R&D Tax Credit 101

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David Hahn, CVA, ASA, MAFF, CM&AA, CCIM, MBA

R&D Tax Credit 101

Chapter 1    R&D Tax Credit Qualification Test
Chapter 2    R&D Tax Credit Quantification
Chapter 3    R&D Tax Credit Calculation
Chapter 4    R&D Tax Credit Documentation
Chapter 5    R&D IRC Section 41 Table of Contents link pertaining to R&D Tax Credit



Chapter 1    R&D Tax Credit Qualification Test
4-Part Test 


ALL of the following four criteria must be met in order to be qualified

Part 1 - Technological in Nature:
Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. Qualified research does not include research in the social sciences (including economics, business management, and behavioral sciences), arts, or humanities.


             ‡ Aiming to discover something based on hard sciences,
            such as:
         
                 Physical or biological sciences
                 Chemistry
                 Computer Science
                 Engineering



          ‡ No soft sciences, such as
         
                 Marketing
                 Accounting

                 Psychology

Part 2 - Permitted Purpose:
 
Process of experimentation is undertaken for a qualified purpose if it relates to a new or improved function, performance, reliability or quality of the business component.

     ‡ New or Improved 
        
                Functionality
                Performance
                Reliability or Quality 

       ‡  Business Components - 6 Types

                Product
                Process
                Formula
                Invention
                Computer Software
                Technique

Part 3 - Technological Uncertainty:
Research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.

        ‡  One or More of the following three uncertain things:

                Capability

                Methodology

                Appropriateness of Final Design

Part 4 - Process of Experimentation:
In general. For purposes of section 41(d) and this section, 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.


        ‡  STEPS TO A PROCESS OF EXPERIMENTATION

                Formulate a hypothesis / Initial idea

                Test that hypothesis / idea

                Confirm, modify, or reject the hypothesis / idea

                Continue revisions and testing until there is a 
                    successful result or the project is a failure


Substantially All Rule
80% or more of project qualifies, capture 100%
(80% of Costs, Time, and Other reasonable measurement)


Shrink Back Rule
If Substantially All  Rule failed, then apply Shrink Back Rule
(Shrink back to next smallest business component and apply Substantially All Rule.  Keep applying until qualified or disqualified.)       

Common Exclusions

  • Research after commercial production
  • Reverse engineering
  • Quality Control
  • Funded research (exception rule)

Chapter 2    R&D Tax Credit Quantification

Wages

  • Have to look at table wages, not gross wages
  • Dividends to owners do not qualify (but reasonable owner compensation may), but self-employment income does
  • Substantially All Rule
  • Major expenses in quantification

    
Supplies

  • Cannot be land or improvements to land
  • Cannot be property of a character subject to depreciation
  • Needs to be used and consumed in the R&D process
  • Process development scrap, prototype material

Funded Research

  • Taxpayer claiming credit must
  • bear the economic risk, and retain substantial rights in the research
  • Do the analysis on the terms of the contract
  • Economic Risk must be analyzed for

            Fee Structure
            Reimbursement provisions
            Inspection/rejection terms
            Termination clauses
            Warranties




Chapter 3    R&D Tax Credit Calculation

Depending on your date of incorporation, initiation of qualified research and ability to collect contemporaneous documentation, you could be eligible for either Regular Credit or Alternative Simplified Credit.

Regular Credit
  • 80s base - for companies that incorporated prior to 1 January 1984 and had 3 or more tax years with qualified research expenditures and revenue between 1 January 1984 and 31 December 1988; or
  • Start-Up base - for companies that incorporated after 31 December 1983 or had fewer than 3 years with qualified research expenditures and revenue between 1 January 1984 and 31 December 1988.

QRE (Qualified Research Expenses) minus Base Amount
Excess multiplied by percentage = Credit
No excess = no credit

Base Amount = Base Percentage * Average Annual Gross Receipts (AAGR) or 50% of QREs, whichever is greater

50% QREs provides statutory maximum

Alternative Simplified Credit

  • For companies that cannot adequately substantiate qualified research expenditures for 80s Base or Start-Up base credit calculation methods.
  • No statutory maximum
   
Chapter 4    R&D Tax Credit Documentation

Substantiating the Credit with the IRS
  • Many taxpayers do not keep detailed records, especially of the process of Experimentation
  • Need to have credible evidentiary basis for credit
  • Substantially All Rule
  • Major expenses in quantification


Documentation

  • Notes - Napkins, pictures, and whiteboards, etc
  • File layout organization
  • Separate R&D cost accounting integrated with internal ERP
  • Calendars and milestones
  • Emails
  • Routers
  • CNC programs
  • Project List

  

Chapter 5    R&D IRC Section 41 Table of Contents link pertaining to R&D Tax Credit





Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Table of Contents

Publication Date - June, 2005

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

* Unless other wise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.


This Audit Techniques Guide (ATG) is presented in several chapters. These chapters can be accessed and then printed by following the links in the Table of Contents below. To print the entire ATG please refer the the PDF version.

Table of Contents

    • Review Form 6765 - Credit for Increasing Research Activities
    • Research Credit Claims (Not on an Original Income Tax Return)
    • Prepackaged Submissions
    • Review the Taxpayer's Research Credit Computation Workpapers
    • Plan the Audit Strategy
    • In General 
    • The Alternative Incremental Research Credit (AIRC)
    • Start-Up Companies 
    • Gross Receipts 
    • Special Rules 
      • Aggregation Rules of Section 41(f)
      • Short Years 
      • Acquisitions/Dispositions 
      • Partnership Issue 
    • Wages
    • Supplies
    • Contract Research Expenses 
    • In General 
      • The Section 174 Test
      • The Discovering Technological Information Test 
      • The Business Component Test 
      • The Process of Experimentation Test 
    • Shrink Back 
    • Exclusions
  1. Reserved
    • Coordinated Issues
    • Awareness Issues
    • Development and Presentation of Issues
    • TA Contact Information
Page Last Reviewed or Updated: 02-Mar-2015





















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