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.
As more companies turn to the credit, the IRS is scrutinizing claims more carefully. A recent court case involving R&D credits claimed by Tax and Accounting Software Corp. (TAASC) of Tulsa, Oklahoma, stresses the need for companies to pay close attention to how they document the discovery test, says accountant Mark Andrus, national director for accounting and consulting company Grant Thornton's R&D services. TAASC developed software that provided new features not offered by any other commercial software. The company argued that developing these new features satisfied the requirements of the discovery test. The IRS countered that discovery actually requires expansion of existing knowledge beyond just new features. While the IRS lost in the first round, it won on appeal.
Nevertheless, in its decision, the appeals court disagreed with the definitions of the test offered by both TAASC and the government. Now business owners are waiting for the IRS to issue a clearer definition, which is likely to happen, says Andrus. Before the TAASC appeals decision, the IRS issued proposed regulations revising its definition of the test, making it less difficult to meet.
Until the regulations are finalized, Andrus 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."
Great Falls, Virginia, writer Joan Szabo has reported on tax issues for more than 16 years.