Let's delve into the crucial step of gathering information for your R&D tax credit study, specifically focusing on the documentation needed for W2 wages and contractor expenses. This stage is all about building a solid foundation for your claim, ensuring that every expense you include is well-supported and meets the IRS's stringent criteria. Think of yourself as a meticulous detective, collecting evidence to prove your case.

1. Gathering Documentation for W2 Wages for Qualified Services

When it comes to W2 wages, your primary goal is to identify the portion of employee salaries that directly relates to qualified research activities.

Here’s how you'll approach gathering this documentation:

• Start with the Core Payroll Records: You'll want to obtain final calendar year or payroll reports for the credit year. The key here is to specifically capture the Box 1 W2 wage .

  • Why Box 1 W2? For R&D tax credit purposes, "wages" are defined as amounts subject to income tax withholding. This includes regular wages and bonuses. It's important to remember that contributions to qualified pension and profit-sharing plans (like 401(k)s) or non-taxable fringe benefits are not included in qualified wages.

2. Gathering Documentation for Contract Research Expenses

For contractor costs, your objective is to identify payments made to third parties for services that, if performed by your employees, would be considered "qualified services".

Here's what to collect and why:

• Initial Identification: Start by examining your General Ledger (GL) detail for accounts related to professional services or review your 1099s for the credit year. These documents help pinpoint payments to external contractors.

• Supporting Contracts and Invoices: Once potential contractor payments are identified, you need to dig deeper into the specifics.

  • Contracts: Meticulously maintain agreements with third-party contractors involved in R&D projects. These contracts are critical because they must demonstrate two key aspects for the research to qualify:

    1. Economic Risk: The agreement must require your company to bear the expense even if the research is not successful. Payments contingent on the success of the research are considered payment for the product/result, not the research itself, and generally do not qualify. The IRS looks for evidence that the taxpayer assumed the risk.

    2. Substantial Rights: Your company must retain substantial rights to the research results. This means you must have the right to use the knowledge discovered in the course of the research (e.g., in developing other products) without additional payment or authorization from the third party. Even non-exclusive rights can be considered substantial.

  • Invoices: Keep detailed records of invoices and payments to third-party contractors. These help verify the actual amounts paid.

General Documentation Principles

To ensure a smooth R&D tax credit study and be prepared for any potential IRS inquiry, always remember these overarching documentation principles:

• Meticulous Record-Keeping: The IRS emphasizes that the burden of proof lies with the taxpayer. This means every claim you make needs strong, clear support. Establish a proactive documentation process throughout the year, rather than scrambling at tax time.

• Contemporaneous Records: While not always possible, aim for "contemporaneous documentation" – records created during the research process. This strengthens the credibility of your claim.

By diligently gathering and organizing this information, you'll be well on your way to substantiating your R&D tax credit claim.