Research & Experimentation Tax Credit

Internal Revenue Code §41 known as the Research & Experimentation Tax Credit or the R&D Tax Credit is a general business tax credit

Tax credit

A tax credit is a sum deducted from the total amount a taxpayer owes to the state. A tax credit may be granted for various types of taxes, such as an income tax, property tax, or VAT. It may be granted in recognition of taxes already paid, as a subsidy, or to encourage investment or other behaviors...

for companies that are incurring R&D expenses in the United States

United States

The United States of America is a federal constitutional republic comprising fifty states and a federal district...

. The R&D Tax Credit was originally introduced in the Economic Recovery Tax Act of 1981 sponsored by U.S. Representative

United States House of Representatives

The United States House of Representatives is one of the two Houses of the United States Congress, the bicameral legislature which also includes the Senate.The composition and powers of the House are established in Article One of the Constitution...

Jack Kemp

Jack French Kemp was an American politician and a collegiate and professional football player. A Republican, he served as Housing Secretary in the administration of President George H. W. Bush from 1989 to 1993, having previously served nine terms as a congressman for Western New York's 31st...

and U.S. Senator

United States Senate

The United States Senate is the upper house of the bicameral legislature of the United States, and together with the United States House of Representatives comprises the United States Congress. The composition and powers of the Senate are established in Article One of the U.S. Constitution. Each...

William Roth

William V. Roth, Jr.

William Victor "Bill" Roth, Jr. was an American lawyer and politician from Wilmington in New Castle County, Delaware. He was a veteran of World War II and a member of the Republican Party, who served as U.S. Representative and U.S...

. Since the credit's original expiration date of December 31, 1985, the credit has expired eight times and has been extended thirteen times. The current extension is set to expire December 31, 2011.

Definition of Qualified Research and Experimentation

Congress intends the credit to reward companies for incurring expenses in the development of new and improved products and processes. The Tax Reform Act of 1986

Tax Reform Act of 1986

The U.S. Congress passed the Tax Reform Act of 1986 to simplify the income tax code, broaden the tax base and eliminate many tax shelters and other preferences...

established the original qualifying activities definition. Since then the definition has evolved to include a four-part-test that is refined by specific exclusions.

Four-Part-Test

Technological in Nature - I.R.C. §41(d)(1)(B)(i) – The final regulations establish that a research and development activity must fundamentally rely on the principles of physics, biology, chemistry, mathematics, and computer science. This test excludes activities related to the social sciences, psychology, arts, and humanities.
Level of Technological Uncertainty - I.R.C. §41(d)(1)(A) - Often referred to as "The Section 174 Test" by the IRS, this test requires the research and development activities have an associated level of uncertainty related to the development or improvement of a product. The required level of uncertainty exists if information available to the taxpayer does not establish a method for determining the ultimate design.
Process of Experimentation – I.R.C. §41(d)(1)(C) - A process of experimentation is the direct result of risk or uncertainty associated with a design. This test requires that the company incorporates a process of theoretical and physical evaluation designed to evaluate one or more design alternatives. The process should show progression from theoretical calculations and sketches, to renderings and prototypes that are physically evaluated.
Permitted Purpose – I.R.C. §41(d)(1)(B)(ii) - The final test requires that the goal of the activity is to improve the fit, form, or function of a product or process for a business component. The IRS defines a "business component" as any product, process, computer software, technique, formula, or invention. This does not include development related to aesthetic changes or technology that does not build on the company’s knowledge base.

Exclusions

Research performed outside the United States, Puerto Rico, or any possession of the United States
Research and development that is funded by a third party
Research performed after commercial production begins
Adaptation of a product or process for a particular customer
Duplication of an existing product or process
Efficiency surveys
ISO certification

Research & Experimentation Tax Credit Calculation

The Research and Experimentation Tax Credit hinges on the quantification of eligible expenses during one of three possible base periods. The three base period calculation methods are referred to as the Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.

Eligible Expenses

The eligible expenses or qualified research expenditures include four types of expenses. The quantification of each of these varies based on each companies' accounting methodologies.

