Taxpayers are always interested in whether certain expenditures qualify as tax deductions. But many taxpayers often forget that expenditures may alternatively qualify for various tax credits, such as the research and development credit. And all things being equal, taxpayers should generally prefer tax credits over tax deductions as the former are more valuable monetarily than the latter.
Regrettably, many taxpayers are unaware that they qualify for certain tax credits. For this reason, thousands of taxpayers each year fail to file the necessary forms with their tax returns, rendering the credits unclaimed. After a number of years, these credits are gone forever due to the statute of limitations for refund claims.
This article explains one of the more commonly missed tax credits: the research and development credit under Section 41.[i] This article also discusses the IRS’s renewed interest in this credit and its new refund claim procedures applicable to taxpayers who seek to claim the credit after January 10, 2022.
The Research & Development Credit
Section 38 houses many permissible tax credits. Among these is the “qualified research activities credit,” the requirements of which are found in Section 41. Section 41 is not an easy read. Rather, it is full of super-technical statutory definitions (often within other statutory definitions) and various formulas and computations. Indeed, the IRS recently commented on Section 41 as follows:
The research credit (as provided by I.R.C. § 41) is a complex area of law involving the application of a four-part test, numerous exclusions, and significant computation and calculation elements to each research activity claimed by a taxpayer in any given tax year.[ii]
And the Tax Court has further commented on Section 41: “The research credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.”[iii]
Credit Amount
Generally, the amount of the qualified research activities credit can be determined through the following formula:
Research Credit Amount = 20 % x [Qualified Research Expenses for Year – Base Amount]
For these purposes, the term “qualified research expenses” means the sum of all amounts paid or incurred during the tax year by the taxpayer in carrying on a trade or business for “in-house research expenses” and “contract research expenses.”[iv]
In-House Research Expenses
“In-house research expenses” is defined by statute to mean all expenses for: (1) wages paid or incurred to an employee for qualified services performed by the employee; (2) any amount paid or incurred for supplies used in the conduct of qualified research; and (3) certain amounts paid or incurred to another person for the right to use computers in the conduct of qualified research.[v]
Qualifying Wages
For purposes of Section 41, the term “wages” has the same meaning as that term is used throughout the Code.[vi] Generally, wages must be separated between those allocable to qualified services and those allocable to other services.[vii] However, there is a taxpayer-friendly rule in the regulations—if substantially all of the services performed by the employee for the taxpayer during the tax year consists of qualified services (i.e., 80% or more), the taxpayer may claim all of the employee’s wages as qualified services.[viii]
“Qualified services” means engaging in either: (1) qualified research; or (2) the direct supervision or direct support of research activities which constitute qualified research.[ix] “Qualified research” is discussed more extensively below. For purposes of (2), however, “direct supervision” means the immediate supervision (i.e., first-line management) of qualified research and not higher-level managers, and “direct support” means services in the support of persons engaging in actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research.[x]
Supplies
Section 41 defines “supplies” broadly to mean any tangible property other than land or land improvements and property subject to depreciation.[xi]
Contract Research Expenses
“Contract research expenses” is defined to mean 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.[xii]
What is Qualified Research?
As shown above, the term “qualified research” is ubiquitous throughout Section 41 and its various statutory definitions. Thus, the heart of Section 41—and a taxpayer’s eligibility for the tax credit—often hinges on whether the activity at issue constitutes a qualified research activity.
Generally, to constitute qualified research, the activity must meet all of the following requirements: (1) the expenditures associated with the activity must be Section 174 expenditures; (2) the activity must be undertaken for the purpose of discovering information which 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 (3) substantially all of the activities must constitute elements of a process of experimentation for purposes of Section 41(d)(3).[xiii] Under Section 41(d)(3), research qualifies if it is conducted for a purpose that relates to a new or improved function, performance, or reliability or quality, unless it also relates to style, taste, cosmetic, or seasonal design factors.
The Section 174 Test
The first requirement to constitute “qualified research” is that the expenditures from the activity must represent Section 174 expenditures. Under the Section 174 regulations, Section 174 expenditures are “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”[xiv] Generally, this definition hinges on uncertainty—the expenditures for the activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a new product.[xv] In turn, uncertainty is present if the information available to the taxpayer does not establish the capability or method in developing or improving the product or the appropriate design of the product.[xvi] Examples in the Regulations provide some additional color on Section 174 expenditures and the uncertainty component.
