, it may be best to ask an accountant before filing taxes. This step can ensure that you take advantage of all of the legal options and that you also avoid claiming ineligible expenses. Given that it is very difficult to classify QREs, it is a good idea for companies to use various types of software and tools to accurately track their expenses and have this information readily available in the event of an audit. These steps can help companies maximize their tax credits, keep clear records, and avoid inaccurate reporting.

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About the Author

Miguel Alexander Centeno

Miguel Alexander Centeno is an author, speaker, and tax leader at Tax Hack Accounting Group. A former Big 4 tax manager, he represents taxpayers in all matters before the IRS, including the U.S. Tax Court. He has been quoted in the Wall Street Journal, Fox Business, and MSNBC on tax related articles and has testified before the U.S. House of Representatives as a part of hearings for the Tax Cuts and Jobs Act. A father of three, Miguel is an avid acoustic guitar player, gravel cyclist and once-a-week yogi.
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