Wages

41(b)(2)(D)Wages for in-house research and development activities usually constitute the majority of expenses eligible for the credit. The research expenditure is only eligible if the wage is paid to the employee for the performance of a qualified service. Qualified Services consist of:

engaging in qualified research
directly supervising qualified research
supporting qualified research

"Engaging in qualified research" means the direct conduct of research and development. "Directly supervising qualified research" is the first-line supervision of qualified research. This does not include the higher-level managers to whom the first-line supervisors report. "Supporting qualified research" includes an employees time spent aiding the direct conduct of research and development. This includes data recording, prototype building, and performing test/trials.

Companies must provide contemporaneous documentation that links an employee's time directly to a project or activity. This documentation takes the form of two methods; Project Approach and Departmental Approach. The project approach relies on a taxpayer's time tracking documentation to directly link an employee's hours to a specific qualified R&D project. The departmental approach relies on oral testimony, contemporaneous engineering documentation, job descriptions, educational background, and other information to develop a time estimate.

Supplies

I.R.C. §41(b)(2)(C) defines the term supply to mean any tangible property other than land or land improvements, and property subject to depreciation. Supply expense must be directly linked to qualified research activities using the taxpayer's accounting system. This can include using general ledgers or job summary reports. Qualified supplies include prototypes and testing materials. The taxpayer cannot include travel, shipping, or royalty expenses as supply expenses.

Contract Research

I.R.C. §41(b)(2)(B) and Treasury Regulation §1.41-2(e) requires a third party to perform a qualified research service on behalf of the taxpayer; and requires the taxpayer to make payment to the third party regardless of success. The "on behalf of" is refined by I.R.C. §1.41-2(e)(3), which requires the taxpayer to have rights into the research results. The contract research payments are included at 65% of the actual expense.

Basic Research Payments

I.R.C. §41(e)(2) qualifies basic research payments made to qualified non-profit organizations and institutions. Basic research refers to fundamental research that focuses on evaluating theories and hypotheses regardless of an application. Basic research payments are included at 75% of the actual expense.

Credit Calculation

The R&D Tax Credit allows for three calculation methods based on the taxpayer's date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation. The Traditional Credit Calculation and Start-Up Credit Calculation provide a credit of 20% of the taxpayers qualified research expenditures that exceed a calculated base amount. The Alternative Simplified Credit base amount is equal 14% of the taxpayers qualified research expenditures that exceed a calculated base amount. Regardless of calculation method the base amount cannot be less than 50% of the taxpayer's current year qualified expenditures. The following sections describe the three calculation methods; Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.

Traditional Credit Calculation

I.R.C. §41(c)(3)(A) establishes a fixed-base percentage calculation for companies that incorporated prior to January 1, 1984 and had 3 or more tax years with qualified research expenditures and revenue between January 1, 1984 and December 31, 1988. The fixed-base percentage is calculated by dividing the taxpayers aggregate qualified research expenses by the aggregate gross receipts for taxable years beginning after December 31, 1983, and before January 1, 1989.

For purposes of the calculation, the resulting fixed-base percentage is multiplied by the average of the taxpayer's gross revenue for the 4 years prior to the calculation year. The fixed-base percentage should only change for purposes of meeting the consistency rule or adjusting for an acquisition or disposition.

Start-Up Credit Calculation

I.R.C. §41(c)(3)(B) establishes a fixed-base percentage calculation for companies that incorporated after December 31, 1983, or had fewer than 3 years with qualified research expenditures and revenue between January 1, 1984 and December 31, 1988. The fixed-base percentage is calculated according to the code as follows.

