The Research Credit: Valuable but Often Overlooked [CPA Journal, The]

The federal research tax credit is designed to encourage longterm increases in the amounts spent on research and experimental activities for research conducted in the United States. With the passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the research tax credit can be claimed for qualified research expenditures incurred from January 1, 2010 through December 31, 2011 for U.S.-based qualifying research to promote innovation. Although difficulties that exist in securing the credit can often cause firms to overlook it, the benefits of the Internal Revenue Code (IRC) section 41 research credit can far outweigh the costs incurred to secure the credit.

In fiscal year 2008 alone, the credit represented an estimated $8.3 billion federal tax subsidy for research and development (R&D), according to IRS Statistics of Income (www.irs.gov/ pub/irs-soi/08cofigarsrchcr.xls). Moreover, in a recent study, the Government Accountability Office (GAO) found that firms taking advantage of the research credit appear to be those with the largest share of business receipts (U.S. GAO, "The Research Tax Credit's Design and Administration Can Be Improved," 2009, www.gao.gov/new.items/dl0136.pdf). It is not the case that small and medium-sized companies fail to qualify for the credit; they are simply ignoring the opportunity.

Even though Congress has consistently renewed the research credit over the past 30 years, its use has been limited by procedural reservations in a number of areas, most notably 1) how to determine whether the company performed any activities during its current fiscal year that would qualify for purposes of the research credit, 2) whether all efforts and costs expended during the year with regards to the permitted research activity qualify for the research credit, and 3) how to compute the research credit and how variations in these computations impact it.

This article highlights relevant questions that may face management when evaluating the potential to qualify for the credit. The authors discuss four common performance tests that taxpayers need to satisfy and identify examples of expenditures that are eligible for the research credit - as well as costs that are ineligible - that can best aid management in understanding and evaluating how to utilize the credit. The authors provide an example displaying how to calculate the credit and discuss which method may best suit a firm. Finally, this article offers additional exceptions and considerations to contemplate when computing the credit, as well as examples of research intensive industries.

How to Satisfy the Performance Tests

The research tax credit is for taxpayers of any size that perform qualified research. Although not discussed in this article, companies can also qualify for research credits related to energy (IRC section 41[a][3]) and university basic research (Joint Committee on Taxation, "Technical Explanation of the Revenue Provisions Contained in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010," December 10, 2010, pp. 104-107). As shown in Exhibit 1, the research must satisfy the four tests in order to be considered qualified for R&D credit purposes.

Expense test. In order for the research activity to qualify for the credit, the expenses associated with the activity must qualify as IRC section 174 expenses, which 1) are incurred in connection with the taxpayer's trade or business, and 2) represent an R&D cost in the experimental or laboratory sense (Treasury Regulations section 1.174-2[a][l]).

Research expenses represent R&D costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty with respect to the development or improvement of a product or process. Uncertainty exists when current information available to the taxpayer is insufficient for the taxpayer to improve product capabilities, the methods for developing or improving the product, or for better designing of the product (Treasury Regulations section 1.174-2[a][l]). Establishing this uncertainty acts as a prerequisite for establishing the existence of a business need for research expenses. Lacking such a business need, companies are precluded from taking the research credit. It is important to note that expenditures qualify as research or development costs based on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed, or the level of technological advancement represented by these research efforts. As such, an identification of the activities associated with the research expenses must be made to ensure that these expenses represent R&D costs in the experimental or laboratory sense.

IRC section 174 treatment is allowed only to the extent that the amount is reasonable under the circumstances (Treasury Regulations section 1.174-2[a][5]). Expenditures for land and depreciable property are not allowed under IRC section 174, although in certain cases, depreciation may be treated as an IRC section 174 expense (Treasury Regulations section 1.1742[b]). Exploration expenditures do not qualify as IRC section 174 expenses (Treasury Regulations section 1.1742[c]). Furthermore, "the provisions of section 174 are not applicable to any expenditure paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore, oil, gas, or other mineral" (IRS, "Audit Techniques Guide: Credit for Increasing Research Activities [i.e. Research Tax Credit] IRC section 41- Qualified Research Activities," www.irs.gov/ businesses/article/0"id=156366,00.html).

