Innovation, oversimplification and a race to the bottom - A buyer’s guide to selecting an R&D tax credit service provider (Part 1)
Choosing an R&D tax credit service provider can be challenging for any company looking for help with claiming their R&D tax credit. This may sound counterintuitive, but a big reason for this is the fact that there are so many service providers out there and many companies looking to select a provider often view the R&D credit service itself as being some sort of commodity whereby the services offered from the various providers are essentially equivalent. Let’s call this the market parity fallacy.
And this belief is understandable. After all, hasn’t the federal R&D credit been around for well over 40 years now? And isn’t it reasonable then for one to assume that broad consensus has already been achieved in terms of how any given company should go about successfully claiming and sustaining their credit? Yes.
And the interesting thing is that, by and large, that broad consensus has actually already been achieved. And today the R&D service offering landscape has never been more exciting with many new entrants that have brought with them new innovative ways to leverage technology to make the process simpler for the user and in some cases even offer a more defensible solution at the same time. And while we do not want to minimize the innovative contributions made of late, the reality is there are some providers who (for reasons we cover below) simply choose to ignore the broad consensus standards opting instead for something that is quick and easy, but that importantly lacks the substance required by the IRS. Let’s call this the current market imbalance.
The purpose of this article is to summarize the current state of the R&D tax credit service provider market and identify the three categories of service providers operating in the space.
What this article is NOT: This article is not intended to be some sort of self-serving bashing of any specific providers or to explicitly recommend one provider over another. To be clear, there are service providers in each category that embrace some or even all of the broad consensus standards and some that simply do not. Our goal here is to be helpful to the reader, so the calling out of any specific providers would in our opinion detract from that objective.
Intended audience: This article is written primarily for the benefit of: (1) the taxpayer (the “buyer of the services''); (2) the tax preparer who signs-off on the tax returns (and therefore needs to be comfortable with the R&D tax credit claimed); (3) other trusted advisors that routinely recommend R&D service providers be used in the first place; (4) other R&D tax credit service providers; and (5) providers who are considering entering the market. Understanding and acknowledgement of the current state of the market is vital for each of these audiences to ensure there is proper awareness of the market imbalance that currently exists and to hopefully lift the expectations of all providers operating in the space. While we embrace innovation wholeheartedly, such embrace should be done while also regarding substance.
The current state of the R&D tax credit service provider market
It has been an exciting past few years in the R&D tax credit service offering space. We have seen many new service providers enter the market, bringing with them fresh new ways of servicing the R&D tax credit customer. This new influx of innovation has reinvigorated the industry and has also sent a message to the traditional providers that they cannot simply rest on their innovative laurels.
However, one downside with this proliferation is that we have also seen a pattern of new entrants more or less replicating what they have seen other new entrants do. And that example has often conveyed something similar to the following:
“Buyers see R&D providers as offering more or less the same commodity. And buyers don’t even really demand substance anyway- what they really value is simplicity. And remember, these credits have a low risk of being audited, and there is a ton of money to be made here so let’s not overcomplicate things. Just need to create an intuitive user flow and include some guarantee on it to give the buyer some comfort and be on your way already.”
This is generally a bad thing for buyers in the short-run since they may end up paying hefty fees and essentially getting nothing in return. Which is generally a bad thing and why this message is so important. The good thing however is that, in time, such practices should naturally be recognized for what they are. The market has an amazing way of self-balancing.
But until then, the fact is that the R&D tax credit service provider market is not balanced. It is actually quite out of whack. This point is undeniable. For example, you have providers operating in the space charging exorbitant fees (sometimes as high as 30% or more) and there is generally no relation to the amount of those fees charged and the amount of effort it takes to calculate and document those credits. You also have a huge variability of what providers deem to be the “minimum bar” for what must be accomplished in order to adequately calculate and document an R&D credit so that it satisfies the IRS requirements. And that imbalance in our estimation will continue to deepen as long as it remains unchecked. As long as there are still providers operating in the space that are intentionally ignoring the substantive requirements (these broad consensus standards of which we will cover below), there will continue to be a critical need to call out this imbalance.
You may ask, how can this be? How are some service providers able to skimp on substance? (i.e. to simply choose to ignore the broad consensus standards in constructing their R&D tax credit service offering).
We see the following contributing factors:
There is a strong funnel feeding overall demand: Trusted advisors routinely suggest that their clients claiming the R&D credit (and rightly so) should use an R&D service provider (since the rules are complex, expertise is needed to calculate the credit). This ensures the demand for the service remains high, which new market entrants, and the VC’s that back them, love.
Pervasiveness of the market parity fallacy (i.e. that all service providers generally offer the same/similar service.). This typically leads to a mindset that says “what really matters is who provides the service cheaper and faster”.
Providers prioritizing “ease of use” as the primary value prop - above all else: Service providers pitching what can only be characterized as a misleading oversimplification of how much time it will or should take them to complete an R&D study - e.g. calculate your R&D credit with us in X minutes! This also has a secondary effect - when you see new entrants that are seemingly able to prop up a new oversimplified business model and then as a result even still more new entrants coming into the market and replicating that oversimplified model. Like begets like.
Providers offering an intentionally misleading guarantee: Service providers typically offer some sort of explicit guarantee backing the work they do (often structured in a way that is cleverly and intentionally misleading to insinuate some higher level of protection being given). The guarantee acts to mitigate any objections the buyer may have (whether raised or not) in terms of overall uncertainty with using the unfamiliar provider or to mitigate any perceived lack of substance in that provider's service offering.
