Wages are the largest expense category 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 R&D, directly supports R&D activities, or directly supervises R&D activities. 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 IRC 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:
- Directly 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 necessarily 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 in this case), 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.
Note that in the event of an audit by the IRS, employee titles will most likely be examined closely. Employees with upper-management titles will likely be scrutinized more than others. For instance, a CEO with a high qualifying percentage would likely be questioned. When determining qualifying percentages for employees where time tracking is not present, this should be taken into consideration. This is not to say that employees with upper-management titles will not qualify for the credit. Depending on several factors such as the structure of the company, the nature of the work, the R&D process, etc., upper-management employees can be highly qualifying. However, special attention should be paid to clearly documenting the types of activities performed by these employees as they will likely be challenged early on in the audit process.