In this episode of Cherry Bekaert’s Tax Credits & Incentives Advisory Podcast, Martin Karamon welcomes Tax Credits & Incentives Advisory leaders Dan Mennel and Vivian Kohrs to talk about R&D documentation as you make investments in technology or look at the ROI of making such an investment.
The R&D Tax Credit is one of the most lucrative incentives available to taxpayers and provides a permanent offset to tax liabilities. This credit is an activity-based credit – meaning that if a taxpayer is performing specific types of activities, the costs incurred to perform those activities go into a separate tax credit calculation.
As it relates to the R&D Tax Credit, Cherry Bekaert’s Tax Credits & Incentives practice is primarily focused on helping companies identify and document qualifying R&D costs.
Discussion includes:
- Types of investment and the four-part test to determination qualification
- How to properly document support for R&D activities, which may qualify as these types of investments
- Real-life examples of qualified R&D investments
- IRS ASC 730 directive
If you have any questions specific to your business needs, Cherry Bekaert’s Tax Credits & Incentives Advisory team is available to discuss your situation with you.
If you haven’t already, catch up on other podcasts covering the R&D topic:
- What’s New with R&D Tax Credits in 2022
- Tax Beat: Digital Transformation and R&D Tax Credits
- The Benefits of using a CPA Firm to Perform Credits & Incentives Projects
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HOST: MARTIN KARAMON: Welcome to the Tax Credits and Incentives Advisory Podcast. I'm Martin Karamon, and today we're going to cover considerations when making investments in technology and evaluating the return on those investments.
HOST: MARTIN KARAMON: Being proactive from the start on contract terms, time tracking, and key documents specific to software development and the software development lifecycle can make a difference. With me today are Dan Mennel and Vivian Kohrs, both leaders in Cherry Bekaert's Tax Credits and Incentives Advisory Practice, also known as TCIA.
DAN MENNEL: Happy to be here. I reside in Northern California in the heart of Silicon Valley. I've worked with technology companies for more than 20 years and am excited to be part of the practice within TCIA with an emphasis on R&D tax credits.
VIVIAN KOHRS: I'm physically in Princeton, New Jersey. My main focus is R&D tax credits. I've been doing this for 10 years across software development companies, startups, and the medical device industry, among others. I am a director at Cherry Bekaert and lead much of the technical documentation work.
HOST: MARTIN KARAMON: The reason for this podcast is that every company is making some investment in software, and we wanted to focus on tax credit benefits that can accompany those investments. To level set, today we'll talk about the IRC Section 41 Research Credit. It is one of the most lucrative credits available to taxpayers and provides a permanent offset to tax liabilities.
HOST: MARTIN KARAMON: The credit is activity-based, meaning that if a taxpayer performs specific types of activities, the costs incurred for those activities enter a separate tax credit calculation. Here at Cherry Bekaert within TCIA, the majority of our practice focuses on working with companies to identify and document qualifying research activities.
HOST: MARTIN KARAMON: Dan, why don't you share the kinds of investments we're talking about and how the R&D credit can impact the return-on-investment analysis?
DAN MENNEL: One advantage of being an R&D credit SME is the deep dives we get to do into clients' technology. We often spend extended time with top engineers and developers and become deeply familiar with a company's technology.
DAN MENNEL: The investments we're discussing are far reaching and nuanced. Any investment in technology that uses labor resources meeting the four-part test in Section 41 can qualify.
DAN MENNEL: A quick refresher on the four-part test: permitted purpose, element of uncertainty, a process of experimentation, and that the activity is technological in nature. We have materials on our website that go deeper into the four-part test.
DAN MENNEL: Specific examples include ERP implementations. This is not about off-the-shelf software; it's about customization of an implementation. The developer of the software, such as Oracle or SAP, may get R&D credit for developing the system, and customization work by the purchaser can also qualify.