In addition, Treasury Regulations section 1.174-2(a)(3) disallows IRC section 174 treatment for certain specified activities, such as -

* the ordinary testing or inspection of materials or products for quality control;

* efficiency surveys;

* management studies;

* consumer surveys;

* advertising or promotions;

* the acquisition of another's patent, model, production, or process; and

* research in connection with literary, historical, or similar projects.

Because IRC section 41 is more restrictive than IRC section 174, expenses allowable under IRC section 174 will still have to meet all the other requirements of IRC section 41 for them to qualify for research credit purposes. For example, with regard to patent procurement, "expenses generally qualify under section 174, but would not qualify under section 41" (Treasury Regulations section 1.1742[a][l]).

Novelty test. For the research expenses to qualify for research credit purposes, one of the objectives of performing the research activity must be to eliminate the uncertainty related to the development or improvement of a product or process (Treasury Regulations section 1.174-2[a][l] and IRC section 41[d][l][A]). Generally, qualified research leads to new or improved processes or products, functionality, product performance, product reliability, product quality, or reduced product costs (IRC section 41[d][3][A]). IRC section 41(d)(3)(B) further restricts as qualified expenses those items relating to research conducted for the purposes of enhancing style, taste (cosmetic enhancement), or seasonal design features.

IRC section 41 specifically requires that qualified research activities lead to the development of information that was uncertain at the outset of the research activity. This uncertainty can relate to the capabilities of the product, the methods used to produce the product, or the appropriate design of the product. Examples of this uncertainty from a production process standpoint could include the following scenarios when, at the outset of the research activity, a company was uncertain whether -

* the improved manufacturing process (the research activity) would integrate well with current processes;

* the new manufacturing process (the research activity) would be improved at a sufficient level to meet customer needs or requirements; or

* the research activity would lead to outcomes that would benefit the company (from a cost or production sense).

Technical test. For research expenses to qualify for research credit purposes, the research must be based on technical fields of study. This test requires documentation that the proposed research activities rely upon principles of the physical or biological sciences, engineering, or computer science. If the research activities make use of theories or applications from one of these disciplines, the research is deemed technological in nature. If they do not, then the research activity fails the technical test and the costs associated with the research activities would not qualify for the research credit.

Scientific method test. Although not referred to as such, the Treasury Regulations require that the research performed involve the formulation of one or more hypotheses, the testing of the hypotheses, and the discarding or refinement of the hypotheses. This approach to research design requires some understanding of the problem and insight into how to solve the problem, as well as actions to validate or refute preconceived notions about the problem. If one of these steps is not performed or no longer needs to be performed because the research process is complete, the expenditures related to these activities will not qualify for the research credit. Because of this requirement, it will be important to document whatever information the company knew during the initial planning stages and what information one intended to discover as a result of the research activities. In addition, the company should also record the development process itself, through laboratory and meeting notes or reports outlining the specific steps taken to discover new information or apply that information to the creation of a product or process.

From a practical standpoint, this test also requires that the company engage in a process of evaluating alternatives designed to eliminate uncertainties. Consider, for example, the design of a new production process, which is inherently a process of experimentation. Companies consider alternative layouts and often test them through the use of simulations or prototypes prior to settling on a given layout for a new production process. Even after adopting a given production process, changes are often made to improve the process before full production takes place. Under these circumstances, the company has applied the scientific method to the production design problem. The company has formulated a hypothesis concerning the best plant layout; tested this hypothesis, either through the use of prototypes or the analyses of similar production processes; and adjusted the final plant layout for what was learned prior to full production.

Do All Research Expenditures Qualify?

As shown in Exhibit 2, the simple answer to this question is no. In general, not all activities performed as part of an R&D project qualify for the research credit. Specifically, a company must incur certain types of costs in their entirety on qualified research activities. Examples of qualified research activities that would satisfy the performance tests mentioned above could include -

* concept formulation;

* technical feasibility analysis;

* product design or packaging design;

* pilot or prototype development;

* testing of the prototype;

* redesign;

* process development or improvement before full production;

* patent application work;

* direct supervision related to the above; or

* direct support associated with the above.

