In depth explanation of QRE's and what will qualify for the R&D credit
Once qualified research activities have been identified and qualified, the next step is to quantify the QRE. The three components of the R&D credit include wages, supplies, and contract research. Typically, internal wage expenses will be the largest component of the credit while supply expenses will be the smallest.
Wages
Wages are the credit driver for most companies. Wages are taxable income as reported on an employee’s Box 1 of Form W-2 and are paid to an employee who performs, directly supports, or engages in R&D. Note that if “substantially all” (80% or more) of an employee’s time is spent performing qualifying research activities, then 100% of the employee’s time is deemed to qualify.
IRC Section 41(b)(2)(D)(i) defines qualifying wages as “all remuneration (other than fees paid to a public official) for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid by any medium other than cash…”, less any amount taken into account in determining the work opportunity credit under Section 51(a).
Wages paid to an employee constitute in-house research expenses only to the extent the wages were paid or incurred for "qualified services" performed by the employee.
For purposes of IRS Section 41, the term “wages” means wages as defined in IRC Section 3401(a). This means all taxable wages as reported on Form W-2, including bonuses and stock option redemptions. It does not include amounts that are not subject to withholding, such as certain fringe benefits or non-taxed income, even if paid for research services performed by an employee.
IRC Section 41(b)(2)(B) identifies three types of qualified services that may qualify for the credit:
- Direct - engaging in qualified research
- Supervise – directly supervising qualified research
- Support – directly supporting qualified research
The term “direct supervision” includes the immediate supervision (first-line manager) of qualified direct research. The term does not include any higher-level manager (more than one level removed) to whom the first-line managers report, even if said manager is a qualified research employee. Treasury Reg. Sec. 1.41-2(c)(2) provides an example of direct supervision as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments.
The term “direct support” includes employees performing services in the direct support of either persons engaging in the actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research. Direct support does not include general and administrative services, or other services only indirectly of benefit to research activities. For example, per Treasury Reg. Sec. 1.41-2(c)(3)(ii), direct support of research includes the services of a secretary for typing reports describing laboratory results derived from qualified research, of a laboratory worker for cleaning equipment used in qualified research, of a clerk for compiling research data, and of a machinist for machining a part of an experimental model used in qualified research.
The majority of taxpayers that claim R&D credits do not have comprehensive time tracking. This is not an issue as there is ample case law to suggest that oral testimony backed by contemporaneous documentation is a perfectly reasonable methodology of allocating personnel engaging in R&D activities.
In McFerrin, a U.S. district court considered a research tax credit study prepared by a tax consulting firm. It concluded that the taxpayer had performed some QRAs, but it refused to accept the taxpayer's estimates given that there were no records of the hours worked by each employee or the hours worked on any qualified research project. It refused to accept employee testimony of the time spent on each project because it was based on 9-year-old recollections and was therefore not probative.
Cohan: The Cohan rule allows courts to make estimates where there is some indication that the taxpayer is entitled to the tax deduction or credit. This ruling was not specific to the R&D credit but has been upheld in every R&D case. This is where the use of estimations based on oral testimony is derived.
Absent a situation like the Trinity Industries case, where records are missing due to factors outside the taxpayer's control (hurricane Katrina), estimates should be avoided if possible. Any estimates should be used only if there is clear evidence that the taxpayer engaged in some QRAs as in McFerrin and there are other records to establish a reasonable basis for the estimates as in Fudim. This could help establish a foundation for the court to apply the Cohan rule to estimate the amount of the research tax credit.
Contract research
Ultimately, the party that bears financial risk related to qualifying research and retains significant rights to the research is entitled to the R&D credit. IRC Section 41(b)(3) defines qualifying contractor research expenses as “65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research”. Note that all contractor expenses must be domestically based.
In the event any contract research expense is related to qualified research and is to be conducted after the close of the taxpayer’s taxable year end, the expense shall be attributed to the period when the qualified research is conducted. Therefore, the prepayment of contract expenses are not qualifying expenses until the qualifying research is conducted.
IRS Treasury Regulations Section 1.41-2(e)(2) provides a three-part test for determining if the payment is for the performance of qualified research where a third party performs the research for the taxpayer. “An expense is paid or incurred for the performance of qualified research only to the extent that it is paid or incurred pursuant to an agreement that: (1) is entered into prior to the performance of the qualified research, (2) provide that research is to be performed on behalf of the taxpayer, and (3) requires the taxpayer to bear the expense even if the research is not successful. If the expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense is considered paid for the product or result, rather than the performance of the research and the payment is not a qualified research expense.”
