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:: Credit for Increasing Research Activites - Qualified Research
Expenses
4.
QUALIFIED RESEARCH EXPENSES
(“QREs”)
Section
41(b)(1) defines QREs as the sum
of (1) "in-house research
expenses" and (2) "contract
research expenses”.
Section
41(b)(2) defines in-house
research expenses as:
-
any
"wages" paid or incurred
to an employee for
"qualified services"
performed by such
employee;
-
any
amount paid or incurred
for "supplies" used in
the conduct of
"qualified research”;
-
under
regulations prescribed
by the Secretary, any
amount paid or incurred
to another person for
the right to use
computers in the conduct
of qualified research.
Section
41(b)(3) defines "contract
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. If an expense is not
set forth in section 41(b), a
taxpayer may not claim the
expense as a QRE.
a.
Wages
The first
category of in-house research
expenditures eligible for the
research credit consists of
amounts paid or incurred for
wages. 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
section 41, the term “wages”
means wages as defined in
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.
Stock options
that are exercised and then
included in wages subject to
withholding, may or may not be
included as wages in the
research credit computation.5
The option is generally granted
as compensation for work
performed and is subject to
withholding upon grant. In such
situations, the type of work
done will determine if the
option spread (wage) is included
in the computation. For
example, if an option is granted
in 1997 and exercised in 2003,
you would look to see if the
work performed in 1997 would
qualify as a qualified service.
If it would qualify, then the
spread is included in wages in
the year the option is
exercised. In other words, look
to the grant year to determine
if it is a qualified service but
include the spread amount the
computation in the year it is
exercised.
Section
41(b)(2)(B) identifies three
types of qualified services:
-
Engaging in qualified
research,
-
Directly supervising
qualified research; or
-
Directly supporting
qualified research .
Treasury
Regulation section 1.41-2(c)
provides further guidance.
The term
"engaging in qualified research"
means the actual conduct of
qualified research, as in the
case of a scientist conducting
laboratory experiments.
The term
"direct supervision" means the
immediate supervision
(first-line management) of
qualified research (as in the
case of a research scientist who
directly supervises laboratory
experiments, but who may not
actually perform experiments).
"Direct supervision" does not
include supervision by a
higher-level manager to whom
first-line managers report, even
if that manager is a "qualified
research scientist“. Specific
attention should be paid to
individuals who do not
"directly" supervise qualified
research activities (i.e.,
management levels higher than
first line supervisors). In
some cases, higher level
research managers may perform
some qualified research or
direct supervision of qualified
research due to their technical
background and expertise, but
this is usually only a minor
fraction of their overall work
activities. In addition,
companies generally have a
certain number of employees that
work within traditional
"research" departments who do
not perform qualified services.
The term
"direct support" means 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. This would include
the services of a machinist for
machining a part of an
experimental model used in
qualified research.6
Direct support of research does
not include general and
administrative services, or
other services only indirectly
of benefit to research
activities.7
This is true whether general and
administrative personnel are
part of the research department
or in a separate department.
Treasury
Regulation section 1.41-2(d)(2)
provides that if substantially
all 8
of the services performed by an
employee during the taxable year
consist of qualified services,
then the term “qualified
services” means all of the
services performed by the
employee for the taxpayer during
the taxable year. The
‘substantially all’ rule for
wages is analyzed on an
employee-by-employee basis, and,
in general, is determined by
multiplying total wages by the
following fraction: Hours spent
in the conduct of qualified
services over total hours spent
in the conduct of all services
(sick leave, for example, would
not be included in the
fraction). See Treasury
Regulation section 1.41-2(d) for
the methodology applicable to
this rule. If the ratio is less
than 80%, the actual amount of
qualified services should be
used
Identifying the
employees whose wages are
claimed as QREs and determining
the services they perform is
perhaps the most important phase
of auditing the research
credit. Payroll records,
employee job descriptions,
performance evaluations,
calendars and appointment books
are good sources of
information. The goal is to
determine what the employee did
and how much time they spent
doing it.
If the employee
pool is large, and it is
impractical to achieve complete
coverage, consider using
statistical sampling
techniques. Audit resources
should focus on those employees
whose job descriptions suggest
they are engaging in
administrative, manufacturing,
marketing, and other
non-qualifying activities. When
appropriate, interviews should
be considered to supplement and
corroborate information obtained
from the review of existing
records.
An important
caveat: Determinations as to
whether an employee is (or is
not) engaged in qualified
services, should not be based
solely on job descriptions or
titles. Credit eligibility is
based solely upon what an
employee actually does, or does
not, do during a specific time
period. It is important to note
the technical and educational
qualification of a researcher,
but this is not conclusive
evidence that the individual
engaged (or did not engage) in
the performance of qualified
services.
b.
Supplies
A taxpayer may
claim the research credit for
amounts it paid or incurred for
supplies used in the conduct of
qualified research. Section
41(b)(2)(C) defines the term
"supply" to mean any tangible
property other than (1) land or
improvements to land, and (2)
property of a character subject
to the allowance for
depreciation. For example,
overhead, license fees and costs
for leasing assets are not
tangible property and,
therefore, not supplies.
Supplies are used in the conduct
of qualified research if they
are used in the performance of
"qualified services" by an
employee of the taxpayer (or
person acting in the capacity of
an employee). To be a QRE, a
supply must be directly related
to the performance of "qualified
services”. Expenses for
property used in general and
administrative activities are
not QREs. Accordingly, for the
purposes of section 41, a
"supply" is non depreciable
tangible property acquired by
the taxpayer that is used in the
performance of "qualified
services". 9
The examiner
should request that the taxpayer
produce documents to support its
claimed supply expense to ensure
that the amount only includes
non depreciable tangible
property acquired by the
taxpayer that was used in the
performance of "qualified
services".