IRC section 41(d)(4) enumerates several other activities for which qualified research credit is not permitted. These include -

* administrative costs;

* training costs;

* routine engineering or software maintenance costs;

* activities, and particularly the costs of these activities, that rely on the social sciences, arts, or humanities;

* research costs incurred after commercial production has commenced;

* the costs incurred to use an existing component to meet a particular customer's needs;

* the costs incurred to duplicate a product or component using reverse engineering;

* routing quality control costs;

* costs incurred to perform surveys, advertise or promote a product, or improve management techniques;

* costs incurred to vary the taste of the product, the style of the product, or the design of the product;

* internally used computer software costs not for use in qualified research;

* foreign research conducted outside of the United States; or

* research currently funded by a grant.

What Are Additional Exceptions?

The one exception to the general mie for research expenditures that do, in fact, qualify is what is termed the "substantially all" requirement for in-house research expenses. In order to determine the wage levels to assign to a qualifying R&D activity, the company needs to identify the portion of each individual employee's time spent on the qualifying activity. If 80% or more of an individual employee's time was spent on qualifying R&D activities, then 100% of his wages are computed when calculating the research credit (IRC section 41[d][l][C] and Treasury Regulations section 1.41-4[a][2]). "Substantially all" of the services performed by the taxpayer by an individual must also fall within the boundaries of qualified research, direct supervision, or direct support (IRC section 41[b][2][B]). If the percentage of time spent is less than 80%, then the actual percentage of time spent by the employee on a qualified R&D activity needs to be determined so that an appropriate amount of the employee's wage can be allocated to the qualified R&D activity. These activities consist of those costs mentioned above. As is the case with research activities, Exhibit 2 indicates that not all expenses qualify for the research credit. In general, the research credit is based on in-house wages paid (not including employee and employer contributions to 401 [k] plans), the direct materials and supplies used, mid the contract research costs incurred when performing qualifying R&D activities.

Direct materials and supplies used in the qualifying R&D activity are also counted in determining qualified research expenses. In addition, time-sharing costs for computer use related to qualified research activities count as qualified research expenses. In contrast, materials and supplies that are capitalized do not qualify for the research credit.

If the "substantially all" requirement is not met, the taxpayer can still implement the "shrink back" rule, as defined in Treasury Regulations section 1.41-4(b)(2). This rule allows the taxpayer to evaluate each subcomponent of the research project, on a stand-alone basis, to determine whether this subcomponent represents a qualified research activity. The shrink-back rule will clearly limit the research credit, but it will nonetheless enable a taxpayer to gain a research credit on key R&D activities.

When the shrink-back rule is used, only specified costs associated with the activities listed above would qualify for the research credit. Other costs related to the research project, but not viewed as qualifying for the research credit, would need to be excluded when arriving at the value of the company's qualified research expenses. Finally, 65% of the contracted research costs associated with the qualifying R&D can be counted when computing the research credit (IRC section 41[b][3][A]). If a qualified research consortium organized primarily to conduct scientific research performs the contract research, then 75% of these costs qualify as research expenses (IRC section 41 [b][3][C]). If the contracted costs are paid to an eligible small business, a university, or a federal laboratory, then 100% of energy research costs only qualify for the credit (IRC section 41[b][3][D]). It should be noted that only contracted costs for which the company maintains the risk and intellectual property generated from the contract research qualify as research expenses for purposes of computing the research credit.

How to Determine the Research Credit?

Exhibit 3 provides conceptual details on how the research credit is determined, and Exhibit 4 shows an example of an actual calculation used in arriving at the tax incentives under the two elective methods. As illustrated, the first step is to total the allowable expenses incurred on qualified research activities. As mentioned above, these costs will largely be composed of wages, including support and direct supervisory wages; direct materials and supplies of a noncapital nature; and any contract research costs incurred.

