27 Dec R&D Tax Credits – IRS Forms 8974, 6765, 3800 & the TCJA
Understanding the tax reporting and compliance procedures of this very interesting tax credit is GOOD BUSINESS for 3 VERY IMPORTANT Reasons:
- MONEY – Taxpayers Save BIG
- OPPORTUNITY – More Taxpayers Qualify
- TIMING – Applicable statues changing in 2022
Since becoming law in 1981 the R&D tax credit has proven to be quite a valuable tax planning tool yielding billions of dollars in federal and state benefits for LARGE US businesses with big compliance budgets.
Now that the tax credit is permanent and can be applied towards employment tax, planning opportunities abound for medium size and smaller companies – including startups!
If evaluating R&D expenditures you should really consider engaging this topic with alacrity!
As a direct result of the changes taking effect in tax year 2022, R&D activities should be pulled into tax years 2020 and 2021 to maximize the current deduction available under IRC Section 174(a), while also enjoying the value of the tax credit under IRC Section 41.
Navigating the Compliance Shoals
The first part of this post focuses on the basic reporting requirements for maintaining worry free compliance with our esteemed taxing authorities and is intended to help navigate the shoals of the following forms to IRS Audit standards:
- IRS form 6765 – Credit for Increasing Research Activities
- IRS Form 8974 – Qualified Small Business Payroll Tax Credit for Increasing Research Activities
- IRS Form 3800 – General Business Credit
This article will also identify modifications the Tax Cut & Jobs Act (TCJA) made to IRC Sections 174 Research & Experimental Expenditures & IRC Sections 41 Credit for Increasing Research asserting in a nutshell that as of tax year 2022 R&D expenses must essentially be amortized.
The post concludes with detail on claiming the credit in my great home state of Colorado.
How Did This Come About
The PATH Act made THREE major changes to the R&D Tax Credit serving as a major catalyst to today’s business environment:
- The credits were made permanent allowing for actual planning.
- The credits can for qualified small businesses offset employment (payroll) tax – more opportunity.
- The credits now offset Alternative Minimum Tax (AMT) – fewer ‘traps’ as it were for:
- Eligible small businesses with less than $50MM in gross receipts
- S Corps and partnerships – each owner must be below the gross receipts threshold to offset AMT
Even though the Credit is nonrefundable, keeping track of your qualified research expenses (QRE) is advised as the IRS allows you to carry R&D credits forward up to 20 years.
How to Report the Credit
The credit is calculated on IRS Form 6765 Credit for Increasing Research Activities using either Section A ‘Regular Credit or Section B ‘Alternative Simplified Credit’. You can also claim the credit against employment taxes, addressed later.
The difference between the regular credit and the simplified credit on the 6765 form distills down to whether you are inclined to:
- calculate your ‘fixed base %’ addressed later
- incorporate average annual gross receipts for the preceding 4 tax years.
- report total qualified research expenses (QRE) for the previous 3 year
The first 2 points above are relevant to Section A – Regular Credit part of the form. Also pleased understand that 3 years of QREs are relevant to Section B, the Alternative Simplified Credit.
Fascinatingly enough the ‘simplified’ Section B is generally more complicated to prepare than Section A in my team’s humble opinion.
Be advised. It is best practice to run the calculation using both Sections A and B to determine whether the 'Regular' calculation or the 'Alternative Simplified' calculation offers the most benefit. Once a 'calculation' election is made for the tax year it cannot be revoked for the tax period in any regard.
Should an election to ‘reduce’ the credit be made?
Another thing that is often confusing is whether to elect to reduce the credit in accordance with Internal Revenue Code Section § 280C afforded in both the regular calculation and the simplified calculation.
If you don’t elect the reduced credit, you must reduce your otherwise allowable deduction for qualified research expenses or basic research expenses by the amount of the credit on line 17 of form 6765.
This is true whether the expenses are deducted forthright in the tax year or amortized over time.
If the credit exceeds the amount allowed as a deduction for the tax year it gets complicated. Hit me up off line for a trip into the weeds.
And finally of course if the credit is not reduced there will undoubtedly be follow up implications to contend with on most state income tax filings.
Calculating the Credit
The credit for the current tax year is then ultimately calculated in Section C of form 6765 taking into consideration the Credit for Employer Differential Wage Payments reported on IRS Form 8932 for taxpayers in the armed services as well as amounts allocated to beneficiaries of estates or trusts.
This is one of the many areas you may need to pause because it could catch even the most astute off guard as not many companies make wage differential payments to active duty employees. But some do!
To be considered a differential wage payment, the payment must be made to a qualified employee who is on active duty for a period of more than 30 days AND the payment must be for wages the employee would have received. Total differential payments cannot exceed $20,000 per employee.
