Earmark CPE

Earn CPE Anytime, Anywhere

Tax Strategy

The R&D Credit Reality Check Every Tax Professional Should Understand

· ·

Picture this: A small business owner walks out of a networking event buzzing with excitement. Someone just told them about the Research and Development tax credit. They’re already mentally calculating how much they’ll save on the custom software they’ve been developing for their consulting practice.

This scenario happens all the time, and it shows the gap between what business owners expect and what the tax code actually delivers. In this episode of Tax in Action, host Jeremy Wells, EA, CPA, breaks down one of the most misunderstood areas of tax law: the Section 41 Research and Development Credit.

The Credit That Sounds Simple But Isn’t

When clients first hear about the R&D credit, they focus on that appealing 20% credit for increasing research activities. It sounds straightforward: spend money on research, get 20% back as a tax credit. But as Wells explains, this credit is much more complex.

“I work with a lot of small service-based businesses,” Wells says. “So it doesn’t come up a lot in my practice, but there have been some cases where we’ve had businesses qualify for the credit, and that’s always a little exciting for me.”

That excitement comes after navigating through layers of complexity that immediately separate hopeful applicants from actual recipients.

Section 41 actually has three different parts: qualified research expenses, basic research payments, and Energy Research Consortium credits. For most businesses, only the first part matters. The basic research component applies to research without specific business goals, which Wells dismisses for his small business clients. “If they don’t have a business goal, they probably are not going to be able to afford to pay me for very long.” The energy research component targets massive global energy companies, not typical clients for most tax professionals.

Here’s where the “20% credit” gets misleading. It’s not 20% of research expenses. It’s 20% of the excess of qualified research expenses over a “base amount.” This base amount calculation is complex, but for most businesses, it defaults to 50% of qualifying research expenses.

Wells breaks down the math: “In general, we’re looking at 50% of qualified research expenses and then we’re taking 20% of that.”

The result? What sounds like a 20% credit actually delivers roughly 10% of qualifying research expenses as an actual tax benefit.

But even this 10% assumes businesses can navigate the qualification requirements, which proves much harder than the math.

The Science Requirement That Trips Up Most Businesses

The real barriers come from qualification requirements that act like scientific gatekeepers. Wells identifies the core problem: “This is probably the strongest limitation on what qualifies for research relevant to my clients. The research has to involve a process of experimentation that relies on the principles of either the physical or biological sciences, engineering or computer science.”

This creates an immediate disconnect. When most business owners think about research and development, they think of any effort to improve their operations: better customer service, more efficient workflows, or custom software. But Section 41 demands genuine experimentation rooted in hard sciences.

The “process of experimentation” adds another hurdle. Wells explains that this process “evaluates one or more alternatives to develop or improve a business component where the result was uncertain.” This isn’t about having a clear goal and executing a known path—that’s implementation, not research. True qualifying research requires genuine uncertainty about whether proposed alternatives will work, plus systematic testing of multiple approaches.

This eliminates entire categories of business activities that feel innovative but don’t meet the technical standards. Market research, customer satisfaction studies, workflow optimization, and business process improvements all fall outside the boundaries. As Wells states, “If your research consists of trying to understand your customers better, that’s not going to qualify as research.”

Software development faces even tougher standards. Internal software must pass what Wells calls “a very high bar” through the high threshold of the innovation test. This test requires proof of “substantial and economically significant” improvements, backed by “significant economic risk” where the business commits “substantial resources” with genuine uncertainty about recovery.

The economic risk part proves particularly challenging for small businesses because it excludes what Wells calls “sweat equity.” He explains, “What doesn’t count here, is that sweat equity, or the time spent by the business owner, or the uncompensated work by their partners, or even their staff.”

This requirement for actual cash rather than time investment doesn’t align with how most small businesses operate. The solo consultant developing custom software or the manufacturing business owner optimizing processes typically invest primarily time and expertise rather than substantial cash. Under Section 41, this automatically disqualifies them.

Making It Work: Expenses, Strategies, and Professional Help

For businesses that navigate the scientific requirements, the wage allocation requirements immediately complicate things for any business hoping to qualify through employee efforts.

Wells explains the 80% rule: “If you’ve got some sort of support staff spending at least 80%, four out of five working days a week directly involved in that research project, then their wages qualify in full.” Anything less than 80% requires careful splitting between research and non-research activities.

