With the IRS placing more scrutiny on the R&D Tax Credit, it is important to be aware of common myths of the credit as well as areas of exposure when building a claim. To dispel some of these misconceptions and provide clear guidance for CPA firms and businesses that may qualify for the R&D Credit, read this week’s blog exploring what types of supplies expenses are eligible for R&D Credit inclusion.
One category of expenses that can present challenges when evaluating and claiming the R&D Credit is “supplies used in the conduct of qualified research”. Defining what can be classified as a “supply” is relatively straightforward, as it must be “non-depreciable tangible property”. Therefore, capital equipment purchases do not qualify, nor do purchases of software tools, subscriptions/licensing fees, rent/lease expenses, or travel and meal expenses. However, it can be more difficult to evaluate if a supply was “used in the conduct of qualified research” and therefore includable in a R&D Credit claim.
Two key factors to assess are the intent of the work the material was used for and if there was technical uncertainty present in that work. We look to see if the material was used to create a prototype to test and evaluate, perform a trial run of a process, or otherwise be a part of a process of experimentation. Then we must determine if there was uncertainty in the outcome as opposed to the materials being used to create a product for sale after the uncertainty has already been resolved. These factors go hand-in-hand with each other, and both should be present for any supplies QREs that are included in a R&D Credit claim. It is important to note that it is possible to include materials as supplies QREs even if they are later sold to the customer, as long as the original intent of the material was to resolve technical uncertainty. Common materials that can be categorized as qualified supplies include laboratory supplies, machined and electrical components, 3D printing filament, raw material, and hardware.
Additionally, it is also important to isolate the supplies used only for the portions of the project containing uncertainty. If an improvement is being made to an existing product, only the materials for the subcomponents that are new or improved should be considered as supplies QREs. If the material is not being used as part of a process of experimentation to resolve technical uncertainty, it is unlikely to qualify and can lead to inflated QREs and additional scrutiny on a R&D Credit claim.
An essential aspect to preparing a defendable R&D Credit claim is proper documentation of expenses. In order to substantiate supplies QREs, businesses must be able to tie material purchases to specific qualified research projects and identify the purpose of the supplies. Furthermore, the invoices should be reviewed to determine if the purchase was for materials or components for a prototype versus payments for services that would be more accurately classified as contract research. A single invoice may contain payments made for both expense types and these amounts should be carefully categorized. At McGuire Sponsel, we regularly consult with our clients to create and refine processes to contemporaneously track and account for qualified supplies expenses.
In our experience with the IRS and state Departments of Revenue, supplies QREs receive significant scrutiny and must be backed by sufficient and detailed documentation to justify inclusion. At times when working with new clients that have transitioned from other providers, we find that the methodology for calculating supplies QREs is lacking or completely missing substantiation leading to overstated QREs and a claim that is difficult to defend in full. Taxpayers should be cautious in their consideration of what supplies expenses to include in a R&D Credit claim and cognizant of the methodology and documentation supporting those figures.
If you have any questions about what supplies expenses to include in a R&D Credit or McGuire Sponsel’s approach to R&D Credit claims, do not hesitate to reach out.