Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Qualified Research Expenses
Publication Date - June, 2005
* Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.
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.
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.
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.
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.