Example. Company is engaged in the manufacture and sale of custom machines. Company contracts to design and produce a machine to meet a customer’s specifications. Because Company has never designed a machine with these specifications, Company is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine. Company incurs a total of $31,000 on the project. Of the $31,000, Company incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design. Company also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine. This $11,000 of costs represents research and development costs in the experimental or laboratory sense.
After uncertainty is eliminated, Company incurs $20,000 to produce the machine for sale to the customer based on the appropriate design. The model produced and used to evaluate and resolve uncertainty is a pilot model. Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under Section 174. However, Section 174 does not apply to the $20,000 that Company incurred to produce the machine for sale to the customer based on the appropriate design.[xvii]
Example: Company is a wine producer. Company is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes. In order to test the effectiveness of the new method of crushing wine grapes, Company incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process. The $2,000 of costs represents research and development costs in the experimental or laboratory sense. Therefore, the $2,000 incurred qualifies as research or experimental expenditures under Section 174 because it is a cost incident to the development or improvement of a component of a process.[xviii]
The Technological Information Test
To be “qualified research,” an activity must be undertaken for the purpose of discovering information that is 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.[xix]
The Business Component Test
The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer. For these purposes, a business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its trade or business.”[xx]
The Process of Experimentation Test
To be “qualified research,” the activity must also meet the process of experimentation test. For these purposes, 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.[xxi] Generally, federal courts and the IRS break the process of experimentation test down further into three separate elements: (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element.[xxii] Each of these elements is tested for each separate business component.
To meet the “substantially all” element, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose.[xxiii]
To meet the “process of experimentation” element, the taxpayer must engage in “a process designed to evaluate one or more alternatives to achieve a result” where the taxpayer is uncertain at the beginning of its research activities regarding the capability or method of achieving the result or an appropriate design.[xxiv] The Section 41 regulations further provide:
A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer sciences and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.[xxv]
To meet the “qualified purpose” element, the research process must relate to a new or improved function, performance, reliability or qualify of the business component.[xxvi] Research activities for style, taste, cosmetic, or seasonal design factors do not qualify. And qualified research specifically does not include the following activities:
- Research after Commercial Production. Any research conducted after the beginning of commercial production of a business component.
- Adaptation of Existing Business Components. Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
- Duplication of Existing Business Component. Any 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, Studies, etc.. Any of the following: (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control.
- Computer Software. Unless otherwise exempted by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in: (i) an activity which constitutes qualified research, or (ii) a production process with respect to which the requirements of (i) are met.
- Foreign Research. Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
- Social Sciences, Etc. Any research in the social sciences, arts, or humanities.
- Funded Research. Any research to the extent funded by any grant, contract, or otherwise by another person (or government entity).[xxvii]
Examples under the Section 41 regulations are helpful in determining whether an activity meets the qualified purpose element:
Example: Company is engaged in the business of developing and manufacturing blue vehicles. Company wants to change the color of its blue vehicles to green. Company obtains from various suppliers several different shades of green paint. Company paints several sample vehicles, and surveys its customers to determine which shade of green the Company’s customers prefer. In this case, the Company’s activities to change the color of its blue vehicles to green are not qualified research because substantially all of Company’s activities are not undertaken for a qualified purpose. All of Company’s research activities are related to style, taste, cosmetic, or seasonal design factors.[xxviii]
Example: Same example as above, except that Company chooses one of the green paints. Company obtains samples of the green paint from a supplier and determines that Company must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints that Company has used. Company obtains detailed data on the green paint from Company’s paint supplier. Company also consults with the manufacturer of Company’s paint spraying machines. The manufacturer informs Company that Company must acquire a new nozzle that operates with the green paint Company wants to use. Company tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines. Under these new facts, Company’s activities to modify its painting process are a separate business component, and Company’s activities to modify its painting process to change the color of its blue vehicles to green are not qualified research. Company did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machine eliminated Company’s uncertainty regarding the modification of its painting process. Company’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control.[xxix]
Base Amount
If a taxpayer has qualified research and otherwise meets the requirements of Section 41, the taxpayer must then compute the “base amount”. For these purposes, the “base amount” is defined as the product of (i) the “fixed-base percentage,” and (ii) the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being claimed (i.e., the “credit year.”).[xxx]
Section 41(c)(3)(A) generally defines the “fixed-base percentage” as the percentage of aggregate qualified research expenses of the taxpayer for the taxable year beginning after December 31, 1983, and before January 1, 1989, to the aggregate gross receipts of the taxpayer for such tax years. If the taxpayer had both gross receipts and qualified research expenses after December 31, 1983, the fixed-based percentage is set by statute, starting with 3% for each of the taxpayer’s first five taxable years beginning after December 31, 1993.[xxxi]
Due in part to the complexity of the “base amount” computations, the Code also permits taxpayers to elect an “alternative simplified method.”[xxxii] Under this method, the credit is equal to 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined.