This gets trickier with executives. Wells has seen businesses try to claim big portions of C-suite wages for research. However, even technical CEOs who contribute to research projects rarely abandon their executive duties entirely. Wells says practitioners must “look at bifurcating, if not entirely writing off, their wages and salaries as not related to the actual research project itself.”

For businesses without internal research capacity, contract research offers an alternative, though with percentage limitations that reduce the effective credit rate. The general rule allows only 65% of contractor payments to qualify, though this increases to 75% for qualified research consortia and 100% for eligible small businesses, universities, or federal laboratories.

Wells breaks down the math for businesses relying entirely on contractors. “If all the qualifying research expenditures are paid to contractors, then we only get about 6.5% of those expenditures in terms of the credit.”

Despite this reduced rate, Wells suggests the contractor route might be easier than internal allocation headaches. “It might also be more advantageous to pay contractors and be able to take 65% of what’s paid to contractors than to worry about taking existing staff and trying to allocate some of their work toward the research project.”

Wells also highlights the payroll tax election as a cash flow strategy for startups. Rather than waiting years to use R&D credits against income taxes, businesses can elect to apply credits against the employer’s 6.2% Social Security tax, creating immediate benefits.

Given all this complexity, Wells strongly recommends working with specialists. “Finding a good, reputable firm to work with or to recommend and refer your clients to. But in general, it’s important that you understand the basis and the basics of section 41.”

Busting Common Myths

Wells addresses two common misconceptions about the R&D credit.

First, that service businesses automatically don’t qualify. While most service businesses won’t qualify for traditional reasons, Wells suggests this shouldn’t lead to automatic dismissal. “It might be possible to advise them in such a way to help them qualify for it, at least in part.” This might involve outsourcing research to qualified contractors, developing products for eventual sale rather than purely internal use, or ensuring research projects involve genuine experimentation rather than predetermined paths.

Second, that payroll is required. Wells points out that contract research expenses can qualify, even if at reduced percentages. While the effective rate drops for businesses using only contractors, “that might be better than nothing,” and “better than thinking that it has to be payroll and therefore nothing qualifies.”

The Bottom Line for Tax Professionals

The Section 41 R&D credit shows how well-intentioned tax policy is accessible primarily to those with sophisticated professional guidance. What sounds like a straightforward “20% credit” turns into a technical challenge that eliminates most hopeful applicants.

For tax professionals, understanding complex credits isn’t just about technical knowledge; it’s about managing client relationships and setting appropriate expectations. The practitioner who dismissively tells clients they don’t qualify without understanding restructuring possibilities doesn’t serve the client well. But the advisor who raises false hopes by oversimplifying requirements creates bigger problems.

Listen to the full episode of the Tax in Action podcast for Wells’ full breakdown of Section 41. His practical approach helps practitioners distinguish between realistic opportunities and unrealistic expectations while serving clients’ best interests.

The R&D credit may be complicated, but understanding its complexities opens doors to legitimate opportunities.

Why S Corporation Elections Backfire More Often Than You Think

· ·

Early in his accounting career, Jeremy Wells, EA, CPA, landed what seemed like the perfect client: a newly independent contractor drowning in tax debt to both the IRS and his state agency. Within just a couple of years, Wells helped transform this financial disaster into a success story. Through strategic S corporation planning, proper bookkeeping, and careful tax planning, his client went from owing thousands to receiving small but satisfying annual refunds.

The S corporation election was absolutely the right move. But Wells emphasizes that this was the right client at the right time, with the right circumstances.

In a recent episode of Tax in Action, “S-Corporation Reality Check,” Wells examines the oversimplified advice flooding social media feeds and startup marketing campaigns. While countless online voices promise S corporation elections deliver automatic self-employment tax savings for any successful self-employed person, Wells sees this advice creating expensive problems for businesses that never should have made the election in the first place.

“There’s a cottage industry developing around this concept,” Wells explains. We’re in a perfect storm where remote work and the gig economy have created lots of successful self-employed people who need tax help, but there’s a shortage of qualified advisors who can provide proper guidance.

The reality is, while this cottage industry promises easy self-employment tax savings, the one-size-fits-all approach ignores critical deal-breakers that can transform a supposed tax benefit into a costly mistake.

