A Practical Guide to Identifying, Gathering, and Documenting a Sustainable
Research Tax Credit Claim (Parker's Federal Tax Bulletin: March 04, 2013)

By Contributing Author: Peter J. Scalise

Introduction

The research and experimentation tax credit or research tax credit (RTC) was added to the Internal Revenue Code in 1981 as a temporary provision at a time when research and development jobs were significantly declining in the United States. That decline was due to these jobs being moved overseas where labor rates and overall operating costs were considerably lower. The RTC was introduced into the Code to motivate business entity taxpayers to incur qualifying research and development expenditures with the high expectations that such an advantageous tax incentive would facilitate in stimulating job growth and investment in the United States and prevent further jobs from going overseas.

Although passed into law in 1981 as a temporary provision, the RTC has successfully been extended over the past 32 years with only one exception. For those historically familiar with the RTC, it should be duly recalled that since the RTC's inception, only once was there a gap -- July 1, 1995, through June 30, 1996 -- from when the RTC expired and when it was reinstated without being retroactively applied. The RTC was recently extended for a two-year period through The American Taxpayer Relief Act of 2012, resulting in the RTC being retroactively reinstated to cover calendar year 2012 and prospectively extended to cover calendar year 2013.

While the RTC serves as a highly valuable tax incentive for business entities conducting qualified research activities, it is imperative that the RTC be methodically documented from both a qualitative and quantitative perspective to ensure a sustainable result on IRS examination. It is critical that the design, implementation, and execution of the methodology for the RTC analysis be in full compliance with all applicable statutory, administrative, and judicial interpretations. This article will serve as a practical guide to identifying, gathering, and documenting a sustainable RTC claim.

Identifying Qualified Research Activities (QRAs)

To identify and qualify research and experimentation activities for purposes of the RTC, Code Sec. 41(d) and Reg. Sec. 1.41-4 require that the following four criteria must be satisfied and documented on a contemporaneous basis.

Technological in Nature Requirement

The research must be undertaken for the purposes of discovering information that is technological in nature. As provided in Reg. Sec. 1.41-4(a)(4), information is technological in nature if the process of experimentation used to discover the information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. Reg. Sec. 1.41-4(a)(3)(ii) further provides that a taxpayer need not seek to obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering, nor is the taxpayer required to succeed in developing a new or improved business component.

Process of Experimentation Requirement

Substantially all (i.e., meaning 80 percent or greater) of the activities must constitute, or be deemed to constitute, elements of a process of experimentation for a qualified purpose pursuant to Code Sec. 41(d)(1), (3). As clarified in Reg. Sec. 1.41-4(a)(5), a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving the result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities.

The so-called core elements of a process of experimentation require that the taxpayer (either directly or through another party acting on its behalf):

(1) fundamentally rely on principles of the physical or biological sciences, engineering, or computer science;

(2) identify uncertainty concerning the development or improvement of a business component;

(3) identify one or more alternatives intended to eliminate that uncertainty; and

(4) identify and conduct a process for evaluating the alternatives.

The regulations provide that such a process may involve, for example, modeling, simulation, or a systematic trial-and-error methodology. Reg. Sec. 1.41-4(a)(5) further provides that a process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.

Technical Uncertainty Requirement

Expenditures attributable to research activities must be eligible to be treated as research expenses under Code Sec. 174. As described in Reg. Sec. 1.174-2(a), expenditures are costs incurred in connection with the taxpayer's trade or business that represent research and development costs in the experimental or laboratory sense. Under Code Sec. 174(c), expenditures generally include all costs incident to the development or improvement of a product, but not expenditures for the acquisition or improvement of land or depreciable property.

Permitted Purpose Requirement

A process of experimentation is conducted for a qualified purpose if the research relates to:

(1) a new or improved function;

(2) increased performance;

(3) enhanced reliability; or

(4) enhanced quality.

