7 R&D Credit Flags Your CPA Should Catch Before Filing - Episode 09

7 R&D Tax Credit Red Flags to Check Before You File (Plus 1 Bonus Most Miss)

The biggest risk with the R&D tax credit is not claiming it, but being able to support it, and provides a one-page checklist of seven red flags plus a bonus issue. I describe a case where a company received a clean-looking R&D form but never filed it properly for the payroll offset, leaving about $200,000 unclaimed. Key flags include failing to map business components separately for the four-part test, incorrectly estimating qualifying wage percentages beyond just engineers, and mishandling contract research, offshore work, and funded/customer-paid work based on contract terms, rights, and risk. The bonus flag warns against an even split of direct research versus supervision/support, referencing Little Sandy Coal and aiming for about 80% direct research. He also highlights Section G readiness on Form 6765 and the need for a substantiation support package, urging review if multiple flags are triggered.

Transcript

SPEAKER_00 0:00

Okay, so here's part of the RD tax credit nobody checks before they file. So I've built these for nearly 10 years as a CPA, and most founders worry about just claiming the credit. But the real risk is whether anyone can support it. I will give you seven potential red flags in this video to check before you sign off. Plus, an additional bonus one, even good CPAs often miss. By the end, you'll be able to hopefully run your own claim through this one-page checklist and know whether you're ready to file, or maybe it's time to pause and take a quick moment to tighten things up a bit. Let me start by what typically goes wrong because it often surprises so many different people. A tech company I came to, they had their RD done by a cookie cutter provider and they got a clean looking form back. Now, that form unfortunately never made it onto the tax return. Nobody connected the form to the CPA and also the payroll provider to claim the credit for the payroll offset. So they sat roughly on $200,000 they never received. A number on a form means nothing if it's not filed correctly, claimed correctly, and then ultimately documented correctly. It's just an empty number on a piece of paper. With that in mind, let's go ahead and jump right into the first flag because this is really a foundational one. So what I see so many times is there's no map of the business components. The IRS doesn't look at your credit as one big bucket of qualified expenditures called, say, software development. They look at it component by component. Think of it as a specific product, a feature, a process or new functionality. Saying, hey, we built a new platform. This is way too broad and it doesn't mean much. Saying something like, we built a real-time reporting module that had run under a strict latency requirement. Something like that. That's a real business component. And each business component has to run through the four-part test on its own. Let's talk about the second flag. Now, the second flag, this one is pretty sneaky. This one hides inside the biggest line item that is often the biggest driver of your credit, the wages and the way you qualify them. You can't assume that every engineer working on the product is 100% qualified and everyone else is zero. The honest way to do this is to take the three-layered approach I talked about in a previous video. So you look at your core engineering team and saying who are the ones that are performing the qualified research? Who are the ones that are really doing that core stuff? Now that's going to be a large driver of it. The second layer is going to be that supervision layer. Who are the individuals, say, directing or reviewing or driving it on a more supervisory level? And then that third layer is going to be that support layer. Say this is your QA, support individuals, requirements folks. Those are the folks that are doing that support work. Those are the three different layers. Now, smaller teams almost always have more qualifying time than they guessed. I would take another look at your qualifying percentages and not just break it down into engineers are 100, everybody else is zero. See what are the types of activities your teams are performing, and smaller teams often wear so many hats and ensure that those percentages align with the activities that were performed. Now, quick aside before we get into the next one, if naming your components and tying your wages already feels like a ton of work, there's a link below. You can go ahead and book and call and we can talk it through together. That's no problem. Either way, keep this list that I'm going through on hand when you want to utilize it. But for now, let's keep going. Let's talk about flags number three, four, and five. These are going to be contract research, offshore work, and funded research. Now, the mistake is treating each one as an automatic yes or no. Really, these are review buckets and the facts decide whether you get to include these as your qualifying expenditures as part of the credit or not. Let's go ahead and start with the review bucket of contract research. Basically, these are the contractors you hired to do research and development. You look at where the work was performed and what was performed and whether the contract gives your company the rights to the product and you bore the risk as well. So work done outside of the US or its territories is completely excluded. It doesn't matter even if it was doing qualified work, those are a separate bucket that you just need to put away. For contract research that does otherwise qualify, the rules generally let you count 65% towards the qualification bucket. But the contract facts are what really decide if you can claim it or not. Now, offshore we talked about, that's its own bucket. Because the credit exists to keep research and development in the United States, any research that was performed offshore is excluded entirely. Say you have a hybrid team, you have to separate the work. You keep the US-based activities, this could be the product