Balance Sheet Red Flags That Kill S Elections

The cottage industry’s relentless focus on self-employment tax savings completely sidesteps fundamental balance sheet realities that can make S elections counterproductive or even trigger unexpected taxable events.

The most dangerous misconception involves debt basis. Unlike partnerships, where partners receive basis credit for their share of entity debt, S corporation shareholders get no such benefit unless they personally loan money to the corporation.

“I can go get a loan and intend to use the funds in my S corporation, but if I personally guarantee that debt, that is not me generating debt basis,” Wells explains. “I am not loaning money to my corporation.”

This distinction catches many business owners—and their advisors—completely off guard. The COVID-era Economic Injury Disaster Loans are a perfect example of this misunderstanding. Thousands of sole proprietorships took personally-guaranteed SBA loans and later elected S corporation status, only to discover that their EIDL debt provided zero debt basis benefit. When these businesses generated losses, shareholders couldn’t deduct them against other income because they lacked sufficient basis.

But there’s another trap buried in the S election process itself. When an LLC elects S corporation status, the tax code requires a two-step transaction that most people don’t understand. First, the LLC becomes an association taxed as a C corporation, then immediately elects S status. During that first step, a Section 351 exchange occurs where the entity’s assets and liabilities transfer to the new corporation in exchange for stock.

Here’s where it gets dangerous: if the business has liabilities exceeding assets—not uncommon for debt-heavy service businesses with minimal fixed assets—this exchange creates taxable gain. “We might be inadvertently generating a taxable event for that owner or those partners when they make that selection,” Wells warns.

The equity structure challenges run even deeper. S corporations demand a single class of stock, pro-rata allocations of everything, and pro-rata distributions with no exceptions. “All items of income, loss, deduction, gain and credits must be allocated to the shareholders pro rata based on their percentages of ownership in the corporation stock, and there are no exceptions to that,” Wells notes.

This inflexibility is particularly problematic for businesses planning future acquisitions. Many small businesses today are built with acquisition in mind—not just Silicon Valley startups, but local businesses designed to be attractive to buyers within three to ten years. S corporations complicate these plans because many acquisition entities aren’t qualified S corporation shareholders. Non-US entities, partnerships, and C corporations can’t own S corporation stock, forcing expensive workarounds.

This is why Wells always asks clients about their long-term goals: “We always have to plan with the end in mind, especially when it comes to equity.”

Operating Agreements: The Hidden S Election Killers

The S corporation promotion industry systematically ignores a fundamental reality: most operating agreements are legal landmines for S elections. Wells’ firm learned this lesson the hard way, which is why they now require operating agreements from all multi-member LLC clients before making any S election recommendations.

“We read through it and try to pick out these terms and concepts and potential red flags,” Wells explains. What they consistently find are documents written exclusively for partnership taxation under Subchapter K—documents that can directly contradict the rigid requirements of Subchapter S.

The most dangerous provisions involve substantial economic effect requirements under Section 704(b). Partnership operating agreements routinely include liquidation provisions requiring distributions based on positive capital accounts. This creates non-pro-rata distribution requirements that are perfectly normal for partnerships but absolutely prohibited for S corporations.

Wells has encountered operating agreements that explicitly prohibit S elections, containing language like “this LLC will always be a partnership for tax purposes” or “the business cannot do any sort of corporate election.” Even more commonly, he’s seen agreements with waterfall distribution clauses that prioritize some members over others—a structure that violates S corporation pro-rata distribution requirements and can trigger inadvertent election termination.

Perhaps most problematic, Wells notes: “I have never seen an operating agreement in an original draft that listed out what happens if an S election takes place.” Most templates simply don’t consider the possibility, leaving businesses with agreements that actively work against their tax election goals.

Even operating agreements that appear silent on these issues often default to state partnership laws that can require non-pro-rata distributions. “If we have an operating agreement that doesn’t really cover these topics, that’s when state law intervenes,” Wells explains.

The solution requires proactive legal work that the quick-and-easy S corporation services don’t provide. Businesses need either revised operating agreements that explicitly allow for S elections or entirely new agreements written with tax flexibility in mind. This legal work might cost a few thousand dollars upfront, but it’s far cheaper than dealing with an inadvertent election termination that requires a private letter ruling or Tax Court intervention.

