The federal research and development tax credit can be a boon to businesses, but as with any portion of the tax code, the rules surrounding it are complex. The IRS recently released a concept unit and a process unit addressing two facets of the credit: how the treatment of R&D costs under FASB standards interacts with certain portions of the Internal Revenue Code, and how to compute qualified research expenses. The authors summarize this IRS guidance with advice for taxpayers.
The IRS’s Large Business and International (LB&I) division recently released two documents on research and development (R&D) costs. The first document, a concept unit, provides examiners with an overview of the treatment of R&D costs under Accounting Standard Codification (ASC) Topic 730, “Research and Development,” and how it correlates with related Internal Revenue Code (IRC) sections 41 and 174 (http://bit.ly/2mgnMfU). The second document, a process unit (http://bit.ly/2m2lW20), provides an explanation of how to implement an LB&I directive related to computing qualified research expenses (QRE) under IRC section 41. This article summarizes the guidance in these two documents.
Concept Unit: ASC 730 and IRC Sections 41 and 174
For financial reporting purposes, R&D costs (when material in amount) are reported as a separate line item on certified audited financial statements. Because ASC 730 is part of GAAP, the amounts presented should be reliable and free from material misstatement. The activities treated as R&D in ASC 730 have many similarities with those covered by IRC sections 41 and 174, and thus the amount reported in the financial statements provides a starting point to identify R&D costs.
The concept unit thoroughly explains various types of research and development costs under ASC 730 and how each type of cost relates to IRC sections 41 and 174. While ASC 730 establishes the financial accounting and reporting rules for R&D costs and activities, section 174 deals with the deductibility of these costs on a taxpayer’s federal income tax return, and section 41 addresses the potential R&D tax credit available.
According to ASC 730, the general rule for accounting for R&D costs is to expense them when incurred because their future economic benefit is uncertain. On the other hand, under IRC section 174, prior to January 1, 2022, taxpayers have a choice as to the treatment of R&D costs: deduct the costs as current expenses, treat the costs as deferred expenses and amortize them when they begin to produce a benefit, or capitalize them. For tax years beginning after December 31, 2021, the only option is to capitalize the R&D costs and then amortize them over a five-year period.
While the similarities between ASC 730, IRC section 41, and IRC section 174 far outweigh the differences, there are situations where ASC 730 includes some costs as R&D costs that do not qualify under either tax code section, and vice versa. A variety of costs may be incurred during the R&D process, and each should be evaluated independently. A comparison of the differences follows.
Both ASC 730 and IRC section 41 acknowledge that research requires obtaining technical information or new knowledge when developing a unique product or process. Section 41 explicitly details a four-part test that research must meet in order to be “qualified” research:
- The research is treated as an expense under IRC section 174.
- The goal of the research is to discover technological information whose application will be useful in developing a new or improved business component for the taxpayer.
- The purpose of substantially all of the research activities relates to a new or improved function, to performance, or to reliability or quality, and not to style, taste, cosmetic, or seasonal design factors [IRC 41(d)(3)].
- It does not include activities for which the research credit is specifically disallowed.
ASC 730 defines development as using the research results 1) to develop a plan or design a new product or process or 2) to make a significant improvement to an existing product or process. IRC section 41 refers to this development phase as a process of experimentation (POE) and relates it to a separate and distinct business component. IRC section 41 requires a taxpayer to identify uncertainty related to developing the research activities and to identify and evaluate alternatives that eliminate that uncertainty. Both ASC 730 and IRC section 41 include “conceptual formulation, design, testing of product alternatives, and construction of prototypes” as development activities.
Included and excluded activities.