Once these costs are determined and summed, the company will then choose whether to use 1) the regular method, or 2) an alternative simplified method, for computing the tax credit (see Exhibit 4 for specific calculations). Either of these election methods relates to the current year and also future taxable years (IRC section 41[c][4][B] and IRC section 41[c][5][C]).

If the company chooses to use the regular method, the company must, in the second step of the calculation, reduce its current-year qualifying research expenses by an amount found by multiplying a base percentage of its past qualifying research expenses by its average annual gross receipts for the four tax years preceding the tax year for which the credit is claimed (IRC section 41[c][l][B]).

The base percentage varies for existing and startup companies. An existing company's base percentage is found by dividing the aggregate qualified research expenses for the tax years after 1983 and before 1989 by the company's aggregate gross receipts for these years. The base percentage for a startup - defined for research credit purposes as a taxpayer that had both gross receipts and qualified research expenses for the first time in a tax year after 1983, or a taxpayer that had both gross receipts and qualified research expenditures for fewer than three tax years beginning after 1983 but before 1989 - is based on the number of years that the taxpayer had qualified R&D expenditures after 1993, with a full phase for the base percentage occurring in the 11th year (beginning after 1993) in which the taxpayer had qualified R&D expenses. If the taxpayer cannot prove the base percentage under the regular method due to a lack of either documentation or records, the IRS is required to completely disallow the research credit, even though the maximum base percentage of IRC section 41(C)(3)(C) equals 16%.

In the third step, once a company determines its baseline research expenses, the company must then reduce its currentyear research expenses by these baseline research expenses. As illustrated in Exhibit 3, this difference is then compared with 50% of the qualified research expenses for the year, with the lower amount representing the amount of a company's current- year research expenses qualifying for the research credit.

Under the regular method, the company will determine its research credit by multiplying its current year qualifying research expenses by 20% in step four. The credit computed must be offset against the company's R&D expenses for the year unless the company elects on its timely filed tax return (which includes extensions) to apply a lower rate (13%) when computing the credit.

If the company elects not to use the regular method to compute its research credit, either because it lacks historical records or is disadvantaged by using the regular method, it can avail itself of the alternative simplified method (see step five). Under the simplified approach, companies with qualified research expenditures in each of the previous three years will compute the research credit at 14% of the difference between the current year's qualified research expenses and 50% of the average research expenses incurred in the previous three years. If a company does not have qualifying research expenses in any one of the previous three years, the credit will be limited to 6% of the current year's qualifying research expenses (IRC section 41[c][5][B]).

How to Decide Which Method to Use?

Taxpayers should carefully evaluate which of the two credit calculation methods to use - the regular method or the alternative simplified method. Tax credit yields should enter into this determination, as well as how best the company can document the financial numbers used in the calculations.

Taxpayers may benefit from using the alternative simplified credit method of calculating the research credit if they have -

* a high base amount of research expenditures under the regular method;

* incomplete records to determine the startup base period research expense percentages; or

* significant growth of gross receipts in recent years.

For some companies, a key benefit in electing the alternative simplified method is the removal of gross receipts from the research credit computation. For example, during 1984-1988, the company may have spent significant amounts on R&D in relationship to sales, say 10% of gross receipts; however, as the company matured in later years, its sales may have increased at a faster rate than its research spending, effectively reducing research expenditures to 5% of sales. As a result, the ratio of qualified research expenses to gross receipts would be lower in these later years, effectively eliminating the credit available under the regular method.

What Type of Documentation Is Needed?

To substantiate the research credit, a taxpayer must prepare and retain documentation in either paper or electronic form. For a number of years, what was contained in this documentation and how it was prepared were often of central importance to IRS examiners, with taxpayers being denied research credits because of the lack of acceptable documentation for qualified research activities and the costs of these activities. Two recent court cases, United States v. McFerrin (570 F.3d 672, 5th Cir. 2009) and Union Carbide Corp. v. Comm'r (TC Memo 2009-50), have rendered opinions concerning what constitutes appropriate research credit substantiation and credible documentation. In both of these cases, the courts ruled that the taxpayers - in the absence of certain contemporaneous records such as a time tracking system, cost centers, or a project accounting system - could estimate research and experimentation expenses by looking to testimony of credible personnel and other available evidence.

