Research and development (R&D) produce innovations that drive growth and prosperity. Recent legislation, including the Tax Cuts and Jobs Act and the Protecting Americans from Tax Hikes Act, has created a favorable environment for small, mid-size, and large companies to benefit from the use of the R&D tax credit. The authors demonstrate how companies can use the R&D credit to increase market value and lower their effective tax rates, discussing various classes of qualifying expenditures and activities that may be considered qualified research in industries that are not commonly known for engaging in R&D. Changes in the treatment of R&D write-offs under IRC section 174 are also discussed.
The federal research and development (R&D) tax credit provides an incentive for U.S. businesses to develop new products or improve upon existing products or trade processes. According to Alliantgroup, the federal government provides an annual subsidy of $12 billion to thousands of large and small U.S. businesses for their R&D activities through the R&D credit (http://www.alliantgroup.com). The R&D credit can offer small, mid-size, and large companies a reduction in federal tax liability and a source of cash through reduced federal tax payments; however, the statistics that attest to the credit’s popularity cannot provide evidence of the amount that goes unclaimed or the number of taxpayers that qualify for the credit but do not claim it.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 had a positive impact on the use of R&D credits for qualified small businesses, but the alternative minimum tax (AMT) for corporations kept many companies from fully benefiting. As a result, some of these companies did not take R&D credits in prior tax years. The Tax Cuts and Jobs Act of 2017 (TCJA) has had a broad impact on the corporate benefits of the R&D credit, including the repeal of the corporate AMT. Taken together, the PATH Act and the TCJA provide business taxpayers an opportunity to increase market value and lower their effective tax rates by taking the R&D tax credit. The IRS now allows taxpayers to stack multiple tax years into one R&D tax credit study, making it more cost efficient for companies of all sizes.
This article closely examines the availability of the R&D credit as a business expense in the post-TCJA environment. The discussion outlines expenditures that will qualify for the R&D credit and observes the potential benefits of claiming an R&D credit under the TCJA. It also examines industries that are not known for their involvement in R&D, in an effort to help taxpayers understand how certain expenses in those industries might be claimed for the credit. Finally, it provides a process to identify, collect, and organize expenses to assist in the claim for the credit on Form 6765, Credit for Increasing Research Activities. CPAs should be ready to advise clients of all sizes, from startups to public companies, on how to best take advantage of this lucrative tax credit.
Qualifying expenses for the R&D credit are loosely defined in Treasury Regulations section 1.174-2, which states:
Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
This guidance regarding qualifying expenses creates opportunities for taxpayers to review their activities, ideally annually, in order to find additional expenditures that would qualify for the R&D credit. Treasury Regulations section 1.174-2 provides, “whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents” (emphasis added). In other words, the expenditures must be from a qualified research activity in order to qualify for the credit.
Furthermore, qualified expenses are categorized into either “in-house research expenses” or “contract research expenses,” which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer. Internal Revenue Code (IRC) 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, amounts paid or incurred for supplies used in the conduct of qualified research, and under regulations prescribed by the Treasury Secretary, any amounts paid or incurred to another person for the right to use computers in the conduct of qualified research.
For contract research expenses, IRC section 41(b)(3) allows 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. If any amounts are paid to a research consortium, then 75% of those expenses will be treated as qualified research expenses. The term “qualified research consortium” means any organization that is discussed under IRC section 501(c)(3) or 501(c)(6), is exempt from tax under IRC section 501(a), is organized and operated primarily to conduct scientific research, and is not a private foundation.
Finally, research or experimentation (R&E) expenses for the development of commercial software represent a special case. Case history provides some guidance for software companies who develop software for commercial purposes. Treasury Regulations section 1.174-2(a)(1) requires that expenditures “be incurred in connection with the taxpayer’s trade or business” and “represent research and development costs in the experimental or laboratory sense.” This means that software development cannot be of a library type or other type not intended to test a scientific or technological hypothesis [TSR, Inc. and Subsidiary v. Comm’r, (1991) 96 TC 903].
It is important to note that the research does not have to result in a successful product or process.
