The Research Tax Credit
Internal Revenue Code (“I.R.C.”) § 41 provides taxpayers with a tax credit for increasing research and experimentation activities. The research tax credit is equal to twenty percent of the increase in the taxpayer’s qualified research expenses (“QREs”) from the year in which the tax credit is claimed and the “base amount.” The “base amount” is the average of the taxpayer’s gross receipts for the four years prior to the year in which the research tax credit is claimed, multiplied by the taxpayer’s “fixed-base percentage.” The taxpayer’s “fixed-base percentage” is the percentage that research spending was of gross receipts for the base period.
Research Tax Credit Base Period
The research tax credit base period consists of years 1984 through 1988, unless the taxpayer is deemed to be a start-up company for purposes of the research tax credit. A taxpayer is deemed to be a start-up company for purposes of the research tax credit if the first tax year in which the taxpayer had both gross receipts and QREs occurred after 1983 or, for the period beginning after December 31, 1983, and ending before January 1, 1989, the taxpayer had fewer than three tax years in which the taxpayer had both gross receipts and QREs.
If the taxpayer is deemed to be a start-up company, the taxpayer must use the special base period rules set out in I.R.C. § 41(c)(3)(ii) for calculating its research tax credit. These rules provide a mechanical formula for determining what years make up the taxpayer’s base amount and the fixed-base percentage.
Qualified Research Expenses
Qualified research expenses can include wage costs, supply costs, contractor costs and certain computer rental expenses that the taxpayer paid or incurred for qualified services in carrying on the taxpayer’s trade or business. The two key terms are “qualified services” and “qualified research.”
The term “qualified services” refers to directly engaging in qualified research or engaging in the direct supervision or support of research activities that constitute qualified research. The term “direct supervision” means the immediate supervision of qualified research and the term “direct support” means services in the direct support of either persons engaging in actual conduct of qualified research or persons who are directly supervising persons engaging in the actual conduct of qualified research.
The term “qualified research” includes research:
- with respect to which expenditures may be currently deducted under I.R.C. § 174;
- which is undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and
- substantially all of the activities of which constitute elements of a process of experimentation for the purpose of achieving a new or improved function, performance, or reliability or quality.
To be eligible for expense treatment pursuant to I.R.C. § 174, the expenses must be related to developing a product’s concept, plan, or design; paid or incurred in connection with a trade or business; and be reasonable under the circumstances. Expenses for the acquisition or improvement of land or depreciable property are not eligible for expense treatment pursuant to I.R.C. § 174.
Research is undertaken for the purpose of discovering information that is “technological in nature” if a process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A “process of experimentation” is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. Research is not conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors.
The term “business component” refers to any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer. A business component, such as a product, may consist of several subcomponents. Where the product does not meet the conditions of qualified research, it may be necessary to consider the subcomponents as separate business components to determine if the subcomponents meet the conditions of qualified research.
Section 41(d)(4) specifically excludes the following activities from qualifying as research:
- research conducted after the beginning of commercial production of the business component;
- research related to the adaptation of an existing business component to a particular customer’s requirement or need;
- research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component;
- surveys or studies, including efficiency surveys; activities relating to management functions or techniques; market research, testing, or development (including advertising or promotions); routine data collection; and routine or ordinary testing or inspection for quality control;
- research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States;
- research in the social sciences, arts, or humanities;
- research to the extent funded by any grant, contract, or otherwise by another person or governmental entity; or
- research related to certain types of software and computer lease payments.
Capturing Qualified Research Expenses
The Internal Revenue Service (“IRS”) takes the position that there are two ways to capture qualified expenses that are for qualified services. Specifically, the IRS expects taxpayers to capture their QREs using either a cost-center or project-based method. The nature and availability of the taxpayer’s business and research records usually dictates which method a taxpayer should use.
Reporting the Research Tax Credit
Once the taxpayer has determined its base amount and credit year QREs, the taxpayer can report its research and experimentation tax credit claim to the government. The research tax credit is reported on Form 6765, which is to be submitted with the taxpayer’s tax return. In reporting the research tax credit, the taxpayer may elect to claim a reduced research tax credit in exchange for a larger I.R.C. § 174 R&D tax deduction. This election must be made on an original and timely filed tax return. Taxpayers often make this election where they will not be able to immediately reap the full benefits of the R&D tax credit, such as where the taxpayer has an alternative minimum tax issue or a situation involving a net operating loss.
Taxpayers are generally able to file amended tax returns for the past three years. This may allow the taxpayer to claim R&D tax credits that the taxpayer failed to claim during the past three tax periods.