Overview:
Over the course of a taxpayer’s research and development activities, they may encounter expenses for “failed prototypes or projects”. Wages, contract research and supply expenses incurred to develop and construct the prototype are qualifying expenditures. When a taxpayer develops the prototype for a customer and does not obtain an ownership interest in a prototype, all of the cost incurred by the taxpayer to develop the prototype are qualifying expenses as long as the taxpayer’s compensation for services is contractually subject to performance guarantees relating to the prototype. Also, when a taxpayer pays a third party to develop a prototype and does not obtain ownership interest in the prototype, all of the cost incurred by the taxpayer to develop the prototype are qualifying.
As with any costs claimed for the R&D credit, it is important to gather documentation supporting the costs included in the credit calculations. In order to sustain R&D supply costs upon IRS examination, taxpayers should have documentation showing how they used the supplies in their R&D efforts and be able to show that the supplies were not property of a character subject to depreciation.
When a taxpayer develops a prototype that is later scrapped, he or she is not creating a depreciable property, and therefore the cost paid or incurred to create the scrapped prototype are deductible expenses under IRC Section 174. When the taxpayer develops the prototype for a customer and does not retain ownership interest in the prototype, all of the costs incurred by the taxpayer to develop the prototype are qualified expenses if the taxpayer provides its customer with performance guarantees relating to the prototype.
Section 174 generally permits a taxpayer to deduct research and experimental (R&E) expenditures that are paid or incurred during the taxable year in connection with his trade or business. Pursuant to section 1.174-2(a), research and experimental expenditures are costs that are incurred in connection with the taxpayer’s trade or business, which represent research and development costs in the experimental or laboratory sense, including all such costs incident to the development or improvement of a product. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. A product, in relevant part, includes pilot models. According to section 1.174-2(a), a pilot model is a representation or model of a product that is produced to evaluate and resolve uncertainty.