The concept unit enumerates various activities that are allowed, or excluded, as R&D expenditures. ASC 730 generally includes broader lists in both categories; for example, it lists 10 specific activities that are considered R&D, whereas IRC sections 41 and 174 simply identify the required traits that activities must have in order to qualify. Based on these traits, the following ASC 730 activities would not qualify under IRC sections 41 and 714:
- Looking for applications of new research findings originally performed for nontechnical products, such as a literary work
- Formulating concepts related to identifying consumer preferences
- Developing screen layout design based on aesthetics such as fonts, colors, or sounds
- Evaluating third-party products (unless in a qualified POE as related to development above).
ASC 730 and IRC sections 41 and 174 generally exclude the same activities, such as those related to commercial production (i.e., engineering follow-through, product testing, trouble-shooting), improvement or design change of an existing product, or legal work related to patents, such as application, litigation, sale, and licensing. The IRC sections also include activities such as advertising, market research, reverse engineering, foreign research, and funded research.
Generally, costs that are related to activities being conducted for others under a contractual arrangement are not considered R&D under ASC 730. Conversely, the IRC allows these as qualified research expenditures if the taxpayer bears the rights and risks of the costs (i.e., the research is unfunded), the activities are being performed in the United States, and the research activities meet the four-part test described above.
Tangible and intangible assets acquired for R&D purposes.
Under ASC 730, the proper accounting treatment of tangible and intangible assets depends upon whether the assets have an alternative future use. If they do have an alternative future use, then the cost of that asset should be capitalized, and the related depreciation or amortization charges should be expensed as R&D; if they do not, their costs should be expensed as R&D at the time they are acquired. IRC section 174 only permits depreciation or amortization of these assets, not immediate expensing, and IRC section 41 does not permit any costs associated with these items unless they qualify as a “pilot model” as defined under Treasury Regulations section 1.174-2(a)(4).
Personnel costs, indirect costs, and contract costs.
ASC 730 includes various costs (salaries, wages, stock options benefits, indirect labor) related to personnel who are “engaged” in research. IRC 174 and 41 are much more restrictive, allowing only “reasonable” compensation and limiting personnel costs to those people directly involved in the research or directly supervising or supporting it. In addition, wages that qualify for the Work Opportunity Tax Credit are excluded. Likewise, indirect costs of any kind do not qualify for the R&D credit but are included as ASC 730 costs. As long as the taxpayer has a right to the research results and bears the expense, whether the research is successful or not, contract services costs qualify under both ASC 730 and IRC 41.
Software Development Costs
While most costs—including materials, equipment, facilities, personnel, contract services, and overhead—are all expensed under ASC 730 as part of R&D, software costs require special analysis. Two specific ASC sections affect the software development costs reported under ASC 730: ASC 350-40, “Internal-Use Software,” and ASC Topic 985, “Software to be Sold, Leased, or Marketed.”
Under ASC 730, the proper accounting treatment of tangible and intangible assets depends upon whether the assets have an alternative future use.
Internal-use software is software that is either 1) internally developed, acquired, or modified only to meet the internal needs of the entity and not planned to be marketed externally, or 2) used to provide a service or produce a product that the customer neither acquires nor gains any right to future use of. Under ASC 350-40-15-7, purchased or leased software used in R&D activities that does not have an alternative future use and internally developed software that is either a pilot project or used in a specific R&D project (whether it has alternative future uses or not) are included in R&D and should be accounted for under the provisions of ASC 730-10. Furthermore, ASC 350-40 takes into account dual function software that either supports or facilitates both providing services and general and administrative functions. Software developed for sale or lease, or otherwise marketed, is specifically excluded from dual function software.
ASC 985 addresses the treatment of costs of software to be sold, leased, or marketed. Simply planning to generate revenue with this software is not sufficient to be considered sold, leased, or marketed; rather, the customer must be able to take contractual possession of the software and run it on its own hardware, not just access it online. Software that customers access online or through cloud computing services is not considered sold or leased, but rather as being used in providing services and therefore falling under ASC 350-40 as internal-use software.
The costs incurred to develop software with the intent to sell, lease, or market are treated as ASC 730 costs up to the point that technological feasibility is established. Once that point is reached, the costs are no longer considered R&D and are capitalized. Technological feasibility is established when all “planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions features, and technical performance requirements” (ASC 985-20-25-2) have been completed.