Claiming the R&D Credit
The Section 41 credit has historically been claimed on IRS Form 6765, Credit for Increasing Research Activities. More recently, however, the IRS has indicated that it intends to make it more difficult for taxpayers to claim the credit, particularly for claims made after January 10, 2022. The IRS’s justification for imposing these new requirements is due to its difficulty in ascertaining whether the taxpayer qualifies and a regulation that provides that taxpayers must generally provide sufficient facts to apprise of the IRS of any refund or claim for credit.
Specifically, by regulation, the IRS is not required to issue a refund or credit unless it receives a claim that sets forth in detail each ground upon which the refund or credit is claimed and facts sufficient to apprise the IRS of the exact basis of the refund or credit.[xxxiii] On October 15, 2021, the IRS issued a Field Attorney Advice (“FAA”) that provided additional requirements taxpayers must meet under this regulation to make a valid claim for credit or refund under Section 41.[xxxiv] If the taxpayer fails to meet the requirements, the IRS has indicated that it will deny the refund or credit claim in its entirety as invalid.
Under the FAA, the taxpayer’s refund claim for a research activity credit is valid if, at a minimum, the taxpayer:
- Identifies all the business components to which the Section 41 research credit claim relates for that year;
- For each business component, the taxpayer identifies all research activities performed; identifies all individuals who performed each research activity; and identifies all the information each individual sought to discover;
- Provides the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (which may be done through using Form 6765);
- Must provide a declaration signed under penalties of perjury verifying that the facts provided in the claim are accurate.
The FAA indicates that if the taxpayer fails to meet these requirements, the IRS will reject the claim as deficient.[xxxv]
Conclusion
Every year, taxpayers who qualify for the Section 41 credit fail to claim it. This is somewhat understandable, particularly in light of the difficulties taxpayers face in determining whether they meet each of Section 41’s various statutory and regulatory requirements. However, business owners who engage in new processes and products should consult with a tax professional to determine whether they are leaving money on the table each year in not claiming the tax credit.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.
[i] All section references are to the Internal Revenue Code of 1986, as amended (the “Code”).
[ii] IRS FAA 20214101F.
[iii] Suder v. Comm’r, T.C. Memo. 2014-201.
[iv] See I.R.C. § 41(b)(1).
[v] I.R.C. § 41(b)(2).
[vi] I.R.C. § 41(b)(2)(D).
[vii] Treas. Reg. § 1.41-2(d)(1).
[viii] Id. at (d)(2).
[ix] I.R.C. § 41(b)(2)(B).
[x] Id. at (c)(3).
[xi] I.R.C. § 41(b)(2)(C).
[xii] I.R.C. § 41(b)(3).
[xiii] I.R.C. § 41(d).
[xiv] Treas. Reg. § 1.174-2(a)(1).
[xv] Id.
[xvi] Id.
[xvii] Treas. Reg. § 1.174-2(a)(11), Ex. 4.
[xviii] Id., Ex. 10.
[xix] Treas. Reg. § 1.41-4(a)(4); see also Max v. Comm’r, T.C. Memo. 2021-37 (quoting legislative history).
[xx] Sec. 41(d)(2)(B).
[xxi] Treas. Reg. § 1.41-4(a)(5).
[xxii] Union Carbide Corp. & Subs. v. Comm’r, T.C. Memo. 2009-50.
[xxiii] Treas. Reg. § 1.41-4(a)(6).
[xxiv] Treas. Reg. § 1.41-4(a)(5).
[xxv] Id.
[xxvi] Id.
[xxvii] I.R.C. § 41(d)(4).
[xxviii] Treas. Reg. § 1.41-4(a)(8), Ex. 1.
[xxix] Id., Ex. 2.
[xxx] I.R.C. § 41(c)(1).
[xxxi] I.R.C. § 41(c)(3).
[xxxii] I.R.C. § 41(c)(4).
[xxxiii] See Treas. Reg. § 301.6402-2(b)(1).
[xxxiv] See FAA 20214101F.
[xxxv] The AICPA has provided comments and concerns to the IRS regarding its implementation of the change in requirements for a valid refund claim for the R&D credit.