There has been
a trend to include a myriad of
non-qualified research related
costs in the credit computation
by claiming such costs are
"supplies”. When reviewing the
supplies claimed as qualified,
focus on the statutory and
regulatory definition of
supplies. For example,
taxpayers often improperly treat
as a supply expense, the general
and administrative costs related
to "self constructed" supplies.
Additionally, the examiner
should carefully scrutinize
"prototype" 10
expenditures to determine
whether the "prototype" is (or
contains) property of a
character subject to an
allowance for depreciation.
Other examples of costs that are
not supply QREs are:
-
travel,
meals or entertainment
-
telephone expenses of
researchers
-
relocation or
rental/lease expense
-
professional dues or
royalty/license expenses
substantial
Supply QREs, in
general, should represent a
small portion of total QREs.
When supply QREs are
substantial, you should be
alerted to the possible
inclusion of capital or other
ineligible expenses being
claimed as QREs.
c.
Contract Research Expenses
A contract
research expense is 65 percent
of any expense paid or incurred
in carrying on a trade or
business to any person, other
than an employee of the
taxpayer, for the performance on
behalf of the taxpayer of
qualified research, or services
which, if performed by employees
of the taxpayer, would
constitute qualified services
within the meaning of section
41(b)(2)(B). Treas. Reg. §
1.41-2(e)(1). If any contract
research expense is attributable
to qualified research to be
conducted after the close of the
taxable year, it shall be
treated as paid or incurred when
the qualified research is
conducted. I.R.C. §
41(b)(3)(B). Thus, prepaid
research expenditures are not
eligible for the credit until
the services are performed.
-
Examining contract
research expenses is one
of the most
straightforward, yet
most often overlooked,
research credit issues.
An important audit step
is to request a list of
all contracts, along
with the dollar amount
of the claimed contract
research expense (by
contract). From this
list, select the
contracts that should be
requested and reviewed.
When there are only a
few material contracts,
all the contracts should
be requested. The
contracts should be
reviewed to determine
whether all the above
legal requirements have
been met.
Assistance of
local counsel can be helpful in
securing these agreements, as
well as assisting with their
interpretation. If requested
contracts are not provided, and
the taxpayer fails to represent
(preferably in writing) that
such contracts do not exist, we
recommend the use of summons.
This will ensure that the
examiner has had the opportunity
to review all of the taxpayer’s
documentation, and if the case
is unagreed, helps to ensure
that no new documentation will
be provided at an Appeals
conference.
Treasury
Regulation section 1.41-2(e)
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 (usually in writing,
but not required) that:
(i) is
entered into prior to the
performance of the qualified
research,
(ii) provides that research
be performed on behalf of
the taxpayer, and
(iii) requires the taxpayer
to bear the expense even if
the research is not
successful.
Qualified
research is performed on behalf
of the taxpayer if the taxpayer
has a right to the research
results. Qualified research can
be performed on behalf of the
taxpayer notwithstanding the
fact that the taxpayer does not
have exclusive rights to the
results. Also, 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 research, and
the payment is not a qualified
contract research expense.
Under Treasury
Regulation section 1.41-2(e), a
contract research expense is 65
percent of any expense paid or
incurred in carrying on a trade
or business to any person other
than an employee of the taxpayer
for the performance on behalf of
the taxpayer of (i) qualified
research, or (ii) services
which, if performed by employees
of the taxpayer, would
constitute qualified services
within the meaning of section
41(b)(2)(B). Where the contract
calls for services other than
services described above, only
65 percent of the portion of the
amount paid or incurred, that is
attributable to the services
described above is a contract
research expense.
Sometimes the
activities to be performed by
the contractor are more clearly
defined in
contractually-referenced work
orders or statements of work
rather than the body of the main
contract. Such documents should
be secured and reviewed.
A service
contract differs from a research
contract in calculating what
amounts will be allowable
contract research expenses. For
example, in a service contract,
the vendor may be paid by the
hour and the research is not
specified. In this case, you
must look at the work done.
Only the amounts paid for
qualified research work would be
included in QREs (subject to the
65% limitation). In a research
contract where there is an
agreed fixed price amount to
perform qualified research, the
entire amount would be subject
to the 65% limitation and
included as a QRE.
5
See Apple Computer, Inc. v.
Commissioner, 98 T.C. 232
(1992), acq., 1992-2 C.B. 1
(rtf, 31kb). and Sun
Microsystems v. Commissioner,
T.C. Memo 1995-69, acq., 1997-2
C.B. 1 (rtf, 25kb) for treatment
of stock options.
6 Other
examples of direct support of
research would include the
services of (1) a secretary
typing reports describing
laboratory results derived from
qualified research; (2) a
laboratory worker for cleaning
equipment used in qualified
research; and (3) a clerk for
compiling research data. Treas.
Reg. § 1.41-2(c)(3).
7
Services of payroll personnel in
preparing salary checks of
laboratory scientists, of an
accountant for accounting for
research expenses, of a janitor
for general cleaning of a
research laboratory, or of
officers engaged in supervising
financial or personnel matters
do not qualify as direct
support. Treas. Reg. §
1.41-2(c)(3).
8
The “substantially all” for
wages differs from the
“substantially all rule” for
Process of Experimentation.
9 For
more information on the
definition of a supply, see
Lockheed Martin Corp. v. United
States, 87 A.F.T.R.2d, ¶ 2001
812 (Ct. Cl. 2001). The only
exception to the general rule is
for certain "extraordinary
utilities" expenditures. See
Treas. Reg. § 1.41-2(b)(2).
10
Taxpayer labels are not
controlling.
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