Research Tax Credit – Qualified Research Expenses
Author: Ashley Thompson
Companies nationwide use the research and development (R&D) tax credit to generate tax savings based on the resources invested in developing new or improved products and processes. BKD’s recent webinar, “The Research & Development Tax Credit for Manufacturers,” explored the effects of key court cases on expenses and documentation. Now, we’d like to take a closer look at eligible expenses for the credit, including wages, supplies and contract research expenditures. For most companies, full-time product development engineers’ wages come to mind first and are easiest to recognize; however, a closer look at definitions and examples may lead to the inclusion of additional wages, supplies or contract research.
Qualified research expenses may only include labor performed in qualified services—tasks performed on projects and efforts that meet the four primary qualifying criteria and aren’t specified exclusions. In summary, for research to qualify for the credit, it must relate to a new or improved product or process, be technological in nature and use a process of experimentation to eliminate technical uncertainties identified at the outset of the project. Qualified services are most often part of engineering, design and development activities and not in accounting, finance, purchasing and selling activities.
Who performs qualified research isn’t an all-or-nothing prospect. In most organizations—especially small and midsize companies—relatively few people are effectively full-time researchers. Full- and part-time research can be qualified labor expenses. Full-time researchers usually are easy to identify; it’s more of a challenge to determine what fraction of “less-than-full-time” employees’ work is spent performing qualified research.
Qualified services include those in which employees are directly involved in research, provide direct support for research or provide direct supervision. Therefore, it’s important to expand the pool of employees potentially involved in qualified research activities. People who design and develop new products and processes are obvious examples of job titles with primary responsibilities for performing research. While engineers and designers often perform qualified research, they’re given technical direction by others and supported by others whose related efforts also are qualified research labor. While technical leaders may be leaders, managers or supervisors, they must provide first-line, not executive, direction (except in rare instances). In small companies, first-line and executive leaders may be the same people; however, in large organizations with greater job specialization, there should be supporting justification and evidence for executive technical contribution. People who provide support for qualified research efforts often have “technician” or “operator” in their job titles, e.g., engineering technician, lab technician, production technician, quality technician and test technician.
Examples of qualified research tasks include:
- Brainstorming alternatives
- Concept development
- Feasibility analyses
- Detailed design
- Prototype development
- Tooling design
- Process development
- Experimental design improvements to manufacturing equipment
- Manufacturing equipment design and development
- Design review meetings
- CAD work for new products
- CAD work for process development
- Prototype testing
- Process validation
- Research data compilation
- Generating lab reports
- Machining an experimental model
- Coding and programming
- Directly supervising research
The tax code and regulations define applicable wages as taxable wages or, more appropriately, W-2 wages. Nontaxable items, such as 401(k) contributions, health insurance contributions and other pre-tax benefit deductions, should be excluded.
As with other categories of qualified expenses, qualified supply expenses must be for material used in qualified research activities. The Internal Revenue Code definition of “supplies” refers to any tangible personal property, except property of a character subject to the allowance for depreciation. Examples of qualified supplies include components used to fabricate and test prototypes, raw materials used during product or process design or testing and scrapped material resulting from a failed research and experimentation project. In addition, costs of manufacturing operations performed by vendors to manufacture a prototype product or component, e.g., coating, heat treating and machining, may be considered qualified supply expenses.
Expenditures for supplies or the use of personal property that are indirect research expenditures or general and administrative expenses don’t qualify as in-house research expenses. Utility expenses are considered general and administrative expenses; however, if you can prove the research required an extraordinary amount of utilities, you can include an appropriate amount. This occurs in utility-intensive processes where experimental production runs are carried out or in product development if an extraordinary amount of utilities is required to operate or test prototypes.
Essentially any item considered depreciable property, such as equipment, should be excluded from the calculation. Unfortunately, the most costly purchases, e.g., equipment for an R&D lab, typically are depreciable property. However, it’s important to consider for whom the supply expense is depreciable. In November 2009, the U.S. Tax Court ruled the definition of qualified supplies includes the purchase costs of production molds sold to a taxpayer’s customer. The molds weren’t subject to the allowance for depreciation by the taxpayer. The taxpayer had risks for performance of the design and manufacture of the mold. This ruling suggests an expanded consideration of qualified supply expenses by companies that design, manufacture and sell equipment, machinery, tooling and fixtures.
Examples of qualified supply expenses include:
- Internal prototype costs
- External prototype costs, such as coating, heat treating and machining
- Lab supplies used during testing
- Prototype equipment sold to customers
- Costs of prototype molds made for short-term use to test a product or process design
- Production molds, tooling or patterns used in research and sold to customers
- Material scrapped from experimental production runs
- Lab supplies used during testing
Contract research expenses are amounts paid or incurred to any person (other than a taxpayer’s employee) for qualified research activities. Note: To include these expenses, you must bear the expense of the research even if it’s unsuccessful; you also must retain substantial rights (not exclusive rights) to the research results (intellectual property developed).
The most easily identified qualified contract research expenses often are recorded and reported in development, engineering, quality or research departments. In some instances, qualified and nonqualified contract research and supply expenses may be commingled, e.g., engineering expenses, manufacturing development, R&D expenses or professional services. In those situations, if the expenses are significant, reviewing vendor names and services or material description and quantities in the accounts should identify potential major qualified expenses. Alternatively, if potential major qualified contract research vendors can be initially identified, reviewing respective vendor accounts payable listings will help determine qualified expenses in a taxable year.
Examples of contract research include:
- Independent contractors
- Engineering consultants
- Design firms
- Engineering firms
- Programming services
- Testing laboratories
- Validation services
- Certification services
Wages, supplies and contract research should be closely reviewed to avoid overlooking significant qualified research expenses. Expanding the employee group performing qualified activities, capturing significant supply items and identifying additional contract research vendors can greatly enhance available credits. If you have any questions on these topics or if you would like to discuss your unique situation, contact your BKD advisor.