Remember to attach a statement for each credit claimed. See the Instructions for General Business Credits, Form 3800, line 4, for specific information regarding this requirement.
On the 3800 form the R&D Tax credit is added together with all the other General Business Credits and appropriately carried over to the front of the income tax return as follows:
- Individuals – Form 1040 Schedule 3, line 54, or Form 1040NR, line 51
- Corporations – Form 1120, Schedule J, Part I, line 5c
- Estates and trusts. Form 1041, Schedule G, line 2b
The term “base amount” is relatively complex and worth a drill down. It is essentially the product of your fixed-base percentage and your average annual gross receipts for the 4 taxable years preceding the taxable year for which the credit is being determined.
Calculating the correct base amount is instrumental in accurately claiming the credit. The term “base years” refers to the years used to compute the fixed-base percentage relating to the calculation of the regular credit under IRC section 41(a)(1) or the three preceding years relating to the election and calculation of the alternative simplified credit under IRC section 41(c)(5).
Minimum base amount
Fixed-base percentage – Historical
The following is taken straight from 26 U.S. Code § 41.Credit for increasing research activities.
Fixed-base percentage is essentially the percentage which the aggregate qualified research expenses for taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.
- If the first taxable year in which you had both gross receipts and qualified research expenses begins after December 31, 1983, or there are fewer than 3 taxable years beginning after December 31, 1983, and before January 1, 1989, in which you had both gross receipts and qualified research expenses the fixed-base percentage is 3 percent for each of the 1st 5 taxable years beginning after December 31, 1993, for which you had qualified research expenses.
- In the 6th such taxable year, ⅙ of the percentage which the aggregate qualified research expenses of the taxpayer for the 4th and 5th such taxable years is of the aggregate gross receipts for such years.
- In the 7th such taxable year, ⅓ of the percentage which the aggregate qualified research expenses for the 5th and 6th such taxable years is of the aggregate gross receipts for such years.
- In the case of the 8th such taxable year, ½ of the percentage which the aggregate qualified research expenses for the 5th, 6th, and 7th such taxable years is of the aggregate gross receipts for such years.
- In the case of the 9th such taxable year, ⅔ of the percentage which the aggregate qualified research expenses for the 5th, 6th, 7th, and 8th such taxable years is of the aggregate gross receipts for such years.
- In the case of the 10th such taxable year, ⅚ of the percentage which the aggregate qualified research expenses for the 5th, 6th, 7th, 8th, and 9th such taxable years is of the aggregate gross receipts for such years.
The most salient part of the calculation, particularly in that we don't live in the '80s anymore (thank heavens) is that for taxable years AFTER 1989, the percentage which the aggregate qualified research expenses for any 5 taxable years selected by the taxpayer from among the 5th through the 10th such taxable years is of the aggregate gross receipts for such selected years.
Important Points to Remember
Maximum fixed-base percentage
- In no event shall the fixed-base percentage exceed 16 percent.
- At the election of the taxpayer, the credit determined shall be equal to 14 percent of so much of the qualified research expenses for the taxable year as exceeds 50 percent of the average qualified research expenses for the 3 taxable years preceding the taxable year for which the credit is being determined.
Special rule in case of no qualified research expenses in any of 3 preceding taxable years
- If there have been no qualified research expenses in any one of the 3 taxable years preceding the taxable year for which the credit is being determined the credit shall be equal to 6 percent of the qualified research expenses for the taxable year.
Consistent treatment of expenses required
- Notwithstanding whether the period for filing a claim for credit or refund has expired for any taxable year taken into account in determining the fixed-base percentage, the qualified research expenses taken into account in computing such percentage shall be determined on a basis consistent with the determination of qualified research expenses for the credit year.
- Gross receipts for any taxable year shall be reduced by returns and allowances made during the taxable year.
- In the case of a foreign corporation, there shall be taken into account only gross receipts which are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
New Tax Benefit for Eligible Small Businesses
Eligible small businesses are entitled to elect a new way to claim the tax credit.
- As a result of the PATH Act smaller companies can now get an employment tax offset allowing the R&D Tax credit up to $250,000 of payroll taxes.
- To be eligible, your company must have average gross receipts of no more than $5 million per year within the last five years.
- If your business qualifies you elect to claim the credit on IRS Form 6765 Credit for Increasing Research Activities by ‘checking the box’ on line 41 Section D – Qualified Small Business Payroll Tax Election and Payroll Tax Credit.
- The credit is calculated on IRS Form 8974 Qualified Small Business Payroll Tax Credit for Increasing Research Activities and carried over to the appropriate employment tax form: 941, 943, or 944.
For many small and medium-sized businesses, Internal Revenue Code § 41 Credit for Increasing Research Activities is one of the most underutilized of all tax benefits because calculating qualified research expenses (QREs) to US Treasury promulgated regulation standards as well as navigating the procedural shoals of of properly reporting can seem daunting.