§41(c)(3)(B)(ii)(I) 3 percent for each of the taxpayer's 1st 5 taxable years beginning after December 31, 1993, for which the taxpayer has qualified research expenses,

§41(c)(3)(B)(ii)(II) in the case of the taxpayer's 6th such taxable year, 1/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 4th and 5th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

§41(c)(3)(B)(ii)(III) in the case of the taxpayer's 7th such taxable year, 1/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th and 6th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

§41(c)(3)(B)(ii)(IV) in the case of the taxpayer's 8th such taxable year, 1/2 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, and 7th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

§41(c)(3)(B)(ii)(V) in the case of the taxpayer's 9th such taxable year, 2/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, and 8th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

§41(c)(3)(B)(ii)(VI) in the case of the taxpayer's 10th such taxable year, 5/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, 8th, and 9th such taxable years is of the aggregate gross receipts of the taxpayer for such years, and

§41(c)(3)(B)(ii)(VII) for taxable years thereafter, the percentage which the aggregate qualified research expenses for any 5 taxable years selected by the taxpayer from among the 5th through the 10th such taxable years is of the aggregate gross receipts of the taxpayer for such selected years.

For purposes of the calculation, the resulting fixed-base percentage is multiplied by the average of the taxpayer's gross revenue for the 4 years prior to the calculation year. The fixed-base percentage should only change for purposes of meeting the consistency rule or adjusting for a acquisition or disposition.

Alternative Simplified Credit

For those companies that cannot adequately substantiate qualified research expenditures for the Traditional or Start-Up calculation methods, or generate fixed-base-percentages that significantly limit the credit, the I.R.C. §41(c)(5) provides an alternative calculation method. This calculation provides a credit equal to 14 percent of the current year qualified research expenses that exceed 50 percent of the average qualified research expenses for the 3 preceding taxable years. As of January 1, 2009, this calculation supplanted the Alternative Incremental Research Credit election.

Since this calculation method is an election, a taxpayer may not apply for this calculation method retroactively. Additionally, I.R.C. §41(c)(5)(C) states this election applies to all of the taxpayer's future claims unless revoked with the consent of the Secretary.

Special Rules

To further supplement the calculation methods and definitions of qualified research and experimentation, the R&D Tax Credit provides special rules for various situations. The following sections briefly describe some of these special rules.

Consistency Rule

In order to accurately calculate a credit, the taxpayer is required to define qualified research expenditures the same from year to year, per I.R.C. §41(c)(5)(A). If a taxpayer changes their definition of qualified expenditures due to the results of an audit, tax court case ruling, or publication of an IRS document, the tax payer must accordingly change their definition for prior years that will affect the results of one of the three calculation methods.

I.R.C. §280C Election

I.R.C. §280C(c)(3) allows the taxpayer to elect a reduced credit amount thereby eliminating the requirement to deduct qualified research expenditures claimed for the R&D Tax Credit. This election can only be made on a timely return.

Controlled Groups

A group of corporations that maintain more than 50% common ownership are treated as one taxpayer for purposes of the R&D Tax Credit. Special brother/sister and spouse rules factor into determining ownership.

Carry-forward and Carry-back

The credits generated for the I.R.C. §41 can be carried forward 20 years and may be carried back 1 year.

IRS Regulation

In April 2007 the IRS designated the I.R.C. §41 Research and Experimentation Tax Credit a tier 1 issue. This designation places the R&D Tax Credit among the most scrutinized tax credits. The initial directive has led the IRS to standardize their audit process by developing a standard information document request and focusing on issues such as the consistency rule, estimated qualified research percentages for employees, and the level of documentation.

Legislation

The legislative intent for the R&D Tax Credit is to increase R&D spending in the United States. Currently separate bills are being proposed in the House of Representatives and the Senate. The House of Representatives bill, cosponsored by U.S. Representatives Kendrick Meek

Kendrick Meek

Kendrick Brett Meek is an American politician who was the U.S. Representative for from 2003 to 2011. He was the Democratic nominee in the 2010 Senate election for the seat of Mel Martinez, but he lost in a three way race to Republican Marco Rubio along with Independent Charlie Crist.-Early life,...

and Kevin Brady

Kevin Brady

Kevin Patrick Brady is the U.S. Representative for , serving since 1997. He is a member of the Republican Party. The district includes a large swath of suburban and rural territory around Houston and Beaumont....