The Math Doesn’t Add Up: Hidden Costs and Incomplete Calculations

The S corporation promotion machine focuses entirely on self-employment tax savings while conveniently ignoring every other aspect of a client’s tax situation. This creates problems where businesses make expensive elections based on wildly inaccurate financial projections.

The most glaring flaw involves reasonable compensation requirements. “A lot of the estimates of tax savings with an S election just estimate reasonable compensation way too low,” Wells observes. “Those tax savings are not the result of the S election. Those tax savings are unreasonably low salaries being paid through those S corporations.”

It’s a mathematical sleight of hand. Of course, any advisor can eliminate 100% of self-employment tax by simply not running payroll to active S corporation shareholders. But this isn’t tax planning; it’s setting clients up for IRS problems down the road.

The Section 199A qualified business income deduction creates another calculation error that the cottage industry ignores. Higher reasonable compensation reduces the pass-through income that forms the basis for this valuable 20% deduction. As Wells explains: “We save a little bit of self-employment tax at the expense of a pretty significant deduction for a lot of small business owners.”

For many successful small business owners, losing substantial QBI deductions easily outweighs any self-employment tax savings from an S election.

State and local taxes deliver the knockout punch to many S election projections. Tennessee imposes a 6.5% tax on S corporations. New York City hits S corporations with an 8.85% rate. California charges the greater of $800 or 1.5% of net income. As Wells puts it, “Those taxes can wipe out any projected tax savings from an S election.”

A business owner in Tennessee could save $3,000 in federal self-employment tax only to pay $5,000 in additional state tax. The cottage industry’s federal-only analysis turns a supposed tax benefit into a $2,000 annual penalty.

The complications extend to asset transactions. S corporations create taxable gain when distributing appreciated property to shareholders, which is a problem that partnerships avoid. For businesses holding real estate or other appreciating assets, this difference can cost tens of thousands in unexpected taxes. That’s why Wells generally recommends not holding real estate in an S corporation.

Similarly, S corporations lose access to Section 754 elections that allow partnerships to step up the inside basis of assets when ownership changes. This valuable planning tool helps partnerships minimize taxes when partners sell their interests or inherit them. S corporations simply don’t have this option.

The Professional Alternative to Checkbox Solutions

The problems with S corporation election advice reveal a broader issue: complex tax decisions are being oversimplified into marketing soundbites. While the cottage industry profits from reducing professional judgment to self-employment tax calculators, tax professionals face a choice between participating in this race to the bottom or demonstrating why expertise matters.

“We need to seriously look at what that entity election will mean for the business today, in the future, and for the shareholders or partners themselves,” Wells says. This level of analysis requires understanding balance sheet implications, legal document conflicts, comprehensive tax calculations, and long-term business planning—expertise that can’t be packaged into a simple online service.

When clients arrive demanding an S election because “everyone online says it saves taxes,” the professional response isn’t to immediately comply or dismiss the idea. Instead, walk them through the complete analysis: balance sheet structure, operating agreement provisions, reasonable compensation realities, QBI impacts, state tax consequences, and future business goals.

This educational approach protects clients from expensive mistakes while positioning you as genuinely knowledgeable rather than just another order-taker. It creates long-term relationships built on trust and demonstrated expertise.

While the cottage industry promises simplicity, its oversimplified approach consistently creates far more complexity down the road. Inadvertent election terminations, operating agreement conflicts, unexpected state taxes, and acquisition complications all require costly professional intervention to resolve.

For tax professionals willing to master this complexity, the S corporation election presents both a professional responsibility and a market opportunity. Clients need advisors who can navigate the factors that determine whether an S election truly benefits their specific situation.

Good tax advice requires understanding the complete client situation, not just plugging numbers into a self-employment tax calculator. 

To hear Wells’ complete analysis and learn how to position yourself as the thoughtful alternative to the S corporation promotion industry, listen to the full Tax in Action podcast episode where he details the specific questions to ask and analyses to perform that separate professional advice from marketing-driven recommendations.

The Implementation Gap: Why Even Legitimate Tax Strategies Fail During Audits

· ·

What’s the biggest mistake tax professionals make? Great ideas that never get implemented. That’s according to Jasmine DiLucci, a tax attorney, CPA, and enrolled agent who has built an impressive following of nearly 500,000 YouTube subscribers by debunking viral tax myths on social media.