I am here to advise you dear reader that even though it is challenging, it is doable with a properly structured approach.
Other Interesting Facts
- The credit offsets the Federal Insurance Contributions Act (FICA)
- Social Security (OASDI) 6.2% of gross wages
- Medicare (HI) 1.45% of gross wages
- Not refundable credit cannot exceed tax
- Unused credits may be carried forward to the next quarter
How to Elect the Credit as Payroll Tax Relief
On a timely filed IRS Form 6765 Section D including extensions:
- Line 41: “Check this box if you are a qualified small business electing the payroll tax credit.”
- Line 42: “Enter the portion of line 36 elected as payroll tax credit (do not enter more than $250,000).”
- Asks a few basic questions about the income tax return
- Determines the credit that can be used each employment tax quarter.
- Attached to Form 941 for the quarter in question or accordingly forms 943, or 944 for the tax year.
When Does the Credit Apply to Employment Tax?
- The Election starts the first quarter after the return is filed.
- IRS form 941 filed March 2019, would be able to use the credit against payroll taxes generated the 2nd quarter of 2019 (July).
Company A – Adult Toyz R Us
- Incurs $6,000,000 in eligible costs related to developing and improving its new line of consumer products between January & March 2019.
- Was founded in 2013 and has generated $500,000 in gross receipts each year to date.
- Eligible expenses generate a credit of approximately $600,000.
- Because the company meets the criteria, it can use $250,000 of these credits to offset FICA payroll tax on its quarterly Form 941 filings for the 2019Q3 filing period.
- The remaining $350,000 in credits will carry forward for 20 years to offset future regular tax liability on the company’s tax return.
For those of you still with me – thank you. Enjoy a cold one, you deserve it. And be sure to carry on for a drill down into how the TCJA impacts R&D Tax Credit Planning.
For those of you willing/able to read on, your stamina is remarkable!
Tax Cut & Jobs Act effect on R&D Tax Credit Planning
As addressed previously, beginning in 2022, IRC Section 174 research and experimental expenditures must be amortized. IRC Section 41 credit for increasing research activities is also changed to align the statutes.
Because you can expense and deduct R&D expenditures currently under either Section 162 or Section 174(a), expense classification has not traditionally raised any significant concern from IRS Revenue Agents.
Of course there is always the exception for passive owners of pass through entities who pay AMT and are obligated to amortize research or experimental expenditures under Section 59(e)(2) when not amortizing them under Section 174(b).me
Once the modified language of Section 174 takes effect in 2022, then we will have to consider the timing difference of a deduction under Sec. 174 as compared to Section 162.
This timing difference in classification of expenditures is a critical issue that should be consider when looking at R&D tax credits as the IRS will be more likely to analyze your classification of expenditures for deductions when claiming the R&D tax credit.
As a result you are obligated to validate IRC Section 41 expenditures as “specified research or experimental expenditures” under IRC Section 174, and amortize those costs over five tax years, or 15 tax years for foreign research.
The modifications for the 2022 tax year and beyond may require a change accounting methods via IRS Form 3115. This change will be applied on a cutoff basis, and thus taxpayers will not have a IRC Section 481(a) adjustment. This is all spelled out in Section 13206(b) of the TCJA.
- If you relied on IRC Section 174(a) or IRS Revenue Procedure. 2000-50 to expense R&D or software development costs the temporary timing difference caused by the IRC Section 174 modifications may sting come tax year 2022.
- Due to the different amortization period requirements for domestic and foreign research or experimentation, if you perform R&D activities outside the United States (15 years) you might want to move that activity back to the US (5 years).
- How the IRS Section 174 modifications change the R&D tax credit:
- This new forced amortization of specified research or experimental expenditures offers tax planning opportunities for business owners of pass through entities as a direct result of the 20% deduction of qualified business income spelled out in IRC Section 199A.
- This is pandering but the amortization of specified research or experimental expenditures may increase qualified business income, and thus increase the IRC Section 199A deduction over claiming the expense IRC Section 174(a). Either way there is clearly a LOT going on here!
Internal Revenue Code § 41 Credit for Increasing Research Activities is less than fully clear to say the least. As such when filling out the forms it is always a best practice to know what the authorities expect.
What IRS Revenue Agents ‘look for’ is spelled out in detail in the IRS’ Research Credit Claims Audit Techniques Guide (RCCATG): Credit for Increasing Research Activities.
This Audit Technique Guide (ATG) is the written playbook if you will detailing how IRS Revenue Agents are to essentially comport themselves and what they may address when scrutinizing your efforts.
