R&D Tax Credit
Research and development activity receives two types of beneficial treatment within the tax code. The first is deduction. The creation of intellectual property by research and development is a capital asset, and would generally be amortized over a 15-year period. An election under IRC Section 174(a)(2)(A) can be made to expense your research and development expenditures in the year they are paid or incurred. The election to expense does not need to be made in a formal manner. It is only necessary that the taxpayer expense its research expenditures on its return.
The second benefit offered to research activity within the code is the Research and Development Tax Credit(s) offered in IRC Section 41. The calculation of the credit is complex, but will usually result in a tax credit of approximately 8% of the taxpayer’s qualifying expenses. However, the amount of expenses used to determine the credit cannot also be deducted for the determination of taxable income, unless an election is made according to IRC Section 280C(c)(3)(A). This election allows for the full deduction of expenses used to determine the credit, but also reduces the credit by 35%. This option is best for companies (or owners of pass through entities) who are subject to the highest tax rates. Thus, the taxpayer receives full deduction of the expenditures and approximately a 5.5% tax credit.
Qualifying Activities
The definition of qualifying research is very subjective. It has been defined and redefined by Congress, and interpreted by the IRS and US courts in different ways depending on the circumstances. In general, IRC Section 174 defines qualifying research as activities that “eliminate uncertainty either about the capability or method of developing or improving the product or about its appropriate design.” Note that the term ‘product’ also includes components of products.
Few examples exist in instructions or publications to help you determine if your activity is qualifying research. The preamble of the IRS 2003 proposed regulation 1.41-4(c)(10) includes the following two examples of non-qualifying and qualifying activities:
A rail car manufacturer customizes passenger rail cars for a particular customer that wants fewer seats and higher quality seating material and carpet. The rail cars were not new business components but only an adaptation of existing business components, which did not require a process of experimentation.
A manufacturer purchases existing robotic equipment and modifies it. In modifying the equipment, the company’s engineers identify technological uncertainty concerning the modification of the existing robotic equipment, develop alternative designs, conduct experiments using modeling and simulation, and engage in extensive scientific and laboratory testing of the design alternatives. The manufacturer’s activities to determine how to modify the robotic equipment are not an adaptation and do qualify for the credit.
Unfortunately, these two examples represent two extremes. They do little to help taxpayers narrow the definition of qualifying activity. Taxpayers should not assume that, because their activity does not mirror the circumstances the second example, it would not qualify. Instead, these examples should be regarded as boundaries. All activities which fall between them could possibly be considered qualifying and should be examined based on their similarity to cases interpreted by the courts.
The courts have offered a greater range of interpretation – occasionally conflicting – on the definition of qualifying research. Many of the cases offer in-depth analysis of the standards of research in specific industries (most notably, the software industry.) If you are uncertain if the engineering or design activities engaged in by your company would qualify as research and development, contact MRO for an analysis of your qualifications.
Qualifying Expenses
If your activities qualify, the expenses that can be used for the determination of credit fall into two categories:
In-house research activities, and
Contract research expenses.
In-house research expenses consist of the sum of the following three types of expenses:
Wages paid or incurred,
Supplies used, and
Computer leases.
An exact determination of which wages and supplies qualify must be made on a case by case basis. In general, wages and supplies expended in the direct performance of research and development qualify; indirect expenses do not.
'Contract research expense’ equals 65% of any amount paid or incurred to persons who are non employees for the performance of either (1) qualified research, or (2) services that would constitute qualified services if performed by employees of the taxpayer (IRC Section 41(b)(3)(A)).
Documentation
Successfully claiming the credit is dependent on appropriate documentation. Due to the highly subjective nature of determining if activities qualify as research, the IRS prefers to attack on the non-subjective front of documentation. Failure to adequately document your activities will cause your credit claim to fail regardless of how well qualifying the nature of the activity is. The majority of IRS court victories against taxpayers have been in cases where the IRS attacked the taxpayer’s documentation. (Historically, in highly subjective tax matters, the IRS prefers to avoid court cases that would set precedent, and ultimately narrow the amount of subjectivity. This is because the majority of taxpayers are averse to the risk associated with subjective positions and will defer to the IRS position. Therefore, in most cases the IRS benefits from the maintenance of subjectivity in the interpretation of tax law.)
The most common method of documenting research activities is by employee surveys. At the end of the year, employees are asked to complete surveys which requires them to estimate the percentage of their time spent on qualifying research activities. This is the weakest method of documentation, and will place your credit at risk of being reversed in audit or partially reversed in appeals court. First, the hours used to determine the credit are based on approximations, not on actual accumulated data. Second , the surveys are not contemporaneous records (contemporaneous records are created at the time of the event, not after the fact). Non-contemporaneous documentation of activities frequently fail in court. Third, and most importantly, surveys frequently fail to document the four essential elements that qualify the activity as research.
Ironically, most companies collect the data necessary to implement an ideal documentation system for the credit, but continue to use the weaker survey system. Most companies have cost data collection systems where engineers allocate their time to jobs or projects by activity code. One of these activity codes is (or should be) research. Only two additional steps need to be taken to develop an iron-clad system of documenting research hours.
First, the engineers and staff must be educated about which activities qualify as research. Second, according to the frequency of your company’s payroll cycle, the employees who reported research activity in each pay cycle must submit research worksheets accounting for all of the research time reported. The research worksheets are relatively simple. Typically, one research worksheet is completed per job worked on in each cycle.
The worksheets ask four questions:
Description of product or component,
Description of uncertainty regarding the development of the product or component,
Description of the alternatives, and
Description of the process used to evaluate the alternatives.
The total hours reported on all sheets for that employee should equal the total research hours reported for that employee in the payroll data for that period. The total of all employee sheets should equal the total research hours reported at the company level for that period. Many companies require the payroll department to verify the existence of the supporting documentation when preparing the payroll. The records are usually saved electronically with project files and payroll files. The dates the files are originated and saved (metadata) prove that they were created contemporaneously.
Some companies use spreadsheets for the accumulation and documentation of the worksheet responses. If a mass spreadsheet is used to accumulate a year’s data, the revised spreadsheet should be saved as a new file every week (not saved over the previous week’s file) to prove that the data was accumulated in a contemporaneous manner. Many companies and engineers prefer the spreadsheet worksheet to completing a separate word file for each project because of the ease of copying responses from old periods to new periods for projects that cross multiple payroll periods, or for engineers who do essentially the same manner of research on many projects.
Completing the worksheet also helps the engineer determine if the particular activity qualifies for the credit. If there is no uncertainty to describe, or if there was only one alternative, then the activity does not qualify. However, if the engineer can answer all four questions, then the activity probably qualifies as research.
Summary
The keys to benefiting from the Research and Development Tax Credit are identifying qualifying activities in your company, and having effective documentation systems in place to defend your credit claim. The cost of implementing these steps is typically a fraction of the tax credit available. Contact MRO today to implement this opportunity for your company.
Brian Murray
Brian has been in public accounting since 1997. Prior to that he was in finance at Kimberly-Clark Corp., audit at M&I Bank Corp., and accounting manager at Browning-Ferris Ind. Brian’s areas of specialty are estate and trust tax and business valuation.