Under Code Sec. 41(D)(3), research is not considered to be conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal deign factors commonly referred to as mere aesthetics.

Identifying, Gathering, and Documenting QRAs

The requirements described above are applied separately to each business component. Code Sec. 41(d)(2)(c) provides that any plant, process, machinery, or technique for commercial production of a business must be treated as a separate business component, and not as part of the business component (i.e., inventory) being produced. In cases involving development of both a product and a manufacturing process improvement for that product, research activities relating to the product are not qualified research unless the requirements described above are met for the research activities relating to the development of the product without taking into account the activities relating to the development of the manufacturing process improvement as discussed under Reg. Sec. 1.41-4(b).

Reg. Sec. 1.41-4(a)(6) provides that if 80 percent or more of a taxpayer's research activities with respect to a business component constitute elements of a process of experimentation for a qualified purpose, the substantially all requirement is satisfied even if the remaining 20 percent or less of a taxpayer's research activities with respect to that business component does not constitute elements of a process of experimentation for a qualified purpose. However, in no event may activities be treated as qualified research if such activities do not fall within the scope of Code Sec. 174 or if such activities are specifically excluded under Code Sec. 41-(d)(4).

If the requirement of qualified research cannot be satisfied when applied first at the level of the product or process that is to be held for sale, lease, or license, or used by the taxpayer in its own trade or business, then such requirements should be applied at the most significant subset of elements of the product or process. This shrinking back of the business component is continued until either a subset of elements of the business that satisfies the requirement of qualified research is reached, or the most basic element of the product is reached and the requirements of qualified research are not met as set forth under Reg. Sec. 1.41-4(b)(2). To that end, even though a taxpayer's research activities, viewed in their entirety, for a new or improved product (i.e., an aircraft) may not satisfy the substantially all test or other requirements for qualified research, activities related to developing or improving a portion of the product (i.e., the flight actuation system) may still be eligible for the RTC.

Statutorily Excluded Activities

Code Sec. 41(d)(4) specifically excludes the following activities from being treated as qualified research and therefore are ineligible for the RTC.

Research After Commercial Production

Activities conducted after the beginning of commercial production of a business component generally do not constitute qualified research if the activities are conducted after the component is developed to the point where it is ready for commercial sale or use. However, even after a product meets the taxpayer's basic functional requirements, activities relating to the manufacturing process still may constitute qualified research under Reg. Sec. 1.41-4(c)(2).

Adaptation of Existing Business Component

Activities related to adapting an existing business component to a particular customer's requirements are ineligible for the RTC. As set forth under Treas. Reg. Sec. 1.41-4(c)(3), this exclusion does not apply, however, merely because a business component is intended for a specific client.

Duplication of Existing Business Component

As illustrated under Treas. Reg. 1.41-4(c)(4), qualified research does not include activities relating to reproducing an existing business component (i.e., reverse engineering) from a physical examination of the component itself or from blueprints and / or detailed specifications drawings.

Surveys and Studies

Excluded from qualified research are activities in connection with:

(1) efficiency surveys;

(2) management functions or techniques;

(3) market research;

(4) routine data collections; and

(5) ordinary testing or inspections for quality control.

Foreign Research

Research conducted outside the United States or its possessions, such as Puerto Rico and Guam, may not be treated as qualified research.

Funded Research

To the extent research is funded by another person or government entity (by grant, contract, or otherwise), such research may not be treated as qualified research. There are limited exceptions to this rule in cases where overruns are incurred that are not funded. For example, if an aerospace company had a cost plus contract with a client and was funded up to $5 million to develop a flight actuation system and that aerospace company incurred $6 million to develop the flight actuation system, then the $1 million overrun could potentially be claimed as part of RTC assuming the aerospace company had substantially all of the rights to the research (i.e., not needing to make a royalty payment to use that technology in the future) and had the economic risk of loss.