R&D Credit IRS Audits Use ‘Specialists’
- IRS engineers are part of LB&I but support all of IRS
- IRS engineers have degrees in numerous disciplines
- Many IRS engineers have graduate degrees
- LB&I > 90% issue assigned to engineer
- SBSE <5% issue assigned to an engineer
- SBSE <5% engineer consults on issue with revenue agent
- Computer Audit Specialists (CAS)
- CAS are part of LB&I
- CAS are typically revenue agents with specialized training.
- CAS assist with retrieving and analyzing electronic data from.
- CAS create sampling plans for revenue agents and engineers.
- Activities usually related to a statistical sampling for IRS Revenue Procedure 2011-42 compliance
- Subject Matter Expert (SME)
- SMEs were formally called Technical Advisers
- SMEs Receive requests from revenue agents for guidance
- LB&I SMEs are part of Business Credit Practice Group
- There are also SBSE analysts dedicated to R&D Credit issues
- IRS Counsel may become involved at the request of:
- The revenue agent
- Another specialist
- The taxpayer or their representative
- Both LB&I & SBSE have local and national counsel
Biggest Problem – Nexus
The nexus problem is the inability to connect specific research project(s) and the underlying activities to the qualified expenses.
IRC Section 41 does not require that you capture the costs of research under a particular approach or accounting methodology. However, § 41 requires you to identify qualified research expenses (QREs) by business component (qualified activity).
Many claims are prepared using a hybrid method that does not properly establish the required nexus between:
- Qualified Research Expenditures (QREs), and
- Qualified Research Activities (QRAs).
Also, most accounting systems contain information to identify and measure expenditures without considering whether research and development activities meet the statutory requirements under § 41.
Taxpayers have employed a number of methodologies in reconstructing the amount claimed for the research credit. Most studies reflect a combined hybrid approach. The hybrid method may be a combination of Project and Cost Center methods, adopting portions of each approach for which records are most easily available.
The manner in which the information is compiled typically does not support the relationship between the accounting records and the research activities. Studies lacking this relationship have failed to establish nexus, and therefore are not audit prepared.
A common example of the hybrid/nexus problem is in the case of qualified wages established by capturing W-2 wage amounts by cost center and multiplying a qualified percentage to individual employee’s wages or department total wages.
The determination of the “qualified” percentage is based on a selected manager’s recollection or estimate of the amount of time particular employees devote to qualified activity, excluded activity, or other non-qualified activities. These managers/employees are sometimes referred to as Subject Matter Experts (SMEs).
Arbitrary and unsupported allocations should not be accepted. These are merely estimates and are not sufficient to support a claim. Allocation percentages applied to expenses associated with qualified research activities may be accepted only when the appropriate prerequisites for applying such an approach have been met.
Many of the Tax Court cases seem to involve the IRS challenging what constitutes Qualified Research Expenditures (QREs) and their nexus to Qualified Research Activities (QRAs). A specific case I found fascinating in this regard is Eric G. Suder et al. v. Commissioner (TC Memo 2014-201).
- Estech Systems, owned by Eric Suder, provided telephone systems for small to midsize businesses.
- The court ruled in favor of Suder, determining that a technical uncertainty does exist when “building significantly larger phone systems than it had ever undertaken.”
- This was in contrast to the IRS claim that large projects always have an “inherent level of uncertainty,” which in their argument, would not qualify as a QRE.
- Suder also introduced the fact that Estech Systems added innovative software and hardware components to the phone systems, in which numerous uncertainties existed.
- The court also ruled in favor of Suder when regarding the application of the process of experimentation.
- A process of experimentation involves “evaluating alternatives to improve function, performance, reliability or quality through trial and error and must be used to attempt to accomplish a result that is uncertain.”
- The IRS presented that Estech Systems simply “evaluated processes by using engineering know-how, common knowledge, and committees,” and that these activities were not processes of experimentation.
- Ultimately, Suder correctly argued that Estech Systems had implemented “a very detailed, multi-level, and systematic system for phone systems development.
- Included in this process were hypothesizing which alternatives would be most effective, testing these alternatives, analyzing the results, and repeating the first 3 steps if needed.”
FOREWARNING FOR SERVICE ENGINEERS, ARCHITECTS AND OTHER SERVICE PROVIDERS
- IRS audits of research and development tax credit claims by service providers, such as architecture and engineering companies, have become inconsistent over the last couple of years.
- IRS audit actions appear to be reversing the long-standing precedent for the type of activities that qualify for the credit.
- Historically service providers have qualified for the R&D credit as long as they satisfied the four-part test referenced above.
- Two main groups benefit from the credit: manufacturers and service providers.
- Nearly half of taxpayers who claim the credit are manufacturers
- nearly one-third of taxpayers who claim the credit are service providers — most of which are small businesses in the fields of architecture, engineering, construction, and computer software design.
