The R&D Tax Credit program is one of the most valuable tax credit offered by the federal government, and most state government. If your company is doing any type of R&D, you could save hundreds of thousands of dollars annually in state and federal taxes, up to 10% of your annual R&D costs. KBKG is the leader in R&D tax credit services and provide comlimentary education to businesses and accounting professional. Our last R&D webinar was attended by hundred of engaged professionals and we are happy to share our answers to your questions. If you think you can benefit from the R&D credit, please visit our R&D qualification form.
Q: Can you include QRE’s to calculate the credit for a business which hasn’t started yet?
A: Yes. Special rules apply to start-up companies to claim the credit.
Q: A little confused on slide on UCC Court case. Are you saying that after a proprietary process is achieved that use of this process in normal production is no longer eligible for the credit?
A: To clarify, UCC was attempting to claim the cost of their production units (ultimately sold to customers) as experimental supplies used to prove out their manufacturing process improvements. The court seems to make a distinction between prototype supplies built to validate the design of the product (qualifying) and production units sent through the manufacturing process to validate a process improvement (non-qualifying).
Q: A while back, the IRS was targeting the studies that were made from templates. They were listing firms by names that used templates. Just curious on an industry update – has the industry seen less and less of this template like studies now?
A: Over the past ten years, we’ve seen an evolution in methodology occurring in the industry to respond to the increased IRS scrutiny regarding the nexus between qualifying business components and qualifying costs. In the absence of a true project tracking system, companies may be confused with how best to create this nexus and how best to organize this information to sustain their credits upon audit. Typically, firms in the industry will use employee time surveys (after the fact) to document hours spent on qualifying business components. We have had great success with substantiating credit claims under audit for the studies we performed, as well as substantiating studies performed by other firms.
Q: Can wages be allocated to R&D if employee has other duties?
A: Yes. However, only the portion of the employee’s time spent on qualified research activities can be included in the credit calculation. A formal time tracking system can greatly assist with this. Alternatively, we have employee time surveys we distribute to track employee time at the business component level.
Q: Can you amend a prior year return and revoke the regular credit altogether?
A: A taxpayer can file an amended return and reverse the credit claim as long as the statute of limitations has not passed.
Q: Can you give some examples of non-qualified activities?
A: Refer to IRC Section 41(d)(4) for a list of non-qualified activities. These include research after commercial production; adaptation of existing business components (i.e., slight changes or alterations lacking the required technical uncertainty); duplication of an existing business component; research involving efficiency surveys, management-related studies, market research, routine data collection and ordinary or routine quality control; research conducted outside the United States or its territories.
Q: Can you use either calculation method on an amended return?
A: Though you may change the amount of credit claimed on a previously filed return, you may not change the credit calculation method used. For instance, if you used the Regular Credit method in a prior tax year, you are stuck with it for that tax year. If you did not claim an R&D credit in an open tax year, and you wish to amend the return to include the research tax credit, you must use the Regular method. The ASC method is not available for use on an amended return.
Q: The company started in 1996. We have never claimed the R&D credit. We want to go back and file amended returns for 2010 thru 2012. We had R&D expenses in years before 2010. How do we calculate the fixed base amount/percentage?
A: Since the company did not exist in 1984-1988, it is designated a Start-up for purposes of the calculation. The fixed-base percentage is calculated starting with the first year (after 1993) in which the company had both gross receipts and QREs (Year 1). It is fixed at 3% for the first 5 years, then fluctuates over the next 5 years before becoming fixed in Year 11. The formula is detailed in the instructions for Line 10 on IRS Form 6765.
Q: Does cost of developing a patent qualify…i.e. legal costs?
A: Although legal fees associated with filing a patent qualify for the R&D deduction (IRC Sec. 174), they do not qualify for the R&D credit (IRC Sec. 41).
Q: I have an engineer who develops, assists in selection, installation, testing, and training of Simulators for energy power plants. Would they be eligible for the R&D Credit?
A: Definitely sounds like he would have some qualifying activities. The extent to which his time qualifies would depend on the details of the activities, the level of technical uncertainty at the outset, and the types of activities he conducts to eliminate the technical uncertainty (i.e., the process of experimentation). Installation and training activities will likely not qualify, but the design, development and testing of the simulators could.
Q: I have seen calculations where the wages also take into an amount for payroll tax expenses…this looks like not correct?
A: For purposes of IRC Section 41, the term “wages” means wages as defined in IRC Section 3401(a). This means all taxable wages as reported on Form W-2, including bonuses and stock option redemptions. It does not include amounts that are not subject to withholding, such as certain fringe benefits or non-taxed income.
Q: If the IRS challenges the fixed base, does this open up any statutes of limitations?
A: No, because any proposed adjustment affects only the credit year, not the credit in the base years.