Identifying, Gathering, and Documenting Qualified Research Expenditures (QREs)

Expenditures that qualify for the RTC generally include: (1) in-house research expenses for wages paid to employees for the performance of qualified services; (2) amounts paid for supplies used in the performance of qualified services; and (3) certain qualified research expenses paid to third parties. The term qualified services includes the services of employees who are actually engaged in qualified research and the services of employees who are engaged in direct support of the first level of research activities that constitute qualified research.

QRE Wages

Compensation for the performance of qualified research services should include only compensation treated as wages for income tax withholding purposes. Therefore, in addition to regular wages, the allocation of compensation to research projects should include bonuses and the compensation element recognized on the exercise of nonqualified stock options, but should not include payments to qualified pension and profit sharing plans, including employee Code Sec. 401(k) contributions and nontaxable fringe benefits. Practically speaking, employee wages as documented on Form W-2, Box 1, should be included and then multiplied by a direct qualifying labor wage percentage. This direct qualifying labor wage percentage, for each person, should be calculated as a numerator that is directly tied to qualifying research projects by hour and a fixed denominator of 2,080 hours, which can be further reduced for paid holidays and vacation and sick time. It is imperative to ensure proper and clear nexus between QRAs and QREs at this stage so that an IRS agent can see the link between qualified research hours by project to specific wage expenditures.

In addition, it should be noted that under a special safe-harbor rule, if at least 80 percent of the services performed by an employee during the tax year constitute qualified services, then 100 percent of the services performed by the employee during the tax year may be treated as qualified services. In all cases, each employee and title / rank within the company should also be documented so that an IRS agent can determine at a high level whether that employee was supervising the research (e.g., Oncology Practice Leader), conducting the research (e.g., Bio-Chemist Researcher), or supporting the research (e.g., Lab Technician supporting oncology experimentation). It should be noted, however, that employee titles are not exclusive indicators for determining whether the activities performed by that employee qualify for the RTC.

QRE Supplies

In general, QRE supply costs can be claimed if the supplies are consumed or destroyed in the research process. The term supplies is broadly defined to include any tangible property, other than land, improvements to land, and depreciable property. Expenditures for supplies that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses. For example, amounts paid for electricity used for general laboratory lighting are treated as general and administrative expenses, although amounts paid for electricity used in operating high-energy equipment for qualified research (e.g., a laser for nuclear research) may be treated as expenditures for supplies in the conduct of qualified research as illustrated under Reg. Sec. 1.41-2(b)(2)(ii).

QRE Contract Research

The amount of third-party contractor costs eligible for the RTC is computed at 65 percent, or 75 percent in cases for payments to select research consortia's, of amounts paid to persons other than employees for services that, if performed by an employee, would constitute qualified services under Code Sec. 41(b)(3) and Reg. Sec. 1.41-2(e)(1). Additionally, contract research performed on behalf of a taxpayer is qualified research only if incurred under an agreement (either oral or written) entered into before the performance of the research, and requiring the taxpayer to bear the expenses even if the research is not successful. Any payment made by the taxpayer to a third party that is contingent upon the success of the research is considered to be paid for the product or result rather than the performance of the research, and thus, may not be treated as qualified research expenses under Reg. Sec. 1.41-2(e)(2).

Gathering Contemporaneous Documentation to Support the RTC

Under Reg. Sec. 1.41-4(d), taxpayers must retain records in sufficiently usable form (i.e., in an audit friendly format per the IRS Audit Technique Guidelines for research tax credit claims) and detail to substantiate claimed QREs (i.e., wages, supplies, and contract research) and QRAs (i.e., at the project level). To that effect, it is critical that sufficient contemporaneous documentation be identified, gathered, properly compiled, and retained as forms of substantiation documentation to assist in ensuring that the IRS does not disallow the merits of the RTC claim should an examination come to fruition.