- Most recently the IRS has been successfully arguing that “services” do not qualify for the R&D tax credit.
- Tread lightly, this dramatic break in precedent has an outsized impact on small businesses that lack the resources to fight IRS denials.
- A consistent theme from IRS examiners in the Small Business/Self-Employed Division that we have experienced is that services provided by architecture and engineering firms cannot meet the “qualified purpose” portion of the four-part test because their research lacks an identifiable “business component.”
- This new position is concerning, given that the IRS Code clearly defines the term “business component” as a product, process, computer software, technique, formula, or invention.
- Historically, the IRS has allowed design drawings to qualify as the business component, since the term “technique” is synonymous with the term “blueprint” or “design drawing.”
- In recent examinations, IRS Revenue Agents ignored the terms “technique” and “formula” in R&D claims for service providers altogether forcing us into the Appeal function.
- While no court cases have addressed this issue directly, there have been cases involving service firms that took the R&D credit where neither the IRS nor the courts questioned whether service providers can qualify for the credit.
- This shows service providers are NOT inherently disqualified from taking the credit.
This is also where accounting standards are significant.
Accounting Standard Codification (ASC) 730
If you follow U.S. Generally Accepted Accounting Procedures (GAAP) you must disclose ASC 730 R&D costs on your financial statements.
ASC 730-10-50-1 states that: “Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented. Such disclosure shall include research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed.”
ASC is available for free at FASB.ORG once you register for the Basic View.
Getting a ‘no change’ examination determination can be seen as a ‘Red Badge of Courage’ as it were without standard operating procedures and a documentation trail.
The secret to the golden flower (no change audit) is to attach a Certification Statement on the tax return or at beginning of an IRC § 41 exam asserting under penalty of perjury that a reconciliation of Form 6765 QREs to an adjusted ASC 730 Financial Statement has been completed and is efficiently explained.
With this statement the IRS will generally be less likely inclined to challenge QREs.
Documentation is Key
The biggest reason taxpayers get leaned on by the IRS is the lack of documentation. If you fail to substantiate your efforts you may wind up in a bad spot with our esteemed colleagues at the IRS.
Treas. Reg. §1.6001-1(a) provides that a taxpayer shall keep permanent books and records sufficient to establish the amount of the credit.
The Tax Court discussed the requirements for properly substantiating a research credit claim in Eustace v. Commissioner. T.C. Memo 2001-66, aff’d 312 F.3d 1254 (7th Cir. 2002).
- The taxpayer, Applied Systems did not claim the research credit on its originally filed returns for 1990-1992.
- Applied Systems thereafter hired a new tax manager who filed claims for 1990-1992 on amended returns.
- Applied Systems had 5 departments and 450 employees.
- The tax manager interviewed some employees and prepared a worksheet to “list the salaries” of the 227 employees that he thought qualified for the credit.
- At trial, the taxpayer offered the testimony of six employees as to the nature of their activities.
- Determination summary:
- The Tax Court found the taxpayer’s reconstruction of qualifying expenses to be “unreliable, inaccurate, incomplete, and wholly insufficient.”
- The Court found the pro-forma “list of salaries,” supplemented by testimony as being insufficient for the taxpayer to meet its burden of proof. Sufficient evidence was not presented to demonstrate that the salaries were paid for qualified research activities.
- The Tax Court held that the taxpayer was required to tie salaries to qualified activities at the sub-component level.
- Furthermore, the Court refused the taxpayer’s invitation to make a “reasonable allocation of salaries to the activities.”
- The taxpayer must show what expenses it paid or incurred in the performance of qualified research activities.
- The Court denied the taxpayer the ability to apply the Cohan doctrine (See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930)) in arriving at an estimate for its QREs and stated that the rule of Cohan did not require the Court to make an allocation of salaries to functionality.
The bottom line message when claiming the credit is documentation, documentation documentation!me
Adequate Backup Documentation Includes
- Concept Proposals
- Cost Benefit Analysis
- Design & Development notes
- Emails Detailing Technical Issues
- Feasibility Study
- Functional Requirements
- Implementation Documents
- Initiation & Concept Development
- Integration & Testing Documents
- Lessons Learned Journal
- Meeting schedules
- Patents / Patent Applications
- Payroll records
- Planning & Requirements Analysis
- Process Diagrams
- Project Management Plan
- Project Action Plans
- Quality Assurance Test Procedures
- Recommendations for Redesign
- Revision Notes / Release Notes
- Risk Management Plan
- Screen Layouts
- Source Code Samples
- Systems Boundary Document
- Systems Design Document
- Technical Meeting Agenda / Minutes
- Test Analysis Reports
- Test Readiness Review
- Trouble-shooting Documents
- User Guides
4 Tests Required to Claim Credit
- Elimination of Uncertainty: To what extent have you reduced or ideally eliminated uncertainty about the development or improvement of the product or process beyond just cosmetic changes?
