The Research & Development Tax Credit (R&D tax credit) is a dollar-for-dollar federal tax credit that incentivizes the development of new or improved products or processes.
Potentially any company that performs “qualifying research activities” (QRAs) on U.S. soil can take advantage of the credit. R&D expenses that qualify for the R&D tax credit are known as qualified research expenses or qualifying research expenditures (QREs).
What kinds of research expenses qualify for the R&D tax credit?
IRC Code Section 41 defines QREs as the sum of “in-house research expenses” and “contract research expenses.”
3 Types of Qualifying In-House R&D Expenses
- Employee compensation for performing “qualified services.”
- Supplies used in the conduct of qualified research.
- Costs associated with cloud-based data storage and analytics.
The third point is straightforward, but the first two need more explanation.
Employee Compensation for Qualified Services
Employee compensation may qualify as R&D expenses. It doesn’t necessarily depend on the job description or job title. Or even the employee’s technical and education qualifications (though those are important). It all depends on whether they performed “qualified services.”
Qualified services are:
- Engaging in qualified research – the actual conduct of the research. For example, this might be a scientist conducting a lab experiment, an engineer drawing up new process plans, or a developer programming new software.
- Directly supervising qualified research – the immediate supervision of qualified research. These employees would be first-line managers or supervisors (a scientist who directly supervises experiments in a lab). It does not include higher-level managers to whom those first-line supervisors report, even if those managers are also in the research field.
- Directly supporting qualified research – services that directly support the employees. They either conduct the actual research or directly supervise those who do. For example, this might include the services of a CNC machinist who produces a part for an experimental model or prototype. It does not include general or administrative services, even if the employees performing them are part of a research department.
Employee compensation is typically the biggest expenditure on an R&D project. Identifying employees who perform qualified services and determining how much time they spend on those activities is one of the most crucial parts of an R&D tax credit study. However, these distinctions can be a bit tricky. The help of a specialty tax firm well versed in R&D tax credits is invaluable.
Supplies Used in the Conduct of Qualified Research
IRC Code Section 41 defines “supplies” as non-depreciable, tangible property used in the conduct of qualified research. Supplies must be used by employees performing the “qualified services.” Also, the supplies must be directly related to the research.
There are several types of property, supplies, and expenses that specifically don’t qualify
- Land or improvements to the land
- Property subject to the allowance for depreciation (like the building used to conduct research)
- Non-tangible expenses like license fees, leases, and rental costs, telephone expenses, entertainment, travel, relocation, professional dues, royalty expenses
- Supplies used for general and administrative activities
According to the IRS Audit Techniques Guide, supplies should make up a small portion of the overall QREs. The IRS might take a closer look to see if non-qualifying expenses were included if the portion is high.
Qualifying Contract R&D Expenses
Companies sometimes need to contract out some of their research activities. They could do this to gain necessary expertise or facilities or to save time and money. But, the R&D tax credit considers that.
Contract research amounts are paid to a third party. They will perform qualified research or services allowed at 65% of the actual cost incurred. However, if that number goes up to 75% if the third party is a “qualified research consortium.” We’ll cover that in a minute. The standards for “qualified research” and “qualified services” are the same as for in-house research. The performance of services must occur before prepaid research expenditures are eligible.
For the contract expenses to qualify, there must be an agreement (usually in writing) between the taxpayer and third party that meets a three-part test
- Entered prior to the performance of qualified research
- Provide qualified research to be performed on behalf of the taxpayer. The taxpayer has a right to the research results, even if it’s not an exclusive right.
- It must require the taxpayer to bear the expense of the research even if it isn’t successful. If payment to a third-party is contingent on the success of the research, then the taxpayer is paying for the product or result. Not the performance of the research. It is not a qualified research expense.
Moreover, part of the purpose of the R&D tax credit is to reward companies for taking the risks. Risks involved in developing new products and processes. No risk, no tax credit.
Payments to Qualified Research Consortia
Payments made to “qualified research consortia” for contract research are treated slightly differently than payments made to other third parties. The taxpayer can claim 75% of the contract research costs instead of 65%. Research to be done on behalf of the taxpayer and at least one other unrelated taxpayer. In short, the two or more taxpayers must be different employers.
So, what are “qualified research consortia?” Tax-exempt 501(c)(3) or 501(c)(6) organizations operated primarily to conduct scientific research. A private foundation can’t be a qualified research consortium. These organizations are typically educational institutions and scientific research organizations.
I believe my company may have qualifying R&D expenses. What is the next step?
Tri-Merit Specialty Tax Professionals help companies determine the size of their potential credit, the usability of those credits, and the appropriate way to support their credit claims.
In short, Tri-Merit will do much of the upfront work to determine if you qualify, at no cost. There’s no risk in exploring the possibilities. Call Jason Jones at (847) 637-5677 x135 to set up a consultation.
Jason Jones, Director – Counsel, Tri-Merit Specialty Tax Professionals
Jason is a Director in Engineering Services and General Counsel based in the firm’s Charlotte, North Carolina office. His responsibilities include audit defense, credit substantiation for R&D credits, business development and counsel to the firm. When Jason joined the firm in 2017, he brought with him 12 years as a corporate finance attorney working with several early stage to mid-level companies primarily in the tech and software development arenas.