Providers offering other “sweeteners”: Some attempt to add even more icing to the cake using other tactics such as offering some sort of cash advance on the value of the credit. The reason we see providers spending energy in trying to make this work is that offering some sort of cash advance or financing option can be like adding rocket fuel to their growth engine. However, not only can it be prohibitively expensive (we have not seen anyone really get it right), but another consequence of offering some sort of advance is that it typically increases the customer acquisition cost (“CAC”) so much so that it puts even more pressure on the provider to limit the level of service they can even build or offer.
Buyer’s affinity for the tech-driven R&D service providers that are doing something not dissimilar to their own mission (i.e. identifying an opportunity to disrupt and better serve a given market). This can lead to buyers identifying with the service provider (seeing them as “like us” or “insiders” or “in the know”), affording a level of trust from the buyer, even if that provider provides little or nothing of value.
The fact that the overall audit risk remains low: The likelihood of the R&D credit being examined by a taxing authority has been, and may continue to be, very low (likely in the low single-digits). This ensures the risk of offering the service remains low, which is another factor that new market entrants, and VC’s that back them, love and bake into their business model.
And it makes sense that this mix of factors would lead to exactly what we have today. Demand for the service remains strong; the perceived risk of audit remains low; and the buyer often sees the service offering as more or less a commodity- all of which essentially guarantee new providers to the space. New entrants can also feel emboldened by seeing service providers entering the market and offering up something of little value, and importantly seeing those examples as being relatively easy to replicate (and they generally are). In a simplistic way, all they think they have to do is build out some API’s (or not), create some fresh and simple UI flow, offer up some distracting guarantee, add additional sweeteners (to taste), and voila. You got yourself an R&D tax credit offering.
The value prop is often as simple as: “hey buyer, none of the other providers get it, but we are different, we are disruptors like yourself, and we built a better flow - it will take you less time and is more intuitive, here are all the people that trust us, and most importantly we have your back (guaranteed)”. Then it’s just about customer acquisition and then churning out these so-called “R&D studies” and continuing to scale exponentially. Again, this is a simplification, but the overarching storyline and motivations remain true.
And to be clear, the typical R&D tax credit service provider does invest in improvements, but those investments are invariably focused on improving the overall process, improving user flow, maintaining and improving stability of the overall system(s), improving management reporting capabilities, and in automating every last remaining routine/administrative task they can that was hitherto performed by a human initially out of pure necessity. And these improvements are necessary and all well and good, but the problem is they don’t directly improve the substance of what is actually being delivered to the client. It’s all about scalability and ease of use - above all else.
As a result, the mentality often fostered is driven by the mantra “keep it simple stupid”. Providers in the space often conclude that it doesn’t make any financial sense to invest precious time and energy in building out a process that does a better job of complying with the broad consensus standards. Especially when the risk of audit remains low and buyers often don’t even necessarily demand it in the first place. And even if providers did prioritize substance, it would create more friction in the user’s ability to get through the flow, and would also require more R&D tax credit subject matter expertise to unblock those users and get them through the flow. Which is also not scalable, let alone the fact that this requires bandwidth from a resource (R&D expertise) which may be in short supply in-house. So, some simply chose to keep it simple and not make any substantive attempt at embracing the broad consensus standards. But others do. As we see, not all service providers are built the same.
Now, let’s take a look at the three main categories of R&D tax credit service providers operating in the space.
The three main categories of R&D tax credit service providers
First, you have the early entrant - the traditional accounting firm that has a dedicated team of R&D tax credit specialists that employs a leveraged resource delivery model. Then, you have the boutique firm that focuses primarily on R&D tax credits and other cash tax savings incentives (and does not hold themselves out as a traditional accounting firm). Lastly, you have the pure tech platform player. The tech platform player is the most recent entrant to the market and has seen tremendous growth in the past few years, in particular since 2016 when the R&D tax credit was opened up to much wider audience (via the option to elect to treat the R&D credit as a payroll tax credit for Qualified Small Businesses (“QSBs”)).
To be clear, the use of these categories (like any other generalization) is a simplification to highlight the distinct types of providers you will find operating in the space. Use of these categories is also not intended to say that a tech platform player for example never informs their process or model with the input of a CPA that has deep subject matter expertise in the R&D tax credit. Nor is it to say that a boutique firm or a traditional accounting firm never leverages technology to create efficiencies in their delivery model. Nor is it to say that the traditional accounting firm is the only category that has any real legitimacy simply because that is where the R&D tax technical expertise originated.
Each category tends to have their own strong suits as well as some common shortcomings (i.e. none of these categories are inherently all good or all bad). To be clear though, the pure tech platform player, which has experienced significant proliferation as of late, is a category that has clearly demonstrated a tendency of oversimplification. Having said that, there are providers in each of these categories that take liberties or short cuts from time to time, just like the others. And we think an important realization here is that each category has the opportunity to learn from the others (all of them). This is perhaps the most important call to action inherent behind this article. And thus why it is critical to take an objective look at what each offers.
In our next article, we will explore each of these categories in more detail, discuss what each service provider category tends to do well and where they can fall short, and ultimately why you should care. We believe this is an important topic to explore in particular given the IRS’ recent push to require more substantive information to be included with any timely filed R&D tax credit position.