Current IRS technical guidance suggests that the IRS has modified its audit procedures for research credit claims in response to these court cases. Specifically, the IRS counsels examiners to "avoid the trap of unnecessarily restricting the audit to the taxpayer's cost capturing system, as opposed to the research credit claimed. Audit adjustments based solely on critiques of the taxpayer's cost capturing approach usually stand little chance of being sustained in Appeals or in court" ("Briefing Paper on Taxpayer Approaches to Capturing Costs for the Research Credit," prepared by the Internal Revenue Service Large and Mid-Size Business Division, Office of Pre-Filing and Technical Guidance, p. 6).

What Other Elements Should Be Considered?

Under IRC section 174, the taxpayer can elect either to 1) deduct or amortize research expenses, or 2) claim the credit for them; however, one may not do both (e.g., no double-dipping). The research credit is also subject to the restrictions of the general business credit. The general business credit along with the 35 other incentive credits detailed in IRC section 38(b) are limited to 25% of the taxpayer's net tax liability over $25,000. To the extent that a research credit was not available for use in the current year, unused credits could be carried back one year and forward 20 years. With the passage of the Small Business Jobs Act of 2010, companies with less than $50 million in assets can now carry back unused research credits for a five-year period. (See Tracy Monroe, "Tax Opportunities that Still Exist for 2010," CPA Voice, December 2010, for a discussion of added changes to tax law created by the Small Business Jobs Act of 2010.)

The Small Business Jobs Act of 2010 also allows the research credit to be applied against the Alternative Minimum Tax (AMT) for 2010. Prior to the passage of the act, many S corporations and partnerships were effectively precluded from using the research credit to offset tax liabilities because of constraints associated with the AMT. With the passage of the Small Business Jobs Act of 2010, these constraints may no longer be present, which may increase the number of individuals that can use the research credit to offset 2010 tax liabilities ("Briefing Paper on Taxpayer Approaches to Capturing Costs for the Research Credit").

In addition to the federal credit, research tax credits have been adopted by many states. While many states follow the federal research tax credit, it is advisable to check with applicable states concerning their research tax credit legislation.

The research tax credit has implications for its consideration by CFOs, financial executives, business owners, and public accounting firms. For example, many businesses may not have even considered that going green or sustaining renewable energy present opportunities to at least initially consider whether they meet the abovementioned prerequisites.

What Are Examples of Industry-Specific Activities?

listed below are examples of specific industries and corresponding research activities that could potentially qualify for the credit:

* Entertainment and media: visual effects, animation, wireless projects, computer gaming, digital television, digital facilities design, web-based systems and interactive media, or media asset management systems.

* Phaimaceutical: drug metabolism, protein discovery, pharmaceutical technology development, drug safety assessment, biostatistics, or drug surveillance (IRS, Pharmaceutical Industry Research Credit Audit Guidelines, 2004, www.irs.gov/ businesses/article/0"id=171486,00.html).

* Food: developing new flavors, extending shelf life, increasing health benefits regarding low-carb and trans-fat compositions, reductions in the spread contaminants, or environmental reductions in wastes and by-products.

What Are the Benefits Involved?

It is important for firms to reevaluate their potential for research-intensive expenses that may qualify for the research and experimentation tax credit in order to assess an overlooked opportunity. The benefits of taking advantage of the credit can range from increases in cash flows to reductions in tax rates. For managers who are overwhelmed about documenting their expenditures or unsure whether their firm qualifies for the credit for increasing research activities, there are many sources that can provide assistance to companies including public accounting firms, tax planning professionals, and business advisory services. These sources provide industry expertise, guidance, and long-range planning.

Taxpayers should carefully evaluate which of the two credit calculation methods to use.

Peter Woodlock, PhD, CPA, ABV, CVA, is a professor of accounting and Karin Petruska, PhD, CPA, is an assistant professor of accounting, both at Youngstown State University, Ohio.