Treasury Regulations section 1.41-4(a)(4) provides that the research must be technological in nature and discover new information (the discovery test). Developing software products that are new and innovative compared with other commercially available software products in the field does not mean discovery of new information, nor does the mere evidence that the taxpayer has developed a new and useful product in and of itself qualify as discovering new information [Tax and Accounting Software Corp. v. U.S., (2002, CA10) 90 AFTR 2d 2002-6107].
Under Treasury Regulations section 1.41-4(a)(5), a process of experimentation is one designed to evaluate one or more alternatives to achieve a result that is uncertain at the beginning of the research activities. Evaluating alternatives can involve modeling, simulation, or a systematic trial and error methodology; this means that simple trial and error to evaluate alternatives in order to validate a process is not sufficient [Union Carbide Corp. and Subsidiaries v. Comm’r, (2009) TC Memo 2009-50]. In addition, evaluating alternatives to eliminate uncertainty arising during the project does not meet the process of experimentation requirement since the uncertainty was not at the beginning of the research activity (U.S. v. Davenport, 110 AFTR 2d. 2009-2722).
Qualified Research Defined
Under IRC section 41(d), qualified research must meet certain requirements in order to qualify for the credit. Qualified research means research—
- with respect to which the expenditures may be treated as expenses under IRC section 174 (also known as the section 174 test),
- undertaken for the purpose of discovering information that is technological in nature (also known as the discovering technological information test),
- the application of which is intended to be useful in the development of a new or improved business component of the taxpayer (also known as the business component test), and
- substantially all of the activities of which constitute elements of a process of experimentation for a purpose (also known as the process of experimentation test).
The IRC section 174 test requires that the expenditure be incurred in the taxpayer’s trade or business and represent an R&D cost in the experimental or laboratory sense, meaning that the expenditures are incurred for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. It is important to note that the research does not have to result in a successful product or process. Uncertainty exists in the context of the section 174 test if the information that is available to the taxpayer is not sufficient to capably develop or improve a product.
For example, Manufacturer X is a pharmaceutical company that makes LDL cholesterol medication. Most cholesterol medications currently on the market are known as “statins,” the side effects of which include headaches, nausea, vomiting, and abdominal cramps. Manufacturer X is currently developing new medication that will control an individual’s LDL cholesterol level without all of these side effects and employs researchers to experiment with new chemical compounds for this purpose. The salary expenditures for the researchers satisfy the section 174 test because the expenditures relate to Manufacturer X’s business activities and were incurred to discover new information to develop or improve a product.
The discovering technological information test requires the research activity to be technological in nature. To satisfy this requirement, the process of experimentation used to discover information must fundamentally rely on the principles of the physical, biological, engineering, or computer sciences. This is not a difficult test to pass. Many hear the phrase “technological in nature” and think of things like robotics. The use of complicated algorithms in robotics would certainly satisfy the discovering technological information test; however, research activity does not have to be a major technological advancement, and it certainly does not have to be overly costly. To satisfy the discovering technological information test, the activity must simply discover new information or knowledge—even if the increased knowledge is minimal—and rely on the principles of one of the sciences listed above.
The issuance of a patent by the U.S. Patent and Trademark Office is conclusive evidence that a taxpayer has discovered information that is technological in nature under the patent safe harbor rule [Treasury Regulations section 1.41-4(3)(iii)]. But it is not conclusive proof of qualified research, since a patent only satisfies the discovery test and all four tests must be met for qualified research.
The business component test requires a taxpayer to apply the discovered information to develop a new or improved business component. As with the previous two tests, this is broadly applied; it is not designed to eliminate many R&D activities, and it can be passed with relative ease. To pass this test, the taxpayer must discover new information (i.e., learn something) that improves the taxpayer’s business and then apply that new information to some component of the business. The component of the business can be almost any significant piece of the business, such as a product, a process, a technique, a formula, an invention, or even software as long as it is to be held for sale, lease, or license, or used in the taxpayer’s trade or business [IRC section 41(d)(2)(B)].
Research activity does not have to be a major technological advancement, and it certainly does not have to be overly costly.