DAN MENNEL: Historically, I've seen 20 to 30 percent of a large ERP implementation's time qualify for the R&D credit. Another example is significant improvements to a manufacturing facility using new processes and software to enhance throughput and yield. These efforts often require technology and customization of equipment that may void warranties.
DAN MENNEL: Supply chain issues over the last year or two have affected many industries' recipes or formulas—chemical manufacturers, paint companies, semiconductors. One small supply change can throw off the entire formula, requiring recertification, reevaluation, and experimentation that fits the four-part test.
DAN MENNEL: Lastly, many clients want greater visibility through dashboards or similar tools that require outside consultants or internal IT teams. These solutions often require unique coding to integrate with legacy systems and are not off-the-shelf.
HOST: MARTIN KARAMON: Vivian, when you think about these investments, what are the key things to consider for documentation when preparing the credit calculation and defending it with the IRS?
VIVIAN KOHRS: Documentation is about 90 percent of this work. You need to be well versed in IRS rules and case law. For ERP implementations, which is traditionally a risky area for the R&D credit, there is specific guidance on what qualifies.
VIVIAN KOHRS: The key is aligning client facts with examples of what actually qualifies. Straightforward configuration of off-the-shelf ERP systems generally does not qualify. We need to determine and document the portion of time spent on customizations and demonstrate why off-the-shelf solutions do not work.
VIVIAN KOHRS: We document the specific modifications and why those changes were technically challenging, and we quantify the size of the problem or the measurable improvement. For example, if a previous process to quote prices took an agent roughly 30 minutes and customization reduced that to seconds, that quantifies the problem and the improvement.
VIVIAN KOHRS: Contractual terms are also important. For funded development, such as building an API for a client, contract terms determine whether the development costs are your R&D credit or your client's. Terms that define where IP resides and who bears financial risk help establish which party is entitled to the credit.
VIVIAN KOHRS: Establishing the nexus between qualifying activities and qualifying dollars is critical. Time tracking is ideal contemporaneous documentation because it ties qualifying projects, activities, hours, and participants together in real time, making it difficult for the IRS to dispute.
VIVIAN KOHRS: Other contemporaneous documents include project charters, release notes, sprint notes, whiteboarding pictures, architectural diagrams, and emails discussing design changes or challenges. These items substantiate the credit and should be retained.
DAN MENNEL: Those are the same documents we look for during reviews. Clients often ask what they can do proactively when working with outside consulting firms. Use the right language in invoices and time-tracking so third-party spend can be converted into qualifying portions of time.
VIVIAN KOHRS: In our R&D credit practice, we work with two types of clients: those making investments in technology and those whose business is technology development. Both can be entitled to the credit if they have substantial rights, financial risk, and economic risk associated with the endeavor.
HOST: MARTIN KARAMON: One topic that came up a few years ago was the directive, originally known as the safe harbor directive specific to audited ASC 730 R&D costs. There was thought that it might change how companies documented the R&D credit. Dan, can you give background on the directive and how it's used today?
DAN MENNEL: There was significant excitement about the directive among technology companies. The question was whether public companies could leverage an audited financial statement line item for R&D as a basis for R&D credit eligibility.
DAN MENNEL: The Silicon Valley tax director group, along with several large technology companies, spent time developing that approach with the hope of reducing study work. However, the IRS decided to carve out certain costs for SaaS—costs reported as 35X or 40 costs on financial statements—and exclude them from the directive.
DAN MENNEL: Because many technology companies operate primarily as SaaS providers, the carve-out removed much of the potential benefit. As a result, most companies moved away from using the directive and returned to a traditional approach for documenting the R&D credit.
DAN MENNEL: Historically, when I began working on research credits around 2003, perhaps 30 to 35 percent of our clients were software-specific. Today that number is closer to 65 percent, reflecting that much business activity is software-driven.
HOST: MARTIN KARAMON: If anyone listening has questions about documentation, IRS best practices, or has not claimed a research credit, our practice is available to scope potential benefits and help with documentation. Dan and Vivian, thank you both for a succinct and robust discussion on R&D credits.
