On 12/19/2014, President Obama signed the H. R. 5771 Bill, known as the Tax Increase Prevention Act. This means that a host of tax credits are being extended to another tax year. Among these is the Research and Development credit. Many small and middle sized businesses do not claim the credit because of the complications in calculating it:
The research credit equals the sum of: (1) 20% of the excess (if any) of the qualified research expenses for the tax year over a base amount; (2) the university basic research credit (i.e., 20% of the basic research payments); (3) 20% of the taxpayer’s expenditures on qualified energy research undertaken by an energy research consortium.
The base amount is a fixed-base percentage of the taxpayer’s average annual gross receipts from a U.S. trade or business, net of returns and allowances, for the 4 tax years before the credit year, and can’t be less than 50% of the year’s qualified research expenses.
However, in January 1, 2007, the alternative simplified research credit went into effect that makes calculations for the R&D credit more straightforward:
The alternative simplified research credit equal to 14% of the excess of the qualified research expenses for the tax year over 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined. If a taxpayer has no qualified research expenses in any one of the three preceding tax years, the alternative simplified research credit is 6% of the qualified research expenses for the tax year for which the credit is being determined.
Here is an example for the alternative simplified research credit: your company averages $20,000 in qualified R&D expenses in the last 3 years, and $25,000 for the credit year. So 14%*($25,000 – 50%*($20,000)) equals $2,100 in R&D credits.
Not all R&D expenses are Qualified Research Expenses (QRE). In order to qualify as a QRE, (1) the expense must be of the type deductible under § 174 of the Code, (2) the research must be undertaken for the purposes of discovering information that is “technological in nature,” (3) the information must be “intended to be useful in the development of a new or improved business component of the taxpayer,” and (4) “substantially all of the activities [must] constitute elements of a process of experimentation.” When an employee has performed both qualified and nonqualified services, only the amount of wages attributable to the conduct of qualified services may be counted as a QRE. However, if eighty percent or more of an employee’s wages are allocated to the performance of qualified services, then all of the employee’s wage can be counted as a QRE.
Below are two current considerations when businesses want to claim the R&D credits based on most recent R&D cases.
Is supervising the direct supervisor of employees who conduct qualified research is a qualifying service under section 41?
On 01/23/14 the case Shami Vs. Comm was decided by the U.S. Court of Appeals, Fifth Circuit in favor of the IRS Commissioner that “the supervisor of the direct supervisor of the employees who conduct qualified research is not himself engaged in qualified research,” “even if that manager is a qualified research scientist.” Meaning that only the first-level managers’ salaries are counted towards qualified service expenses. Any salaries for the second-level managers (whom the first-level managers report to) will not be counted as qualified service expenses.
Can capped contracts expenses be qualified for the R&D credits?
There are 3 types of contracts, the first type is fixed-price contract (no matter how much costs in materials and labors incurred, contractors can only charge the client a fixed amount); the second type of contract is cost-plus contract (the contractor are allowed to charge extra for the extra labor and materials incurred to finish the project); and finally capped contract (same as a cost-plus contract, but contractors are only allowed to charge the client up to the capped amount specify in the contracts. Since the R&D credits only be claimed for the expenses that are not funded by others, and the entire risks must be placed on the contractor, capped contracts expenses cannot be used to claim for the R&D credits. As the case Geosyntec Consultants, Inc. v. U.S. (04/15/2013) pointed out, unlike fixed-price contracts where contractors take all the risks, the capped contract place the burden of risk on the clients instead; therefore, capped contract expenses are not qualified for the R&D credits, unless the contract indicate clearly that the entire risks are place on the contractor.
More importantly, in order to claim the R&D credits, “tax payer . . . must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credits.” In order words, the burden of proof is on the taxpayers who want to claim the credit.