The process of experimentation test requires that substantially all of the activities comprise elements of a process of experimentation for a purpose. The “substantially all” threshold is only satisfied if at least 80% of a taxpayer’s research activities, measured on a cost or other reasonable basis [and without regard to IRC section 41-2(d)(2)], constitute elements of a process of experimentation for a purpose.
Essentially, this test requires that most of the taxpayer’s research activities involve a process of examining a solution or a set of solutions to a research question. For example, Company Y is a defense contractor that manufactures military vehicles, specializing in armored vehicles such as tanks. Company Y is evaluating several different possibilities with its hydraulic systems used to assemble a tank’s turret. Some of the alternatives involve pulling the turret, while others involve pushing it. By evaluating all possibilities regarding the turret assembly, Company Y is engaging in a process of experimentation and satisfying the fourth and final test.
The following activities are specifically excluded from qualified research activities: research after commercial production; activities for adaptation; activities of duplication; activities relating to surveys; studies, and research relating to management functions; foreign research; research in the social sciences; funded research; and research performed outside of the United States. Treasury Regulations section 1.41-4(c) discusses these excluded activities.
Taxpayers can claim an R&D credit for basic research payments made in the tax year under IRC section 41(a)(2). Basic research is defined as an original investigation to gain scientific knowledge without having a specific commercial objective. This definition does not include basic research conducted outside of the United States, nor research in the arts, humanities, or social sciences. Basic research must be performed by a qualified organization, which includes certain qualified educational systems considered to be higher educational institutions, qualified scientific research organizations, and qualified grant organizations under IRC section 41(e)(6). Taxpayers can also claim an R&D credit for amounts paid or incurred in carrying on any trade or business during the taxable year to an energy research consortium [IRC section 41(f)(6)(A)].
The R&D Tax Credit Post-TCJA
Congress did not modify the R&D credit as part of the TCJA. Other tax credits and incentives, such as the domestic manufacturing deduction, were either revised or repealed entirely. The fact that the R&D credit was kept as a permanent tax credit, along with the reduction of the corporate tax rate from 35% to 21%, indirectly increases the net benefit of the credit upon election of a reduced credit following IRC section 280C(c)(3), where the reduced credit is net of the highest tax rate. [The amount of credit in any taxable year is the amount equal to the excess of the amount of credit determined under section 41(a) without regard to section 280C(c)(3), over the product of the amount of credit.] The Exhibit shows a sample fact pattern wherein, due to the change in the corporate tax rate, there is now a $28,000 (21.5%) increase in the value of the R&D credit ($28,000 ÷ $130,000).
Sample Differences in the R&D Credit Before and After the TCJA
Alternative Minimum Tax and the R&D Credit
Since January 1, 2016, only eligible small businesses may use the R&D credit to offset AMT, per the PATH Act. IRC section 38(c)(5) defines an eligible small business as a nonpublicly traded corporation, a sole proprietorship, or a partnership with average annual gross receipts over the prior three years of $50 million or less. Congress kept this favorable incentive for eligible small businesses, while the TCJA repealed the AMT for corporations. As a result, businesses previously subject to the AMT now have the advantage of offsetting their taxable income with the R&D credit. The corporate AMT repeal is effective for tax years beginning after December 31, 2017.
Businesses previously subject to the AMT now have the advantage of offsetting their taxable income with the R&D credit.
There are limitations on the amount of taxable income that the R&D credit can offset. IRC section 38(c) states that general business credits, which include the R&D credit, can be used to offset up to $25,000 of tax and up to 75% of any tax above $25,000. It is important to note that AMT carryovers after 2017 can be used to offset any tax liability in excess of general business credit reductions. Furthermore, for tax years 2018 through 2020, 50% of any excess AMT credit carryover is refundable and may be subject to a sequestration rate (see “Effect of Sequestration on the Alternative Minimum Tax Credit for Corporations,” http://bit.ly/2lRoFLP). Any AMT credits that remain after the 2020 tax year will be fully refundable in the 2021 tax year.