- Under IRS § 174 you must start with demonstrated UNCERTAINTY about:
- method, or
- Under IRS § 174 you must start with demonstrated UNCERTAINTY about:
- Process of Experimentation: What experiments, simulations, modeling or hypothesis did you use?
- Treas. Reg. § 1.41 4(a)(5) “A process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or method of achieving that result is uncertain as of the beginning of the taxpayer’s research activities.”
- Treas. Reg. § 1.41 4(a)(6) “Substantially all” (≥80%) of the activities must constitute elements of a process of experimentation that relates to a qualified purpose.
- Technological in Nature: What principles of science or engineering did you deploy in the research & development effort?
- Physical Science
- Biological Science
- Computer Science
- Economic or Financial research does NOT qualify
- Permitted Purposes: What specific improvements are you attempting for a business component held for sale, lease, license to customers or otherwise used in their trade or business?
- Development activities relating to style, taste, cosmetic or seasonal design factors do not qualify.
Qualifying Research Activities (QRA) Include
You must have both Risk AND Rights to research.
- Risk means that you bear the expense even if the research is not successful as per Reg. § 1.41 2(e)(2)(iii).
- You must also have a right to the research results Reg. § 1.41 2(e)(3).
The activity must be applied at the business’ functional component level and intended for the development of a new product, process, formula or software for things like:
- Work related to Patent applications
- Software Development for sale
- Design tools
- Certification testing
- Environmental testing
- Automated manufacturing processes.
Qualifying Activities do NOT Include
- Consumer surveys
- Market research
- Management studies
- Patent acquisition
- Models acquisition
- Ordinary testing
- Efficiency surveys
- Anything after the beginning of commercial production
- Adaptation of existing business component
- Duplication or Reverse engineering
- Quality control
- Non U.S. research where the work is performed
- Funded research
Qualifying Research Expenses (QRE)
With regard to employees be sure to take advantage of the Substantially All (80%) Rule speeled out in US Treasury Reg. § 1.41-2(d)(1)
- “if substantially all of the services performed by an employee… [qualify], then the term “qualified services” means all of the services performed by the employee for the taxpayer during the taxable year…”
- If ≥80% qualify then 100% of the wages qualify for that employee.
- As noted previously, the denominator is the “performance of services” so vacation, sick time, and holiday time is excluded from the calculation.
- Legal Fees for a patent.
- US-Based Contractor Fees
- 65% of amounts paid to non-employees for qualified activities
- 75% of amounts paid to certain qualified research consortia
- 100% of amounts paid for energy research to eligible:
- small businesses
- universities, and
- federal laboratories
- Supplies – Tangible property used or consumed in qualified research activities for prototype development.
- Excludes assets subject to depreciation as per IRC §168 – both acquisition & improvements.
Projects in which the Credit may apply
- Development of beer formulations – my fav!
- Development of new strains or cross-breeding of products with improved nutritional value
- Development/improvement of new harvesting techniques and/or soil development
- New or improved processes to increase yield upon harvest
- Development/improvement of fertilizers, irrigation systems, etc.
- Development of methods and techniques to protect crops from disease and/or pest control
- Development/improvement of custom equipment configured to operate in specific environmental conditions
- Development and/or implementation of automated processes
- Machine Shop
- Biology/chemistry Laboratories
- Development or experimentation with new cultivation techniques
- New or improved feeding or breeding techniques for livestock
- Development of monitoring capabilities for field conditions
- Military grade camera systems
- Mobile radar
- Improvement to facilities resulting from environmental and/or safety efforts
- Development of cosmetics
- Software Development
- Licensing system software
- Messaging apps
- Computer animation
- Web development
- Cloud-based risk mitigation
- Investment software
- Prototype designs for:
- Medical instruments
- Telecommunications equipment
- Chilling systems
- Development of Power generation systems
- Development of Drug formulation processes
- Development of Innovative extraction techniques.
Internal Use Software (IUS)
There is a little bit of a Dr. Jekyll Mr. Hyde thing going on with the tax implications of internal use software (IUS).
Presently IRS regulations on internal-use software provide clear guidance and favorable rules for including internal-use software in qualified research activity (QRA) determinations as long as sufficient nexus to the activity can be established.
Final Regs. § 1.41 4 adopted Oct. 4, 2016 for Internal use Software (IUS) clarifies the ‘High Threshold of Innovation Test’ for claiming tax credits as offsets to software development expenditures as follows:
- Innovative measurable improvement
- speed improvement
- cost reduction
- any other measurable improvement
- no longer unique and novel
- Excludes software for use in:
- an activity that constitutes qualified research, and
- a production process
- No “Revolutionary Discovery” required (Proposed)
If you answer ‘Yes’ to any of the 5 questions below there is NO ‘High Threshold of Innovation Test for IUS:
- Is the software for use in an activity that constitutes qualified research?
