Wages have the biggest effect on how much or how little credit a company can generate. In most cases, wages are the biggest single qualified expense category for most taxpayers. In order to determine how much of your total wage pool would qualify for the credit, you need several things:
- Name
- Job Title
- State
- W2 Box 1 Wage
- Qualified Percentage of Time.
Form W2
The only wages qualifiable for the credit are W2 Box 1 wages. Below, you can find a sample W2 form:
Form W-2
For Partnerships (From 1065) filers, you are also able to capture guaranteed payments as wages which can be found on the Schedule K-1 Box 4a of each individual in the ownership group.
Schedule K-1 (1065)
State
As far as the biographical data is concerned, everything is straight forward with the exception of the State field. This is NOT the state of residence of the employee (though if you utilized Smart Payroll Connect this will be the default populated value), it is where the employee performed significantly all of their research. For instance, if my company was based in California, and my employees lived in Nevada but commuted to work every day, then I would list them as being in California by populating the State field with a CA. However, if my company was based in California, and half the employees worked from home in Nevada, I would input NV into the State field for those employees who worked from home in their state of residence.
Important
The State field is for denoting where a specific employee performed their qualifying activities, NOT where they reside.
Qualified Percentage of Time
In order to determine an employee’s qualified percentage of time, the first step is to analyze what Business Components they worked on over the year. The term “business component” means any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer (I.R.C. § 41(d)(2)(B)). For instance, if you are a software company that develops a SaaS platform, your business components may be individual modules of that platform. If you are a manufacturing company, your business components may be the various families of products that you design and mass produce.
Important
Development work that is done on behalf of a client only qualifies if that client is paying for the work on a fixed fee contract. Any hourly agreements cannot qualify for the R&D tax credit.
Once you determine the number of qualified business components that you are actively developing, you begin analyzing how much time an employee spends conducting qualified activities. For instance, if my software company has two (2) SaaS platform products and my lead developer spends 50% of their time designing code and conducting code reviews for Product A and 50% of their time doing the same for Product B, their overall qualified time would be 100%.
Important
Any activity that occurs outside the United States is non-qualifiable.
Generally, most R&D activity will happen within the specific phases of your company’s development process and usually end when all technical uncertainties are overcome. Below, is a common product development life cycle we might see at a software development company.
At a manufacturing company, the process is similar.
Below is a table with examples of qualifying activity along with a description. Please use this as a reference in conducting your analysis.
|
Qualified Activities |
Description |
|---|---|
|
Computer Simulation & Modeling |
Developing computer software models and/or analytical tools for analysis purposes or solving technical problems. |
|
Conceptual Development |
Developing concept drawings/prototype details, preparing performance calculations, determining material/component requirements, etc. |
|
Design / Code Review |
Review and analysis of engineered designs and/or software code. |
|
Equipment Programming |
Development of programs for production equipment utilized in pre-production runs. |
|
Patent Research |
Assisting with patent applications, including patent research and preparation of documentation; not including legal or filing issues. |
|
|
Work regarding patent applications such as patent research and preparation of documentation; not including legal or filing issues. |
|
Product & Process Development |
Conducting hands-on research and development activities associated with new or improved products or manufacturing processes. |
|
Prototype Development |
Design, fabrication, and/or assembly of prototypes, pilot models, first articles, and/or samples for validation. |
|
Quality Assurance |
Development of Quality Assurance processes designed to validate new products and/or processes. |
|
Scale to Full Production |
Problem-solving relating to scale-up of new products to full-scale production. |
|
Software Development |
Developing computer software for sale or licensing to external parties (e.g. SaaS platform). |
|
Software Development Tools |
Developing computer software for internal non-business-related functions (e.g. scripts developed for automated testing of code, programs developed for new production processes, etc.). |
|
Specifications & Requirements Definition |
Work relating to the development of performance parameters and specifications for new or improved products and/or manufacturing processes. |
|
Design |
Developing designs using engineering and/or computer modeling. |
|
Technical Project Management |
Direct supervision of employees developing new or improved products and/or manufacturing processes. |
|
Technical Project Support |
Participating in R&D activities such as preparation of data and reports, product/process demonstrations, meetings and presentations, etc. |
|
Technical Project Support |
Providing technical support (e.g. code review, subject-matter expertise, etc.) to employees carrying out qualified R&D activities. |
|
Technical Sales |
Conducting application engineering work such as preliminary computations and concept development in support of sales team. |
|
Testing & Validation |
Conducting tests and/or analyzing new or improved products and/or process systems. |
|
Tooling Development |
Work relating to the development of tooling, fixtures, jigs, molds, casts, etc. |
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