The tax professional must generally understand the basics of R&D tax rules or risk overlooking the benefits due to the taxpayer.
While there are still tax credit issues to understand with R&D, we are also, surprisingly, looking at new restrictions on current deductibility.
Which customers may be affected?
Reading on our topic, “product” is often encountered. But keep in mind that it is entirely possible for even the owner of a middle market service business to have R&D.
R&D expenses generally include all expenses related to the development or improvement of a product. R&D expenses include expenses for obtaining a patent, such as attorney fees spent to file and perfect a patent application.
The term “product” includes all of the following:
- Pilot model
- To treat
- Similar property
R&D can reach software work, for example. Research may involve prototypes, systems, patentable activities, environmental testing, software development (see “IRS Issues Reasonable Internal-Use Software Regulations for Research Tax Credit”, Bertiglia and Windram , Tax Clinic, The Tax Adviser, 4/1/17).
R&D generally emphasizes costs in the “experimental or laboratory sense”. (Reg. 1.174-2(a)(1)). The identification of eligible research will emphasize technology. For example, marketing research is not eligible.
The tax rules may apply to otherwise qualifying R&D work that is at a particular stage. Although this is the nature of the research, costs that might otherwise be eligible are excluded if they relate to “the adaptation of an existing product or process to the needs of a particular client “. (See IRS instructions for Form 6765 Rev. Jan 2022, “Qualified Search”). The R&D credit does not apply to research, despite its technical nature, after commercial production.
In general, the topic of analyzing the customer situation for R&D qualification can involve many questions and sometimes a lot of professional time. The IRS estimates approximately one business day to understand and prepare the R&D form (IRS Instructions for Form 6565 Rev. Jan 2022, p.6).
Keep in mind that this estimate, which may well be low in the author’s opinion, does not address the resolution of relevant tax facts for a particular client, including an “R&D study”. The nature of the subject can be complex, but the key is often that the tax professional is able to ask the right questions.
Tax declaration – 2021 and before
Part of the tax practitioner’s job is to understand the taxpayer’s operations well enough to prepare Form 6765, Credit for Increased Research Activities. Our goal here is to help the tax practitioner prepare to discuss our topic with the client for the purpose of quantifying R&D.
The form takes into account the “regular credit” (section A), the “alternative simplified credit” (section B), the calculation of the credit for the current year (section C) and the payroll tax election and the payroll tax credit for qualifying small businesses. The last form, which does not include a tax year designation, is dated December 2020.
The tax incentive is intended to encourage increased R&D spending, hence the name of the form – “Credit for Increased Research Activities”. The underlying concept is focused on increasing research activity, but also on increasing R&D relative to its size.
As you gain a better understanding of how the form works, it will help you identify customers who may have significant R&D credit. The first main objective is line 16, which adds lines 1, 4 and 14.
Line 1 corresponds to amounts paid or committed to energy consortia. The instructions here caution to enter these amounts only here and note that the scope is primarily for payments to Section 501(c)(3) organizations that conduct energy research.
Line 4 focuses on amounts paid for basic research to qualified research organizations on the qualified organization’s base period amount for the previous 3 years (Section 41(e)). The focus here is on payments to a qualified university or research organization.
R&D customer support usually focuses on internal research, so lines 1 and 4 will often not be an issue. Line 14 is usually the primary focus.
R&D initially calculated in rows 5-8 focuses on: salaries, supplies, rental or computer rental costs plus an applicable percentage of contract research costs. Computer rental or rental charges apply to computers off the taxpayer’s premises. Contract research costs do not provide as much benefit as eligible in-house research costs.
Salaries cannot include compensation used to calculate work opportunity credit. The focus here is on payments such as workers receiving assistance, some veterans, ex-criminals, others. (See “Work Opportunity Tax Credit,” irs.gov). The independents are not left out; see the definition of “salary” as possibly including self-employment earnings (s. 41(b)(2)(D)(ii)).
Contract research typically accounts for 65% of contract payments to outside groups; that is, research that is not “internal”. (See “Auditing Technical Guide: Credit for Increased Research Activities (i.e. Research Tax Credit) IRC Section 41* – Qualified Research Expenses.” IRS.gov, June 2005).
Contract payments to non-internal researchers may be eligible up to 65%, but less than internal costs. The 65% may be 75% in the case of a research consortium (see Sec. 41(b)(3)). At this point, the tax professional will have quantified the total qualified research expenses, line 9.
Line 10 asks for a fixed base percentage, not exceeding 16%. (See generally Regs. 1.41-3, and form instructions for line 10). The instructions here distinguish a non-start-up (an “existing business”) telling that business to divide the aggregate qualified research expenses for the years beginning after 1983 and before 1989 by the aggregate gross revenue for those years. A start-up is defined as a company with less than three tax years beginning after 1983 and before 1989, or having gross receipts and eligible research expenses for the first time beginning after 1983.
The R&D deduction will essentially be the lesser of two digits. The fixed base percentage (no more than 16%) multiplied by the relatively recent average annual gross receipts must exceed the current total qualified research expenditure.
The relatively recent period corresponds to the four years preceding the current year. It is a limitation. The other limit is 50% of 20% of qualified research expenses; i.e. 10% of eligible current expenses. It is not uncommon for the calculations to yield a deduction of 10% of qualifying R&D expenses.
There are other subsets of choices and elections. For example, there is the alternative simplified method, plus credit issuances reducing the deduction or capitalized amount (see US overview in KPMG’s Global R&D Incentives Guide, 2021).
Calculations may need to focus on a controlled group, using a common ownership rule of more than 50%. The result would then be distributed among the members of the group.
Customer R&D deduction and credit management
The pre-2022 rules allow qualifying R&D to be deducted, although there is also a rule focusing on depreciation over at least sixty months. The Tax Cuts and Jobs Act ensured that R&D costs after 2021 would be capitalized and amortized over five years, or longer if the work is performed outside of the United States and its possessions.
The importance of identifying qualifying R&D expenditure has always focused on extraordinary benefits. However, after 2021, the question becomes more rudimentary of identifying expenditures that may need to be capitalized for tax purposes.
Despite the new federal capitalization rules, the rules on R&D credits continue to incentivize. The R&D credit has had periodic extensions, from a year ago to many years ago, but was later made permanent with the Protecting Americans from Tax Hikes (PATH) Act of 2015. (“Research and Experimentation (R&E) Credit,” U.S. Department of Treasury, Office of Tax Analysis, 12/10/16, pp. 1 of 22).
The R&D credit (aka the “R&E credit”) is almost certainly here to stay, despite the surprising legislative rollback of current deductibility. IRS concern about R&D rationale came with additional support required for refund claims filed after Jan. 10, 2022. (IR-2021-203, 10/15/21; see “Research Credit Claims (Section 41) on Amended Returns Frequently Asked Questions”, IRS.gov).
The nature of the subject, R&D, is essentially investigative, as is the work of the tax specialist to help the client concerned. The issues of scope of tax benefits (federal and state) and qualification can also be complex.
There is the surprising new post-2021 rule limiting the current deductibility of R&D. In rare cases, the complexity and scope of the benefits may justify hiring an R&D specialist. In general, it is recommended that the scope of the tax practitioner’s R&D review questions encompass not only the current year, but also previous years, as it is no longer at all uncommon for R&D to arise in tax returns. changes from your customers.