- Is the software developed for use in a production process that meets the requirements of qualified research?
- Is the software developed with hardware as a single product?
- Is the Software to be Sold, Leased, Licensed?
- Is the software developed to interact with or allow third parties to initiate functions or review data on your system?
The TCJA changed the language in section 174 from “research or experimental expenditures” to “specified research or experimental expenditures,” and adds a special rule under Sec. 174(c)(3) that specifies that for purposes of Sec. 174, any amount paid or incurred in connection with the development of software is treated as a “specified research or experimental expenditure.”
As a result, the TCJA eliminates any opportunity to rely on Rev. Proc. 2000-50 to claim tax credits for IUS development expenditures effective in 2022.
This is what the IRS initially asks when they scrutinize
1. Have you retained a third party to assist you in preparing this claim?
- If yes, provide a copy of the engagement letter pursuant to which the third party provided the assistance.
2. Did you make an I.R.C. §280C(c)(3) election on your original tax return?
- If yes, provide a copy of the original election.
3. Are you required by I.R.C. §41(f)(1) to aggregate your research expenditures with other members of the same controlled group or other trades or businesses which are under common control?
4. In computing the group credit for the credit year, which includes computation of the base amount, have you included all members of the controlled group and trades or businesses which are under common control, in accordance with the aggregation rules of I.R.C. §41(f)(1)?
- If no, explain why not.
5. In computing the credit for the credit year, have you accounted for all acquisitions or dispositions of a major portion of a trade or business or major portion of a separate unit of a trade or business, as required by I.R.C. §41(f)(3)(A) or §41(f)(3)(B)?
- If yes, provide a list and the dates of all acquisitions and dispositions from the earliest base year to the end of the claim year, and if no, explain why you have not accounted for all such acquisitions and dispositions.
6. Did you use project accounting to capture costs in your financial books and records?
- If yes, did you use this project accounting to identify and capture the qualified research expenses (“QREs”)?
- If no, describe the method used to identify and capture the QREs and describe how this alternative method connects QREs with the financial books and records.
7. What is your adopted method of accounting for treatment of research and experimental expenditures for the particular project or projects?
- How did you treat the expenses that you are now claiming to be QREs in arriving at taxable income on the original and prior year tax returns?
- Were they originally claimed as research and experimental expenditures for a particular project or projects as current expenses under section 174(a) or deferred expenses under section 174(b), or as capital expenditures under section 263(a), section 263A and regulation section 1.174-1?
- Did you report the QREs in compliance with your adopted method of treatment of R&E expenditures? If not, please explain.
- Identify the entry line(s) and dollar amount included on each line of the income tax return to reflect how the QREs were originally reported and characterized to compute taxable income, i.e:
- salaries and wages
- cost of goods sold
- other deductions entry lines.
8. Do the QREs include any expenditure for overhead expenses, general and administrative expenses, indirect research expenditures or depreciation allowances?
- If yes, provide the dollar amount(s) of QREs claimed for each type of expenditure.
9. Provide the following information:
- Identify and list each new or improved business component for which the QREs are being claimed.
- For each business component identified above, provide:
- QRE wages by employee
- QRE supplies
- contract QREs by contract
- reconcile the QREs by business component to the total QREs reported on your Form 6765.
- With respect to each QRE amount identified above:
- Do you have contemporaneous documentation substantiating the claimed amount?
- If so, then for each new or improved business component, provide a list of the documents available that substantiates:
- Qualification of each business component
- Determination and quantification of qualified wages by employee
- Determination and quantification of qualified supplies
- If you relied on the general ledger, provide a list of applicable accounts.
- Determination and quantification of contract research by contract
- Include a list of the contracts and the QRE amount for each contract.
10. For research you performed as a contractor:
- Do you have contemporaneous documentation that identifies your claimed research expenses by contract, QRE amount and each new or improved business component?
- Have you retained copies of all the contracts for which such research expenses have been claimed?
- Do the terms of each contract for which such research expenses have been claimed provide for the performance of qualified research
- that payment(s) to you (the contractor) were contingent on success of the research; and,
- that you would retain substantial rights to the results of the research?
- Provide a list of the contracts and the QRE amount for each contract.
11. Does the claim rely on any oral testimony or employee surveys to determine the QREs in the credit year?
12. Does the claim rely on estimates or extrapolations to determine any portion of the QREs in the credit year?
- If yes, describe the methodology by which estimates or extrapolations were used to determine the QREs for the credit year, and provide the dollar amount of the QREs which were estimated or extrapolated.
13. Provide your detailed calculation of the fixed-base percentage and the base amount in electronic format.
- If not available in electronic format, provide the computations on a spreadsheet.