leadership, design testing, and maybe the oversight, that stuff qualifies, but then you need to exclude the rest that is done offshore. So if you run a hybrid or contractor heavy team, let me know in the comments because this one is going to matter for a lot of different folks. Then there's the funded or customer paid work. The whole question here is who bore the risk of the work if it failed and who owns the rights to the final product. If you funded the work and you own it, that's more typically your credit to claim. If the customer paid for it and then they own it, the credit may be theirs. You know, getting paid to build something doesn't disqualify you automatically, it just really needs to be reviewed with the CPA. This one can become quite nuanced, so I would definitely recommend you check with your CPA, look at the different terms, see who bore the risk and ultimately who had the rights, and make sure the terms match up to what's happening in real life. Let me take a quick pause here because this is where claims oftentimes go really wrong. The contract, the offshore, and the funded buckets need someone to read the contracts line by line to ensure that the terms match up to what's happening to see if you have the right to the credit and claiming for that work. If you would like me to walk through it with you, I'm happy to do so. There is a link in the comments below where you can book a call and we can go through it together. Let's get back to it. So here's the one I almost never hear anyone bring up, and it's the bonus flag I promised you at the beginning of the video. So once you've sorted all of your activity, I want you to look at the total makeup of the qualified work. What I mean by that is say you end up with one third of the qualified expenditures coming from that direct research layer. And maybe you have another third coming from the supervision layer and another third coming from that support layer. Having an even split like this, this is a flat. This goes back to a tax court case called Little Sandy Cole. And it's where the government has been paying a lot more attention to lately. Basically, what they want is they want substantially all of the work to be qualified in that direct research bucket. So think around 80% with supervision and support together, making up 20% or less. If your skews the other way, that's going to be a problem. If nobody's ever walked you through this rule, honestly, you're not alone. It's a very nuanced area. The fix is a real technique and it's why it counts as an advanced rule. So basically, what you need to do is shrink back the business component, you pair it back to a tighter piece where the direct development genuinely is 80% and the supervision and support fall to that 20%. Now you have a more defensible boundary around it. Once your analysis is done, look back at your activity and see if it leans heavy on supervision or support. And that's your signal to tighten the business component and really shrink it back until you get that direct research at 80% or above. If your direct versus support and supervision is split anywhere near even, I'd want you to have that looked at before it ever gets on a tax return. If you'd like to look at it together, there's a link. We can book a call and talk through it together. Otherwise, talk with your CPA, talk with your tax advisor because this is an area that is a big focus for the IRS. You can figure out pretty quickly if you're in a good spot or not. Now, let's move on to the last two flags, and this will really decide whether your credit can stand up to any scrutiny if somebody comes knocking. Flag number six, this is Section G readiness. Section G is the new part of the Form 6765 where the IRS now wants serious detail right on the form. This is that kind of detail that they used to only ask when there was an audit. But now what they're wanting is they want it straight up on the form itself. Being Section G ready means that you can connect each business component to each of the cost buckets. Think wages, supplies, computer rental, contractors. A final number on its own, it's not going to get you there. This is an area that they're really, really focused on. Let's move on to the final flag, number seven. This is the support package. And really, look, this is the bridge from the credit back to the work that was done. A real credit claim has completed forms, a summary of how the credit was built, a methodology memo, and documentation of the products as well. These show the technical challenges and the experimentation examples. This is your evidence if anyone ever asks how did you come up with the credit. Ideally, your CPA can put this together and provide your copy so that you have it for your files. But this is a really crucial piece of the puzzle because if you have a form without any substantiation, unfortunately it can end up being just an empty number. Okay, I've spoken enough. Here's how you can use what we've just went through. I want you to run your claim down this one-page review, looking at each one of these flags and see how many of them you trigger. If you trigger one, usually that's a simple cleanup, no problem. Maybe you have two or more, you should definitely pause and get it reviewed before it's filed. Hopefully, this is super easy and you can run through this list yourself, and it wasn't too painful. If you'd rather go through it together, there's a link in the below that I'm happy to book a call and we can chat about it together. Finally, there's a quick note before we wrap. Everything that I covered today is educational content only, and it's really just giving folks information on how the RE tax credit generally works. Every company's situation is going to be different, and the exact amounts depend on your specific fact pattern. This isn't individual tax advice for your company. Please check with your CPA or your own tax advisor for your specific situation. Final thing, remember, the number on its own is never going to be the asset. The defensible claim that's the real asset. Thanks for watching, and I will go ahead and see you in the next one.