Corporate taxpayers can now use both AMT credit carryovers and R&D credit carryforwards to offset future taxes. Businesses should take a close look at prior research activities to see whether a maximum amount of R&D credit was claimed and whether the company did not claim a prior R&D credit because of the AMT. A business can take the credit for all open tax years, and tax credits may carry forward 20 years. Businesses that operate in industries not known for taking R&D credits should also perform this examination, as it may lead to substantial tax savings. Such R&D credit opportunities are discussed below.
IRC Section 174 Considerations
Taxpayers have the option to either claim the R&D credit or to deduct or amortize qualified expenses under IRC section 174. Currently, section 174 expenses are either deducted in the current year or capitalized and amortized over a useful life of at least 60 months or for 10 years. Beginning in tax years after December 21, 2021, expenditures under section 174 must be capitalized and amortized ratably over a five-year period, if conducted within the United States, or a 15-year period, if conducted outside the United States. This may result in a shorter amortization period and provides an incentive for businesses to keep or move research or experimentation activities to the United States.
Furthermore, the TCJA changed the language in IRC section 174 from “research or experimental expenditures” to “specified research or experimental expenditures.” Amounts paid or incurred for software development are explicitly treated as specified research or experimental expenditures under section 174(c)(3). (If this language change becomes effective for tax years beginning after December 21, 2021, taxpayers will not be able to rely on Revenue Proceeding 2000-50 to deduct software development costs.) Taxpayers may consider incurring planned R&D expenditures prior to 2022 in order to take advantage of the ability to currently deduct research or experimental expenditures under section 174 and claim a reduced credit under section 280C.
R&D Write-off Option
IRC section 59(e) allows corporations to elect to capitalize all or a portion of R&D expenses and amortize the cost over a 10-year period. Because IRC section 59(e) was not repealed by the TCJA, corporations may still make this election. A section 59(e) election can increase taxable income, allowing for net operating losses to be carried forward. Corporations with income from foreign sources may consider eliminating any domestic net operating losses using the section 59(e) election in order to utilize available foreign tax credits.
Industries Not Known for R&D
Certain industries are known for engaging in R&D activities, such as pharmaceuticals, high-tech, manufacturing, healthcare, and chemicals. Opportunities also exist, however, in industries that are not generally known for conducting R&D activities. Provided below are brief examples of activities within selected industries not known for their R&D activities; these examples illustrate that, with some creative thinking, new opportunities can be found to take advantage of the R&D credit. Of course, the guidelines presented in IRC section 41 for qualified research expenses and qualified research activities must be followed.
The movie industry offers many opportunities for the R&D credit. Examples may include the discovery of new visual effects and new methods for the distribution of films, including digital distribution and video streaming. Discovering new methods of shooting movies, such as using digital cameras, can also be a qualified research activity.
Opportunities also exist in industries that are not generally known for conducting R&D activities.
Online streaming services.
Online streaming services are a multibillion-dollar industry, led by giants such as Netflix, Google, Amazon, and Apple; these companies have opened up new ways to utilize R&D tax credits. For example, Netflix’s latest 10-K report shows that it has been spending increasing amounts on developing algorithms that utilize customer usage habits and make viewing and ordering suggestions, as well as investing in automating portions of its postage, packaging, and payment processes.
Qualifying research also exists within the agriculture industry. For example, opportunities exist in discovering new methods of hybridization or development of new strains of crops, plants, or livestock. R&D opportunities also exist in the development and implementation of new irrigation systems, evaluation and implementation of new techniques to increase yields, improvements in harvesting techniques, and development or experimentation with new feeds or feeding techniques for livestock.
There can be many opportunities for qualifying research activities within the architecture industry. For example, developing unique energy-efficient features for residential and commercial structures can be considered qualified research. Designing site orientations to take advantage of natural elements such as sun and wind could also qualify. Finally, developing new methods for configuring master construction plans might qualify for the R&D credit.
Many overlooked opportunities also exist for qualifying research in the construction industry. For example, designing new and efficient heating, ventilation, and air conditioning (HVAC) systems can be qualifying research. Other examples include exploring new construction techniques, designing new and improved electrical systems, developing and improving construction equipment, and preparing structure and facility designs.
Many of the opportunities that exist within the restaurant industry involve food science. Food science is the study of the physical, biological, and chemical makeup of food and the concepts underlying food processing. Qualifying activities may include exploring innovative processes that improve the nutrition, safety, and preservation of food, such as developing blockchain technology to track a food product back to its source.
