The federal tax laws require business owners claiming the R&D credit to discover information that is "technological in nature," a so-called discovery test. The definition of the test is likely to be modified, but for now, many companies find it undefined and confusing.

The credit is designed to encourage businesses to increase their spending in R&D. While the credit is not permanent, Congress has continually extended it. The Tax Extension and Relief Act extended the credit through mid-2004. Unlike a deduction, which reduces taxable income, a credit is a dollar-for-dollar reduction in your tax bill.

Until the regulations are finalized, Mark Andrus, national director for Grant Thornton's R&D services, recommends that companies using the credit be ready for the possibility of an audit. Here's how to protect yourself:

  1. During the development project--or in the initial planning stages--be sure to document what you didn't know and what information you intend to discover.
  2. Document the development process. Keep laboratory and meeting notes or reports that outline steps taken to discover new information or to apply new information to the development of a new product or process.
  3. Use a tax expert to help with the documentation. The credit can help defer the cost of innovation, but the rules are complex and fluid.
  4. While the IRS will probably continue to challenge companies on the test, Andrus says, "businesses can continue to claim the R&D credit, but to maximize the opportunity, follow the recommendations above."

Source: "Is That New?"