I sat down with Jasmine for a conversation on the Earmark Podcast. We kicked things off by discussing the issue of false information about taxes that spreads on social media. Jasmine also highlighted an even deeper concern: even legitimate tax strategies can face serious issues if implemented incorrectly.

Why Social Media Fuels Tax Misinformation

Jasmine says one reason so many “loopholes” and sketchy strategies go viral is that true tax expertise rarely gets posted online. Skilled professionals are busy running firms, while less experienced creators spread half-truths. This leads to flawed tips on topics like clothing deductions or marking up the inside of a shirt with a tiny business logo, all to claim a tax write-off.

The clothing deduction test is a great example. The test has existed for decades, complete with court rulings stating clothes are only deductible if they’re unsuitable for personal wear. But many influencers ignore this, telling people to slap a hidden logo on their regular clothes. As Jasmine points out, these strategies often fail in an audit. Taxpayers who rely on them risk penalties and extra scrutiny.

Implementation Over Theory: The Real Reason Plans Fail

For Jasmine, the greatest pitfall is the implementation gap—the space between hearing a tax idea, reporting it correctly on a return and documenting what was done. 

She highlights the short-term rental loophole as a perfect example. While the idea is legal, most filers never produce the logs, election statements, or rental agreements proving they qualify.

“If it’s not on the return that way,” Jasmine says, “then what did we just do? Nothing.”

Clients often pay thousands for big-picture “plans” but fail to handle bookkeeping or gather the right records. By the time they’re under audit, there’s no backup for the deduction. Those clients face costly disputes with the IRS, sometimes losing deductions they could have secured with basic documentation.

The Shift in Responsibility: Why Clients End Up Holding the Bag

Misinformation creates tension between clients and professionals. Many taxpayers see social media videos telling them they can write off anything. Then, when their tax expert says “no,” it causes conflict. Some preparers cave and let questionable deductions slide. Others keep warning clients but never clearly explain the “why.”

During an IRS audit, that defense of “my tax preparer said I could” means little. The IRS holds taxpayers responsible for their returns. Jasmine notes that low-level auditors sometimes miss legal details, so a wrong deduction might slip by. But if a client’s case goes to appeals or tax court, illusions fall apart without real support.

Bridging the Gap with an Integrated Service Model

Jasmine’s firm avoids the implementation gap by offering an integrated approach: tax planning, accounting, and preparation, all under one roof. She insists on year-round contact, keeping detailed records, and ensuring clients follow the steps for valid deductions. Her team also handles IRS resolutions, so she knows firsthand where taxpayers slip up.

Working with a single provider can prevent the “blame game.” Instead of paying one person for theory, another for the return, and a third for bookkeeping, Jasmine’s clients get everything in one place. This structure helps them stay organized, meet documentation rules, and rely on correct returns from the start.

Scaling Through Delegation and the Right Tools

While her integrated model works, Jasmine admits it wasn’t easy to build. She did almost everything herself early on—sales calls, tax returns, and marketing. Eventually, she found experts who could handle each function at a high level.

She also credits technology for streamlining processes:

  • Canopy for practice management
  • CCH for tax software
  • Calendly for scheduling
  • Slack for team communication
  • Superhuman for email management

For tax research, she recommends the Bradford Tax Institute because it clearly cites legal authority. She warns that AI chatbots sometimes invent court cases, so relying on them can be risky.

Join Jasmine’s Free Community

Jasmine welcomes taxpayers and fellow professionals to her free tax community at actualtaxlaw.com. There, she shares detailed answers about IRS notices, audits, and new tax updates. Users can post questions or upload documents for possible video reviews.

Earn Free CPE for Listening to the Episode

Tax ideas don’t save you money if you don’t implement them correctly. Closing the gap between theory and execution can shield taxpayers from costly audits and give professionals a clear advantage. Whether logging short-term rental days or documenting a true business expense, proper follow-through matters more than any buzzworthy trick.

If you’d like to hear the full interview and gain more insights on best practices, listen to the full episode of the Earmark Podcast. You can also earn free NASBA-approved CPE by registering for the course on the Earmark app and taking a quick quiz to verify your learning.