Federal Credit for Increasing Research Activities
The Federal Credit for Increasing Research Activities “R&D Tax Credit” under Internal Revenue Code (“IRC”) §41 and 174, was enacted to incentivize businesses to invest in the development of new or improved business components to create new jobs in the U.S. and for companies to be competitive in the world marketplace.
The federal R&D credit rate is 20% (14% for Alternative Simplified Credit calculations). In addition, most states have some form of credits or incentives for research and development activities, which allows companies to get a double benefit for their research expenditures.
Unfortunately, many companies are not taking full advantage of these business incentives; are significantly understating their credits; or do not have the necessary documentation to adequately support their credits claims. The following information sheds light on what types of R&D expenses are qualified for the R&D Tax Credit.
IRC. §41(b) (2) defines wages as "in-house research expenses” as paid or incurred to an employee for qualified services (either direct research, supervision, or support activities). Many different company personnel perform many research activities that may be considered qualified wages for the R&D Tax Credit.
For example, many firms frequently hire specialized personnel who are supervisors and high-level executives who have direct supervision responsibilities over their employees who are conducting direct research activities. High-level executives quite often are highly educated and skilled workers, many with advanced degrees, and can be involved in all major new or improved drug development activities. In addition, these high-level executives, including the founders of the company, are many times the inventors or co-inventors on their company’s new patents.
Another employee group that performs research activities are manufacturing personnel. While they may not be the core scientists, engineers, or researchers at a company; manufacturing personnel nevertheless perform an important research and development function for the company. For example, manufacturing personnel’s job responsibilities frequently include: R&D equipment setup/breakdown and cleaning; hands-on manufacturing operations; materials dispensing, preparing test documentation, preparing laboratory batches, and perform scale-up experiments to facilitate technology transfer for the manufacturing line, procure and maintain inventory for new manufacturing techniques, and interact with technical personnel to ensure testing of prototype materials as needed.
Contract Research Expenses
We discussed employee activities as an eligible research expenditure, but what other R&D costs are often overlooked or not properly documented? One such expenditure is contract research expenses, which is 65% of “any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research” is eligible for the R&D Tax Credit.
For example, a company may hire a third-party scientist to conduct a study or perform a test on the company’s behalf, especially if the companies do not have the expertise in-house. In this situation, there are several factors to consider before you can claim these expenses as eligible contract research expenditures.
First, the activities need to be conducted on a qualified project that meets the IRC §41 eligibility requirements. Once those tests are satisfied, the actual contract or agreement needs to be reviewed and evaluated under the “Rights” and “Risks” tests since the taxpayer must have some rights to the results of the research and must take on the economic risk of the research. Under the R&D tax credit regulations, the qualified research will be treated as being performed on behalf of the taxpayer only is the taxpayer has a right to the result. In addition, the regulations require the taxpayer to bear the expense even if the research is not successful. To this end, companies need to make sure they review all their contracts for credit eligibility when hiring outside contractors or consultants who perform research for them.
Another potentially qualifying R&D expense is supplies. Supplies are any tangible property other than land, land improvements or other property subject to depreciation that is used or consumed during research. Supply expenses must be directly linked to qualified research activities, including prototypes and testing materials. Travel, shipping or royalty expenses cannot be included as supply expenses. Taxpayers routinely fail to properly claim their supply expenses because they have not shown how these expenses were used during research or conversely, they failed to recognize them as an eligible expense in the first place.
Many activities and related expenditures at companies are eligible for significant R&D Tax Credits. The more knowledgeable a company is in capturing the appropriate activities, the more credit benefits they will receive. When in doubt, companies would be wise to consult with R&D Tax Credit specialists who can help them navigate through the complex nature of identifying and documenting these available credits and business incentives.