Process Unit: Computing Qualified Research Expenses
In September 2017, the Commissioner of the LB&I Division issued a directive, “Guidance for Allowance of the Credit for Increasing Research Activities under IRC 41 for Taxpayers that Expense Research and Development Costs on their Financial Statements pursuant to ASC 730.” Its purpose is to provide both taxpayers and revenue agents with a methodical and efficient manner for determining QREs.
The LB&I process unit explains the directive and outlines the steps needed to implement it. (It should be noted that these apply only to LB&I taxpayers who prepare certified audited financial statements in accordance with U.S. GAAP.) Furthermore, taxpayers must disclose the amount of currently expensed ASC 730 R&D expenses as either a separate line on the income statement or as a separate item in a note to the financial statements.
The process unit provides a multistep approach for taxpayers to adjust the amount reported as R&D costs on their financial statements to the amount reported as QRE for income tax purposes, and to reconcile the differences in those two amounts. The first five steps reconcile the amounts reported as R&D on the financial statements to the QRE amounts allowable under IRC sections 41 and 174, providing an adjusted ASC 730 R&D amount to claim on Form 6765, Credit for Increasing Research Activities. An additional (and optional) five steps provide guidance for separately identifying R&D expenses that exceed the adjusted ASC 730 R&D amount. These optional steps provide information to the LB&I exam team, which is useful in determining the scope of its research credit examination.
Determine the financial statement R&D expenses under ASC 730; this is the amount reported as “Research and Development.”
Subtract all foreign entities’ R&D costs. Although the financial statements will include worldwide R&D, foreign entities’ R&D must be removed to determine amounts allowed for IRC section 41.
Remove costs that qualify as R&D for financial reporting purposes but do not meet the requirements of IRC sections 41 and 174. This includes the costs of obtaining a patent and attorney’s fees related to making that patent application. This is a multistep process, described in Appendix C of the directive.
Book wage and wage-related accounts, including stock options, must be adjusted to the amounts allowed under IRC sections 41 and 174. This is also a multistep process, described in Appendix D of the directive.
Identify the adjusted ASC 730 financial statement R&D expenses that are permissible under IRC sections 41 and 174 as wages, supplies, and computer rental or lease costs.
The LB&I process unit explains the directive and outlines the steps needed to implement it.
The remaining steps are optional and provide supplemental information to help examination risk assessment of qualified research expenses. The last step is a summary of costs.
Determine the amount of wages excluded from adjusted ASC 730 R&D expenses. This step and step 7 provide assistance in assessing risk in qualified research expenses originally reported in financial statement cost centers. This will assist examiners in determining if there is enough risk to further examine wage-related expenses.
Determine contract costs excluded from ASC 730 expenses.
Determine non-ASC 730 wages and stock options. This step and step 9 identify and explain qualified research expenses reported outside of ASC 730 for financial reporting purposes. Identification of the source of the qualified research expenses assists examiners in determining if there is enough risk to further examine these expenses.
Determine non-ASC 730 non-wage costs. This covers a multitude of contract costs, such as supplies, computer rental or lease costs, and contract costs for research performed in the United States.
Identify where qualified research expenses are reported in the appendices, as required under the directive.
Following the Guidance
R&D expenses are a significant cost and the subject of many an IRS examination. Businesses that account for R&D costs under ASC 730 for financial reporting purposes and then attest that the costs reported as QREs for tax reporting are book ASC 730 R&D costs, less specifically excluded costs (such as foreign research), may still be examined, but the scope of the examination, as well as its cost for both the taxpayer and the IRS, will be significantly reduced. If the entity properly calculates the QREs following the steps outlined in the process unit/directive and certifies them as required by the directive, the LB&I examiners likely will not challenge adjusted ASC 730 R&D expenditures for the credit year in question.