19 Feb Research Tax Credits, Qualified Research Expenses (QRE) & IRS Form 6765, Credit for Increasing Research Activities
Being married to aÂ fermentation biologist has allowed me access to a wide swath of fascinating experiments involving media from bio-fuels to home brew. So no matter how many esoteric Internal Revenue Codes I vamp up in public or in social gatherings-like an idiot savant, I can rarely out nerd the love of my life with 3 notable exceptions: research tax credits, qualified research expenses (QRE) & IRS Form 6765, Credit for Increasing Research Activities.
For that I am grateful, as I should be, right?
Nevertheless our time together on this planet as two individuals with our own idiosyncratic lenses, at arguably the pinnacle of life, we have grown to agree on many things with one standing out.
Most scientific based start up business plans that Cathy and I look at, the general lack of research tax credit consideration in underlining financial models is fascinating. At issue it seems is that research expenses from a tax perspective are nuanced and perceived as scary, particularly as they pertain to employment costs, particularly for visionaries.
But they don’t need to be that way!
Generally speaking when it comes to labor costs, as perÂ 26 U.S. Code Â§ 41 – Credit for increasing research activitiesÂ employees either actively developing, supervising development or supporting the development process are deemed qualifying research expenditures (“QRE”) for the research tax credit.
Many people interested in the business of science tend to dance around research tax credits out of fear.Â Larger corporations however claim over $10 billion dollars in research tax credits every year and you should be claiming yours if your operation or business plan qualifies.
First off, what is the R&D tax credit?
- It was established by law in 1981 to act as an incentive to spur U.S. research and economic competitiveness and made permanent in 2015.
- It is critical to the growth of U.S. innovation.
- To qualify, research must entail activities that generally satisfy a four-part test.
The activity must include the elimination of uncertainty, the process of experimentation, be technological in nature, and have a qualified purpose (the business component test).
- Once a business plan is funded and a research lab is up and running, from the perspective of a tax practitioner the biggest pitfall to avoid is lack of transparency in research activities.
- Operational transparency between the research and the tax functions is paramount in claiming the tax credit and defending the tax return.
- Complete transparency though can be difficult to achieve particularly when research functions tend to be either spread out across severalÂ employees or departments with varying roles.
- Or in the case ofÂ newÂ upstarts, not properly annotating how staff spend their work day and record their time.
- There rarely seems to be consistency in assessing what employee costs can be defensibly attributed to research as everyone seems to have their own ‘model’ for calculation purposes with some being complete bullshit and others overtly conservative. THIS IS WHERE SWEET MUSIC IS MADE!
- The best approach in calculating the tax credit IMHO has beenÂ to identify the specific roles within a business that each person assumes by quite literally interviewing each workerÂ and drafting a tax-centric version of his or her job description. This is then used as a basis forÂ definingÂ the qualifying portion of salary attributable to research for tax credit purposes.
- My approach to date has relied on customization because generally it seems no two taxpayers in the scientific community offer standardized employee trackingÂ necessary forÂ calculatingÂ the credit.
- The objective remains steadfast over time, to defensibly maximize research tax credits within the confines of the Code.
- So there tends to be a fair amount of uncertainty when it comes to tax credit claims madeÂ unless you know what the hell you are doing, many don’t. The funny thing is it is not rocket science.
What is a Qualifying Research Expenditure (QRE)?
- Qualified research means research for which expenses may be treated as Internal Revenue Code section 174 expenses. Ha Ha click the link <-
- The research must be undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component. Â Blah blah!
- Substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.
- All of the research activities must be applied separately with respect to each business component of the taxpayer to which many taxpayers assert the ‘kiss my ass bitch’ mantra.
What is NOT a Qualifying Research Expenditure?
- Research conducted after the beginning of commercial production.
- Research adapting an existing product or process to a particular customerâ€™s need.
- Duplication of an existing product or process.
- Surveys or studies.
- Research relating to certain internal-use computer software.
- Research conducted outside the United States, Puerto Rico, or a U.S. possession.
- Research in the social sciences, arts, or humanities.
- Research funded by another person (or governmental entity).
- For special rules concerning the allocation and apportionment of research and experimental expenses between U.S. and foreign source income, see Internal Revenue Code sections 861 through 864.
Top Considerations when preparing IRS Form 6765
- You can either claim the regular credit in Section A of IRS Form 6768, or Elect the alternative simplified credit in Section B.
- To determine which method is preferred you may want to figure your credit using both of the methods for which you are eligible to get the maximum credit allowed.
- Once elected, the alternative simplified credit (ASC) applies to the current tax year and all later years.
- A current tax year’s ASC election may not be revoked.
- You may revoke the election for a later tax year by completing Section A relating to the regular credit and attaching IRS Form 6765 to your timely filed (including extensions) original return for the year to which the revocation applies.
- See Regulations section 1.41-9(b)(3).
- Basically any individual, estate, trust, organization, or corporation can claim a credit for increasing research activities.
- Any S corporation, partnership, estate, or trust that allocates the credit to its shareholders, partners, or beneficiaries must complete this form as well.