In cases in which a company is government regulated, such as with Life Science companies (i.e., Pharmaceuticals, Bio-Technology & Medical Devices), then the FDA record-keeping requirements can be leveraged to support research activities. As another example, with Aerospace & Defense companies, the FAA and DCAA record-keeping requirements can also be leveraged to support the research activities. In cases where companies apply for a patent or have a patent granted, these forms of contemporaneous documentation serve as the strongest forms of qualified research documentation due to the inherently arduous process to apply for a patent.

From a Best Practice Tax Controversy perspective, the following list of forms of contemporaneous documentation provides several examples of key documents that the IRS typically requests to review during the course of an examination:

(1) complete project lists identifying the full scope of research based projects vs. the actual claimed research projects after conducting systematic project based interviews;

(2) patents or patent applications;

(3) annual R& D or technology plans;

(4) research project authorization requests;

(5) internal and external correspondence on R& D;

(6) design requirements or functional specifications;

(7) testing scripts or testing logs;

(8) modifications reports or error logs;

(9) technical reports or plans;

(10) laboratory notebooks;

(11) ingredient consumption worksheets; and / or

(12) raw material usage records.

It is highly recommended that the more contemporaneous documentation from the aforementioned list that can be obtained should be obtained and meticulously compiled in an audit-ready format, as it will incontestably assist in strengthening the merits of the RTC claim and overall RTC filing position (i.e., always strive for More Likely Than Not or higher, but never file a claim unless you can get at least to Substantial Authority, as discussed below).

From a risk-management perspective, to mitigate or avoid income tax return paid preparer penalties pursuant to Code Sec. 6694 (i.e., penalties that are assessed on both paid tax return preparers and tax advisers that are deemed paid tax return preparers due to their consulting on matters that constitute a substantial portion of their client's tax returns even if they were not engaged to prepare nor review the tax return), a More-Likely-Than-Not standard should be satisfied. The subsequent standards of the applicable levels of opinions should be scrupulously analyzed when assessing an RTC filing position:

(1) Will Standard: Generally, a 95 percent or greater probability of success if challenged by the IRS. A Will opinion generally represents the highest level of assurance that can be provided by an opinion.

(2) Should Standard: Generally, a 70 percent or greater probability of success if challenged by the IRS. A Should opinion provides a lower level of assurance than is provided by a Will opinion, but a higher level of assurance than is provided by a More-Likely-Than- Not opinion.

(3) More-Likely- Than- Not Standard: A greater than 50 percent probability of success if challenged by the IRS. The More-Likely-Than-Not standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under I.R.C. 6662A.

(4) Substantial Authority Standard: Typically, greater than a Realistic Possibility of Success standard and lower than More-Likely-Than-Not standard (i.e., 40 percent probability of success).

(5) Realistic Possibility of Success Standard: Approximately a one-in-three or greater possibility of success if challenged by the IRS.

(6) Reasonable Basis Standard: Significantly higher than the Not Frivolous standard (that is, not deliberately improper) and lower than the Realistic Possibility of Success standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority.

(7) Non-Frivolous Standard: Approximately a 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstance should a tax professional ever render services with this level of comfort.

(8) Frivolous Standard: Approximately a less than 10 percent chance of being upheld upon examination by the IRS and accordingly under no circumstances should a tax professional ever render services with this level of comfort.

It should be noted that each of the standards above has a relevant meaning to both taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. Note that the percentages listed for More-Likely-Than-Not and Realistic Possibility of Success are specifically provided for and discussed in the regulations. In contrast, the percentages for Substantial Authority, Reasonable Basis, Non-Frivolous, Frivolous have been developed based on their relative importance in the hierarchy of standards of opinion as primarily provided for in congressional committee reports. Moreover, while not scientifically calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

Conclusion

When identifying, gathering, and documenting an RTC claim, both from a qualitative and quantitative perspective, taxpayers should be careful to adhere to all applicable statutory, administrative, and judicial interpretations and consult a true subject matter expert in this area to ensure a strong tax return filing position and a sustainable result upon IRS examination.

About the Author

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP.

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