- Identify each new or improved business component for which the base years’ QREs were incurred.
- For each such business component, provide the QRE wages by:
- contract QREs by contract
- reconciling to the total QREs used to compute fixed-base %.
- Provide a separate list for each base year.
- If your fixed-base percentage is based upon being a start-up company, identify the first year that any entity first paid or incurred QREs, and identify that entity.
14. Does the claim rely on any oral testimony or employee surveys to determine QREs in the base years?
15. Does the claim rely on estimates or extrapolations to determine any portion of the QREs in the base years? If yes:
- Describe the methodology by which estimates or extrapolations were used to determine the QREs for the base years, and
- Provide the dollar amount of the QREs, by base year, which were estimated or extrapolated.
16. Does the claim rely on estimates or extrapolations to determine any portion of the gross receipts used to compute the fixed base percentage and the base amount? If yes:
- Describe the methodology by which estimates or extrapolations were used to determine the gross receipts for the fixed base percentage and the base amount, and
- Provide the dollar amount of the gross receipts, by year, which were estimated or extrapolated.
17. Was any form of sampling used to determine your QREs?
18. Have you complied with the consistency requirement of I.R.C. §41(c)(6), which requires that the QREs used in determining the fixed-base percentage be determined on a basis consistent with the determination of the QREs for the credit year?
- If yes, state how you complied with the consistency requirement in determining the fixed-base percentage that was reported on your original (if applicable) and amended Form 6765.
19. Provide the name(s) and phone number(s) of the person(s) who completed this questionnaire.
What are the risks of claiming the R&D credit?
- IRS scrutiny – Like any other tax position, it is possible that the IRS will examine an R&D credit position. Amended tax returns claiming R&D credits that are used in the years under examination have been more likely to be examined.
- IRS penalty and interest. If the IRS disallows a credit it may assess a penalty if it was claimed through negligence or results in a substantial understatement of income tax equal to 20% of the credit disallowed. The IRS may also assess interest due on that 20 percent from the date that the tax should have been paid.
Penalty Regarding Erroneous Claim for Refund or Credit
The U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act of 2007 (the “Act”) added a new penalty for the filing of an erroneous refund claim. This penalty, under IRC § 6676(a), provides that if a claim for refund or credit with respect to income tax is made for an excessive amount, then the person making such claim shall be liable for a penalty in an amount equal to 20 percent of the excessive amount.
The penalty imposed by § 6676 does not apply to any portion of the excessive amount of a claim for refund or credit which is subject to a penalty imposed under the Accuracy Related or Fraud Penalties. §6676(c). It also does not apply to the earned income credit. § 6676(a)
State R&D Tax Benefits
Many states offer the R&D tax credit which generally follows the federal regulations and IRS guidance on what constitutes Qualified Research expenditures (QREs).
However, there are some states that are an exception to the federal guidelines, such as Colorado, Connecticut and California:
- Colorado requires that the credit be part of an enterprise zone. More on that follows below
- Connecticut has a lower threshold defining expenditures under Internal Revenue Code § 174 Research and experimental expenditures which allows a greater amount of expenditures to qualify as for the R&D tax credit.
- California utilizes a different definition of gross receipts and only includes sales of real, tangible, or intangible property held for sale to customers in the ordinary course of the taxpayer’s trade or business delivered or shipped to a purchaser within California and does not include service-related receipts, rents or interest.
36 States Offer an R&D Tax Credit
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Dakota
- Rhode Island
- South Carolina
Colorado Research & Development Tax Credit
Soak up the following tantalizing facts that I’ve had the pleasure of stumbling over while working with Colorado startups:
- The Colorado Department of Revenue puts out excellent written guidance in the form of FYI Income 22 Research and Development Income Tax Credit for Enterprise Zones
- The R&D credit is administered by the Colorado Enterprise Zone Program, in accordance with Colorado Code of Regulations § 39-30-105.5, Enterprise zone research and experimental expenditures credit.
- The credit is equal to 3% of the amount by which qualified research expenditures (QREs) in the enterprise zone exceed the taxpayer’s average QREs from the preceding two years.
- In each tax year, the taxpayer may claim no more than 25% of the total credit (the remainder being carried forward) plus any applicable carryover amount from a prior year up to 25% of the original credit.
- Taxpayers must annually pre-certify with their local EZ Administrator to be eligible to claim the credits by filing Colorado Department of Revenue form DR 0074.
- Colorado taxpayers MUST receive approval from their local EZ Administrator.
- Certification documents must be submitted with the Colorado income tax filing.
- To the extent that the credit for any year exceeds the tax liability for such year after other credits have been claimed, the excess may be carried forward and claimed until it is used.
For more information on this contact me at your convenience.