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 the Healthcare sector and what activities and business practices are eligible for R&D Credit inclusion.
When identifying potential R&D Credit opportunities with alliance CPA firms, we find it useful to stratify businesses into different sectors and industries to determine where good opportunities may be present as this varies across industries. One sector that is ever evolving and therefore ripe with R&D activities is healthcare. However, in recent years we have observed many misconceptions regarding what activities and business practices are eligible for R&D Credit inclusion.
Certain industries within the medical and healthcare sector are frequently conducting R&D activities, such as pharmaceutical and medical device development. When a company is developing a novel product or a new application for an existing product, technical risk and uncertainties will usually be present. In these instances, it becomes important to consider if the taxpayer is bearing the economic risk of the project to ensure it is not considered funded research as defined by §41(d)(4)(H), because it is common for these projects to receive government grants or other financial backing. The presence of a funding mechanism is not an immediate disqualifier, but a review of the contract(s), grants, or any other documentation is necessary to ensure the party that holds the economic risk and retains substantial research rights correctly claims the R&D Credit.
During the last few years, we have fielded numerous questions on whether general medical and dental practices can claim the R&D Tax Credit. This is compounded by some providers aggressively pushing medical practitioners into making risky claims with inflated qualified research expenses. While certain taxpayers may be conducting qualified activities, we have seen misconceptions about whether or not common or routine procedures meet the qualifications of the R&D Credit. An R&D Credit eligible project must contain technical uncertainty that can only be resolved through experimentation, and in general, routine care or common procedures do not rise to the technical uncertainty required to satisfy the technical uncertainty test. For example, if a dental practice creates a custom set of dentures there is unlikely to be significant enough technical uncertainty to meet the four-part test. Just because the product being created is custom for a specific customer does not mean it meets the R&D Credit qualifications; in fact this would be a classic example of the Adaptation Exclusion. However, if a medical practitioner is developing a novel procedure, new/improved medical device or product, or a custom solution that requires multiple iterations to successfully execute, then the project may satisfy the R&D Credit criteria.
Additionally, it would be prudent to examine the extent of resources dedicated to these types of activities each year. If only one or two minor projects are present, the claim may not generate a meaningful return as only qualified expenses related to those projects would be eligible for inclusion in the R&D Credit calculation. But if significant resources, including employees’ time, are invested in developing new products/procedures or research-intensive custom projects are a regular occurrence, then the R&D Credit would be worthwhile for a medical or dental practice to explore.
Another industry within the healthcare sector where we are seeing significant R&D investments is the development of healthcare-based software applications. This can take many forms, whether full scale Electronic Health Record (EHR) systems, administrative/HR systems, or specialty applications. Beyond assessing the technical risk and economic risk of the project, additional requirements must be met if the developer is intending for the software to be for internal use. The software being developed must meet a high threshold for innovation and not be readily available as a “off the shelf” solution. For example, if a hospital system is developing or implementing a new scheduling system, there must be some functionality or custom improvement that differentiates the application from a standard solution that is readily available in the market.
Businesses within healthcare industries are constantly changing to develop and implement new technologies for improved patient care and operational efficiency. This presents a significant opportunity for these taxpayers to claim the R&D Credit but also presents many questions on the correct application of the tax code and regulations. Decision makers and CPAs should carefully evaluate the businesses practices of healthcare companies and the details of the credit qualifications when considering whether or not to pursue the R&D Credit.
If you have any questions about the R&D Tax Credit qualifications or McGuire Sponsel’s approach to R&D claims, do not hesitate to reach out.