Q: On the 4 part test it says spending for an improved business component may qualify. But on the non-qualified activities it states that an adaptation of an existing business component would not qualify. These seem to be exclusive statements, could you clarify?
A: The “adaptation” of existing business components refers to slight changes or alterations, which may lack the required technical uncertainty. Dependent on specific facts, this could include activities involving integration, configuration or customization of a business component to meet a customer’s requirements. This would be more along the lines of a plug-and-play solution than true research and development. Refer to Treas. Reg. Section 1.41-4(c)(3), Examples 3 & 7, specifically.
Q: Please explain how you got the 1.3% for example #2.
A: For Example #2 of the Regular credit calculation, the 1.3% fixed-base percentage was not calculated. This was for illustration purposes to show the need to make sure and identify the proper QREs and gross receipts as both have an impact on the fixed-base percentage and the overall calculation. For comparison purposes, it also shows the advantage to a company whose base amount is limited by 50% of its current year QREs.
Q: R&D credit available for a beverage manufacturer who changes the formula? Or only on new product?
A: Improvements made to an existing business component (in this case, the formula) may qualify. I suspect the issue would be what types of improvements to function, performance are being made and what technical uncertainties exist in reaching the optimal formula to meet the requirements. Coca-Cola and Pepsi spend millions of dollars in R&D per year on improvements to existing products as well as process improvements. This is definitely a facts and circumstances situation.
Q: Taxpayer makes a product, which it sells in a two-ounce container. Taxpayer decides to create a new container for the delivery of the product. Would the designing of the new container be R&D?
A: It may be considered R&D. Depending on the facts (e.g., size/shape/weight of the new container, is there new material used to create the container, how does the material react to the contents it is transporting, is there an impact on the shelf life or transportability of the product, how is the new container sealed to protect against leaks, what new environmental conditions is the new container to be designed to withstand, etc.). All of these facts represent potential technical uncertainty that would require experimentation to resolve to achieve the optimal design.
Q: Client sees a beach chair made of wood and cloth and develops a similar-looking chair made of solid surface materials and cloth. Would this be R&D?
A: It may be considered R&D. The fact that the client is attempting to design a chair similar in appearance to one made by another company is not relevant. The focus should be on the technical challenges and the engineering activity involved in creating a similar looking design out of substantially different materials, while simultaneously maintaining (or improving) the functionality and performance as that provided by the wood and cloth chair.
Q: What level of documentation of QREs is needed for base years? Typically a record of time spent on projects is missing.
A: The courts and the Treasury Regulations call for reasonable support. The IRS in some cases have tried to demand more support than is required and have lost. Recent court cases (Union Carbide & McFerrin) have upheld the “Cohan Rule” and allowed Taxpayers with little or no documentation to rely on credible oral testimony to substantiate R&D activity and expenses. The whole substantiation issue is a major reason why there is a movement toward a more simplified calculation, requiring less historical data. Having said that, we help our clients develop a good documentation process to avoid problems.
Q: When did it no longer require the Discovery Test? When did the Discovery Test go out?
A: The 2003 Final Regulations did away with the “discovery test.” Prior to 2003, companies, in order to qualify for the credit, had to attempt to discover information beyond what was already known in the industry. With the passage of the 2003 Final Regulations, the standard changed to discovering information unknown to the Taxpayer. This standard has been upheld in recent court cases (see FedEx and Union Carbide).
Q: Would activities related to the development of major new software release qualify as a QRE?
A: It may be considered R&D. Factors in favor of it being R&D would include the technical challenges involved, the nature of the software enhancements (i.e., functionality, performance, reliability, quality) and the process of experimentation. Debugging activities generally do not qualify. Also, you want to pay close attention to the additional rules if this development is for Internal-use software (IUS); see Treas. Reg.
Q: Would you consider a homebuilder to have qualifying time? When would the commercial production period be deemed to start for a homebuilder?
A: Generally, some of a homebuilder’s activities may qualify. Examples could include designing the structure, developing technical specifications, technical improvements to the construction processes, integration of key subcomponents (HVAC, materials, designs), and designing structures to new codes (e.g., energy, structure, LEED, etc.). These activities focus on the technical uncertainties inherent in the design and tests performed to validate the design prior to construction. Although qualifying activities may occur after construction begins, the project is generally deemed to be in commercial production at that time. General construction activity may not qualify.
Q: What is the code section reference of the “discovery test” definition?
A: IRC § 41(d)(1)(B) defines “qualified research” as that activity “which is undertaken for the purposes of discovering information–“. The 2001 Final Treasury Regulations interpreted “discovering information” as “activities intended to discover information that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering” (See T.D. 8930). The 2003 Final Treasury Regulations revised this interpretation to include research that “is intended to eliminate certain uncertainty concerning the development or improvement of a business component” (See T.D. 9104).