- The most important point to note IMHO is that partnerships and S corporations must file this form to claim the credit.
- All other taxpayers can report this credit directly on IRS Form 3800 – General Business Credit.
- As in life though there are exceptions to this general rule if you are a taxpayer that is an estate or trust and the credit can be allocated to beneficiaries.Â For more details, see the Instructions for Form 1041, Schedule K-1, box 13.
- Corporations filing an amended return to claim a credit or refund of the research credit, seeÂ http:// www.irs.gov/irb/2008-13_IRB/ar12.html for information on where to file.
For you nerds that want to drill down
Treasury announced regulations (TD 9666) that will allow companies to take the Research and Development Alternative Simplified Credit (ASC) on amended returns.Â This seemingly arcane change means more dollars in the wallets of innovative small to medium size businesses. The following are the most important points:
- The previous regulations allowed companies to take the ASC only on original returns. Â NO MORE!
- Allowing ASC on amended returns is a game changer because even under ASC it is not a walk in the park for a business to qualify (requiring books, records, etc.) for the R&D tax credit.
- The reality is that for many small and medium business owners itâ€™s not worth the overhead expense to qualify for the ASC if they are only getting one year of benefit.
- By allowing the ASC on amended returns â€“ our Treasury and the IRS have completely changed the math for thousands of small and medium business owners.
- Who shall now see for the first time the benefits of the R&D tax creditÂ – for example, a marijuana cultivator we know ofÂ who previously decided not to take the R&D tax credit because her company would only see a benefit of $135,000 for the current tax year, now she is able to amend her companyâ€™s previous tax filings and will qualify for roughly $150,000 in tax credits separate and distinct from state tax R&D credits for which she is eligible.
- THIS IS HOW TAXPAYERS SAVE SERIOUS $$ FOLKS! Â JUMP ON BOARD.
Now the only other problem to overcome is self-censoring by businesses that donâ€™t think they qualify for the R&D tax credit!
Tens of thousands of businesses â€“ especially small and medium size businesses â€“ wrongly think they donâ€™t qualify.
A key is to understand that the R&D tax credit isnâ€™t just for basic research, but is also for applied research.Â Moreover,Â the number of industries potentially eligible for the R&D tax credit is vast based on thisÂ list.
If you or your company invests in making or improving things or processes, make sure you are taking full advantage of your R&D Tax Credits. The following is a list of resources for those inclined to get the most out ofÂ IRS Form 6765 Credit for Increasing Research ActivitiesÂ including:
- IRS Audit Techniques for Research Tax Credit
- Current-year Deduction of Research & Development Expenditures
- Amortization of R&D Expenditures
- Instructions IRS Form 6765 Credit for Increasing Research Activities
- Notice 2008-39Â Credit for Increasing Research Activities: Filing Address and Requirements for Certain Claims for Credit or Refund
- IRS Form 3800 – General Business Credit
- Instructions -Â IRS Form 3800 – General Business Credit
Forewarning for Service Engineers, Architects and Other Service ProvidersÂ
- IRS audits of research and development tax credit claims by service providers, such as architecture and engineering companies, have become inconsistent over the last couple of years.
- IRS audit actions appear to be reversing the long-standing precedent for the type of activities that qualify for the credit.
- Historically service providers have qualified for the R&D credit as long as they satisfied the four-part test referenced above.
- Two main groups benefit from the credit: manufacturers and service providers.
- Nearly half of taxpayers who claim the credit are manufacturers
- nearly one-third of taxpayers who claim the credit are service providers â€” most of which are small businesses in the fields of architecture, engineering, construction, and computer software design.
- Most recently the IRS has been successfully arguing that “services” do not qualify for the R&D tax credit.
- Tread lightly, this dramatic break in precedent has an outsized impact on small businesses that lack the resources to fight IRS denials.
- A consistent theme from IRS examiners in the Small Business/Self-Employed Division that we have experienced is that services provided by architecture and engineering firms cannot meet the “qualified purpose” portion of the four-part test because their research lacks an identifiable â€œbusiness component.â€
- This new position is concerning, given that the IRS Code clearly defines the term â€œbusiness componentâ€ as a product, process, computer software, technique, formula, or invention.
- Historically, the IRS has allowed design drawings to qualify as the business component, since the term â€œtechniqueâ€ is synonymous with the term â€œblueprintâ€ or â€œdesign drawing.â€
- In recent examinations, IRS Revenue Agents ignored the terms â€œtechniqueâ€ and â€œformulaâ€ in R&D claims for service providers altogether forcing us into the Appeal function.
- While no court cases have addressed this issue directly, there have been cases involving service firms that took the R&D credit where neither the IRS nor the courts questioned whether service providers can qualify for the credit.
- This shows service providers are NOT inherently disqualified from taking the credit.
- Guidance should be developed perhaps in the form of a checklist of activities conducted by taxpayers in the Architecture and Engineering fields that qualify for computing the credit.
- As with the IRS’ guidance model for Developing New Pharmaceutical Drugs and Therapeutic Biologics, if a taxpayer meets the criteria and makes the appropriate certification with their tax returns, an audit would NOT be necessary.
- For more on this hit me up offline.