, H.R. 422 proposes to make the credit permanent and increase the Alternative Simplified Credit from 14% to 20%. Senators Max Baucus

Max Baucus

Max Sieben Baucus is the senior United States Senator from Montana and a member of the Democratic Party. First elected to the Senate in 1978, as of 2010 he is the longest-serving Senator from Montana, and the fifth longest-serving U.S...

and Orrin Hatch

Orrin Hatch

Orrin Grant Hatch is the senior United States Senator for Utah and is a member of the Republican Party. Hatch served as the chairman or ranking member of the Senate Judiciary Committee from 1993 to 2005...

are cosponsoring bill S. 1203. This bill proposes to make the credit permanent, increase the Alternative Simplified Credit from 14% to 20%, and terminate the other calculation methods.

In the 112th Congress, Representative Rush Holt is sponsoring H.R. 134 to make the R&D Tax Credit permanent.

Economic Effect of the Credit

The magnitude of the R&D Tax Credit's economic effects are debated by many economists but a majority of them agree the credit does increase R&D spending in the United States. While measuring the actual effect of the credit is difficult, a 2005 study by Ernst & Young measured the amount of dollars returned to companies in the form of the R&D Tax Credit.

17,700 corporations claimed $6.6 billion in R&D Tax Credits on their tax returns in 2005. Approximately 11,300 C corporations and 6,400 S corporations claimed the credit.

Corporations claiming the R&D Tax Credit in 2005 divided up by size are 29% had $1 million in assets or less, 25% with assets of $1–$5 million, 25% with assets of $5–$25 million, and 21% with assets of $25 million or more.

14,953 corporations with less than $50 million in total assets claimed more than $891 million in Federal Research and Experimentation Tax Credits.

71.2% of these corporations had a Standard Industrial Classification in some type of Manufacturing, the remaining 28.8% include Services, Information, and Agriculture.

Relevant Tax Court Cases

Norwest
Norwest
Norwest Corporation was a banking and financial services company based in Minneapolis, Minnesota, United States. In 1998, it merged with Wells Fargo & Co. and since that time has traded under the Wells Fargo name.-Early formation:...

v. Commissioner, 110 T.C. 454 (1998)
Fairchild Industries
Fairchild Industries
Fairchild Industries was created from a name change from Fairchild Hiller Corporation, division and subsidiaries: Fairchild Aircraft Marketing Company, Fairchild Aircraft Services Division, Fairchild Republic Division, Fairchild Space and Electronics Division, Fairchild Stratos Division, Burns Aero...

, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995), rev’d, 30 Fed. Cl. 839 (1994)
Lockheed Martin
Lockheed Martin
Lockheed Martin is an American global aerospace, defense, security, and advanced technology company with worldwide interests. It was formed by the merger of Lockheed Corporation with Martin Marietta in March 1995. It is headquartered in Bethesda, Maryland, in the Washington Metropolitan Area....

Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000), rev’d, 42 Fed. Cl. 485 (1998)
Apple Computer
Apple Computer
Apple Inc. is an American multinational corporation that designs and markets consumer electronics, computer software, and personal computers. The company's best-known hardware products include the Macintosh line of computers, the iPod, the iPhone and the iPad...

, Inc. v. Commissioner, 98 T.C. 232 (1992), acq. in result 1992-2 C.B. 1
Fudim v. Commissioner, 67 T.C.M. (CCH) 3011 (1994)
Eustace v. Commissioner. T.C. Memo 2001-66, aff’d 312 F.3d 1254 (7th Cir. 2002)
Union Carbide Corporation v. Commissioner, 97 T.C.M. (CCH) 1207 (2009)
United States v. McFerrin, 570 F.3d 672, 675 (5th Cir. 2009), rev'd, 492 F. Supp. 2d 695 (2007)
FedEx Corp. v. United States, No. 08-2423 (W.D. Tenn. 2009)
Procter & Gamble Co. v. United States, 733 F. Supp. 2d 857 (S.D. Ohio 2010)
Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688 (2010)
TG Missouri Corp. v. Commissioner, 133 T.C. 278 (2009)