Supplies
IRC Section 41(b)(2)(C) defines supplies as “any tangible property, other than land or improvements to land, and property of a character not subject to the allowance for depreciation”. Qualifying supplies expenditures are used in the conduct of qualifying research if they are used or consumed in the performance of “qualified services” by an employee of the taxpayer (or person acting in the capacity of an employee). Certain industries, such as software development, will generally have little or no qualifying supply expenses.
Some examples of qualified supply expenses (non-exhaustive) include:
- Internal prototype costs
- External prototype costs, such as coating, heat treating and machining
- Lab supplies used during testing
- Prototype equipment sold to customers
- Costs of prototype molds made for short-term use to test a product or process design
- Production molds, tooling or patterns used in research and sold to customers
- Material scrapped from experimental production runs
- Lab supplies used during testing
Some examples of ineligible (but commonly requested) supply costs include:
- Expenses used in general and administrative services
- Travel, meals and entertainment
- Relocation
- Rental or lease payments
- Professional dues
- Royalty or license expenses
- Server costs
- Subscription services
- Building materials cost
Supplies Case Law:
Trinity Industries: In a U.S. district court case, Trinity Industries Inc., No. 3:06-CV-0726-N (N.D. Tex. 1/29/10), the court held that the taxpayer (Trinity) is, in certain situations, entitled to the Sec. 41 research credit for qualified research expenditures (QREs) for activities relating to the design, development, and construction of new types/classes of ships. Trinity considered these first-in-class ships to be prototypes because the specific designs had never been previously attempted and, once validated and proven to meet their objectives, would be duplicated and commercially produced.
Because Trinity was not able to offer sufficient evidence for the court to determine QREs for a business component smaller than the entire vessel (Hurricane Katrina destroyed many of the records), Trinity adopted an all-or-nothing approach for each ship and applied the 80% threshold in Regs. Sec. 1.41-4(a)(6). Thus, Trinity would qualify for the research credit only if substantially all (80%) of the costs to build a first-in-class ship were QREs.
Because the first-in-class ships are essentially developed as prototypes, the court appears to conclude that the costs of materials used in developing and constructing prototypes may be qualified. The court did not seem to condition its conclusions about the qualification of costs in the development/construction of a prototype on whether the prototype is successful and eventually turned into a salable product.
Similarly, if the risk of failure is applicable to a prototype on a project basis, when activities are substantially all qualified (80% or more) under Sec. 41, nonexperimental costs, such as paint, could be included in the total qualified cost of the prototype.
Union Carbide Corp. v. Comm’r: the taxpayer (UCC), a manufacturer of plastics and chemicals, claimed R&D credits based on the development of new and improved production processes. The majority of QREs that the taxpayer claimed in the lawsuit were supply costs attributable to raw materials used in their improved production processes. These materials were ultimately manufactured into products and sold to UCCs customers and would have typically been considered costs of goods sold for accounting purposes. Essentially the taxpayer claimed all materials for all processes regardless of whether they were old or new products.
In reviewing UCCs allocated supply costs, the court held that the company’s claimed supply costs did not qualify under the law. UCC argued that because the law did not define the phrase “used in the conduct of qualified research” the words should be given their plain meaning and that UCCs use of the supplies was sufficient to qualify for the credit. The court disagreed, finding that the development of a new production process should be distinguished from the company’s product manufacturing and that UCC would have purchased the supplies used to manufacture products regardless of whether or not the company conducted the research.
TG Missouri: the taxpayer manufactured plastic molded products for customers in the automotive industry. In order to manufacture the products, the taxpayer designed and developed molds. In some instances, the taxpayer retained ownership of the molds and depreciated them. In others, TG Missouri sold the molds to its customers, thus removing them from the company’s accounting books, and retained possession of them to use in further research and to produce replacement parts. When the company sold the molds to its customer, it claimed the costs that it incurred for the molds as supply costs in calculating its research credit.
In November 2009, the U.S. Tax Court (TG Missouri Corp v. Commissioner, 133 T.C. No. 13) ruled that the definition of qualified supplies may include the purchase cost of production molds sold to a taxpayer’s customer. Depending on the facts and circumstances of the taxpayer, production molds that are not subject to depreciation by the taxpayer and no interest is retained by the taxpayer, may qualify as a qualifying supply expense by the taxpayer.
Prototype Expenses: 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.