Opportunities also may exist in the retail industry. Several retailers are investigating new methods for fraud detection and prevention. Another retailer spent two years developing a prototype for a compostable and biodegradable t-shirt that uses less than 1% of the water used to manufacture a regular t-shirt.
It is impractical to discuss every industry in which qualifying research activities occur, but as the above examples demonstrate, possibilities exist throughout all industries. All that may be required is a better understanding of qualified research and qualified expenditures, coupled with a diligence to take a closer look at the taxpayer’s activities.
Guidance for Identifying R&D Expenses
The below is not intended to be a firewall for a potential IRS audit, but simply a process to identify, collect, and organize expenses to assist in the claim for the credit on Form 6765. Businesses should seek the counsel of a tax professional in the preparation or audit defense of the R&D credit.
The first step in the process is to identify each separate activity that satisfies the four research activity tests under IRC section 41(d)(1). Make sure that each activity is tracked separately for associated R&D expenditures. For example, consider a taxpayer that has identified three different qualifying research activities: Activity 1, Activity 2, and Activity 3. Those three activities must be kept separate.
Next, all qualifying “in-house” R&D expenditures within each of those separate activities must be tracked. Some taxpayers may only engage in contract R&D and not in-house R&D. To continue the earlier example, the taxpayer should identify all in-house R&D associated with Activity 1, and all those expenditures should be categorized as Activity 1 R&D expenditures. The same should be done for Activities 2 and 3.
Next, all nonqualifying expenditures from each activity must be eliminated from the category total. As discussed above, certain expenses associated with R&D are not qualifying R&D expenditures, such as travel, meals, and entertainment.
For contracted research, a taxpayer should review all contracts to determine which party bears the financial risk of failure and which party retains the rights of ownership to the research findings. The issue here is determining which party—the customer or the research contractor—can claim the R&D expenditures. For example, if Taxpayer X enters an agreement with a research contractor, is it paying for the performance of research, known as “funded research,” or is it paying for the use of successful technology owned by the research contractor? The latter would probably not qualify as R&D expenditures. In Dynetics Inc. and Subsidiaries v. U.S., (115 AFTR 2d 2015), a research contractor was denied the claim of R&D expenditures for the R&D credit because the court ruled that the contract was funded research. The contract should stipulate that the taxpayer bears the financial risk of the research, regardless of the outcome of the research project, and retains ownership rights. Therefore, reviewing all contracts for financial risk and ownership rights is a must.
Corporations that did not take the R&D credit in AMT years can now benefit from R&D carryforwards.
Furthermore, for contracted research, itemized invoices should be inspected for the exact expenditures incurred. In addition, if the same contractor is used on multiple research projects, request separate billings by project. This should allow easier organization of R&D expenditures by project and should provide better documentation of those expenditures.
Finally, businesses should retain all records of R&D spending. IRC section 6001 and Treasury Regulations section 1.6001-1 require taxpayers to keep and retain records to substantiate all claims made on tax returns and forms. Records should be maintained for a minimum of three years, with a recommended period of six years.
The TCJA, taken together with the PATH Act, provides ample opportunity for small, medium, and large businesses alike to minimize their tax liability through the use of the R&D tax credit. The repeal of the corporate AMT presents a unique opportunity: Corporations that did not take the R&D credit in AMT years can now benefit from R&D carry-forwards. Corporations can also use R&D credits along with AMT carryovers to minimize future tax liability. The IRS is considering guidance to address whether a business that engages in entrepreneurial activities, such as lengthy phases of R&D, with the purpose of earning income, but as yet has no income, can qualify as an active trade or business under section 355(b) (IRS Statement Regarding the Active Trade or Business Requirement for Section 355 Distributions, http://bit.ly/2lZ6GTA).
Now is a good time to reexamine prior, current, and future R&D activities in order to take advantage of the R&D tax credit, regardless of industry. In addition to the federal R&D credit, many states also offer R&D tax credits. CPAs should be sure that businesses are taking advantage of the benefits that these credits offer.