Commonly, a businesses’ main concern is filing its tax returns. Although this makes sense, it is not wise, business owners must implement systems now for certain deductions and credits they plan to take in the future.
To assist taxpayers, Congress offers incentives through deductions and credits. A deduction is an amount that you deduct from your taxable income. Meanwhile, a credit is a dollar-for-dollar reduction. Currently, the most discussed credit is the “Employee Retention Credit” or “ERC”. Although, this is something I encourage businesses to see if they should amend their 2020 and 2021 tax returns, I also ask businesses to turn their heads to year 2023.
Companies that conduct research must keep a record keeping system to substantiate the qualified research expense credit (“Research Credit”). The Research Credit, codified under Section 41, is 20 percent of the excess of a taxpayer’s qualified research expenses (“QREs”) for the taxable year over the base amount.
Section 41(b)(1) states that QREs include “in-house” research expenses, “contract research expenses,” and leasing computers in the conduct of qualified research. Further, Section 41(b)(1) states that QREs apply to investments in products, processes, software developments, or improvements with an explicit commercial purpose. Importantly, Section 41(d)(3)(A) made it clear that the research does not have to be original, or even succeed. The four-part test to determine if an R&D activity applies for the tax credit:
· Business Component Test: Section 41(d)(2) and Treas. Reg. Section 1.41-4(a)(5)(ii) states that the business component can be a product, process, function, invention, software or technique. Treasury Decision 91-104 made it clear that a qualified project must involve a qualified purpose such as new or improved function, reliability, durability or efficiency. the project possesses uncertainty regarding the capability, method, or appropriate design for improving or creating a product or technology.
· Technological in Nature Test: Treas. Reg. 1.41-4(a)(4) requires focuses upon the type of information being discovered or sought in the project. The purpose of the research is discovering information that is technological in nature. Treasury Decision 89-30 requires that the research involve sciences and math, whereas non-technological or soft-sciences, such as social sciences, psychology, marketing, or management/leadership studies, are excluded.
· The Uncertainty Test: This incorporates guidance from Section 174 into Section 41; therefore, it is sometimes referred to as Section 174. There are three types of uncertainty: capability uncertainty, methodology uncertainty, and appropriate design uncertainty. Section 41(d) requires that the uncertainty test requires that the taxpayer undertake research for the purpose of discovering information for developing a new or improved business component of the taxpayer.
· The Process of Experimentation Test: Treas. Reg. Section 1.41-4(a)(2)(iii) requires that this test focuses on how the technical uncertainty is resolved. Section 41(d)(3)(A) requires that substantially all of the research activities are elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality of a business component.
If the Four-Part Test fails at any point the analysis can “shrink-back” or reframe the research project to a sub-component or subset of activities where the Four-Part test could be met. Treas. Reg. 1.41-4(b)(2) states that if the requirements are not met at the originally defined project level, the analysis would next be applied at the most significant subset of elements of the product, process, formulae, invention, software, or technique.
Section 41(d)(4) excludes research with respect to computer software developed by (or for the benefit of) the taxpayer primarily for the internal use by the taxpayer, other than for the use in an activity which constitutes qualified research or a production process with respect to which the 4 tests for determining qualified research are met. This does not include software created for use by third parties. In Treas. Reg. Section1.41-4(c)(6)(viii), Example 7, a manufacturer developed software for a website with the intent to allow third parties to access data on the manufacturer’s database, to order manufacturer’s products, and track the status of their orders online. At the beginning of the development, the manufacturer did not intend to develop the website software for commercial sale, lease, license, or to be otherwise marketed to third parties. The manufacturer developed the software to allow third parties to initiate functions or review data on the taxpayer’s system, rather than for a general and administrative function. Accordingly, the IRS concluded that the software was not developed for internal use. Further, if a business conducts research towards cloud computing, they may qualify under Section 41(b)(2)(iii).
Certain activities cannot be qualified research. Section 41(d)(4) states that qualified research does not include:
· research after commercial production;
· adaptation or duplication of existing business component;
· market research;
· routine or ordinary testing or inspection for quality control;
· research outside the United States;
· research related to the social sciences, arts; or
· research funded by any grant, contract, person, or governmental entity.
Little Sandy Coal Co. v. Commissioner, T.C. Memo. 2021-15 at 39 has shown that the Credit applies to the costs of developing the concept of a product but not the costs of building the product itself, unless it is the pilot model. The holding in TG Missouri supports the conclusion that a contractual obligation to build a product does not preclude the product from being built to resolve uncertainty.”
Direct supervision and direct support classify as qualified research. Treas. Reg. Section1.41-2(c)(2) states that “direct supervision” means the first-line management of the research, not management by a high-level manager. Treas. Reg. Section1.41-2(c)(3) states that “direct support” means services in the direct support of either persons engaging in actual conduct of qualified research or their direct supervisors. Examples of direct support include a secretary typing reports describing laboratory results, a laboratory worker cleaning research equipment, a clerk compiling research data, and a machinist machining a part of an experimental model used in qualified research.
Substantiating the Deduction
Filing for the QRE increases your chances of being audited by the IRS. During the Examination, the taxpayer must prove to the IRS that it met all four aforementioned tests and does not fall under one of the exclusions. As seen in McFerrin v. State, 344 Ark. 671, 42 S.W.3d 529 (2001), during an examination, the taxpayer must possess the required documentation to prove they meet the requirements for a deduction. As shown in Moore v. Commissioner, T.C. Memo. 2023-20 at 11, even if a court believes that an employee’s activity was qualified research, the court needs a basis for estimating how much time the employee spent on a qualified research project.
To save the stress of trying to find proof at the end of the year there are two types of wage allocation systems that are generally used:
· employee interviews/surveys; and
· time recording systems.
The employee interview and survey process consist of explanations after the close of the tax year, the nature of their department’s work and estimate the amount of time spent on qualifying research. General survey questions typically consist of:
· description of the department’s general function;
· description of the department’s significant R&E activities;
· description of the technical or design uncertainties;
· description of the alternatives or hypotheses evaluated;
· description of the business component being developed;
· whether the department provided direct support to R&E;
· percentage of employees’ time spent on qualifying research; and
· whether the department developed internal use software.
Time recording systems is a process by which a computer system is employed by the taxpayer and it records the employees’ time spent on qualifying research projects and qualifying research activities. Detailed time records typically include the number of hours spent on a particular project, product feature, or system and the number of hours spent on a specific type of activity within each project (e.g. design modeling, software tests, building prototypes). Ideally, the system should also capture time spent on non-research activities, such as:
· training seminars;
· general management tasks;
· foreign travel;
· vacation time; and
· time spent on leave.
Exam may challenge the system as unreliable if the employees cannot identify non-qualified activities.
Whichever test is employed, as seen in Siemer Milling v. Commissioner, T.C. Memo. 2019-37 at 31, the business owner must ensure that they build a record that shows they formulated or tested hypotheses, or engaged in modeling, simulation, or systematic trial and year.
Taxpayers must turn to today’s operations and decide at the frontend if they plan to file the QRE. When a company puts a strategic plan in place, they not only save them stress at the end of the year, and struggle from employees’ poor memory, but they will have a much greater chance of success during an Exam.