Why R&D Tax Benefits Are Important to Tax Prosby
Research and development tax benefits are easily overlooked. Many taxpayers without scientists on site may still qualify for R&D benefits. We’re also entering a period after 2021 wherein R&D costs are to be capitalized for federal tax purposes.
The tax professional generally needs to understand the basics of the R&D tax rules or risk overlooking benefits due to the taxpayer.
While there are still tax credit benefit issues to understand with R&D, we are also, surprisingly, looking at new restrictions on current deductibility.
Which Clients May Be Affected?
In reading on our topic, “product” is often encountered. But keep in mind, it is quite possible for even the middle-market service business owner to have R&D.
R&D expdenditures generally include all expenditures incident to the development or improvement of a product. R&D expenditures include the expenditures of obtaining a patent, such as attorney's fees expended in making and perfecting a patent application.
The term "product" includes any the following:
- Pilot Model
- Similar Property
R&D can reach software work, for example. Research may involve prototypes, systems, patentable activities, environmental testing, development of software (See “IRS issues reasonable internal-use software regulations for the research tax credit,” Bertiglia and Windram, Tax Clinic, The Tax Adviser, 4/1/17).
R&D usually emphasizes costs in the “experimental or laboratory sense.” (Regs. 1.174-2(a)(1)). The identification of qualifying research will have a technological emphasis. For example, marketing research doesn’t qualify.
The tax rules may turn on otherwise qualifying R&D work being at a particular stage. Even if it is in the nature of research, costs that may otherwise qualify are excluded if they pertain to “adapting an existing product or process to a particular customer’s need.” (See IRS Instructions to Form 6765 Rev. Jan 2022, “Qualified Research”). The R&D credit doesn’t apply to research, despite its technical nature, after commercial production.
In general, the topic of analyzing the client’s circumstances for R&D qualification can involve many questions and sometimes significant professional time. The IRS estimates about a day of work just understanding and preparing the R&D form (IRS Instructions to Form 6565 Rev. Jan 2022, p.6).
Keep in mind that estimate, which may well be low in the author’s opinion, doesn’t touch on resolving the tax relevant facts for a particular client, including an “R&D study.” The nature of the topic can be complex, yet the key is often for the tax professional to be able to ask the right questions.
Tax Reporting - 2021 and Earlier
Part of the tax professional’s job is understanding enough of the taxpayer’s operations to prepare Form 6765, Credit for Increasing Research Activities. Our goal here is to help the tax professional prepare to discuss our topic with the client toward the goal of quantifying R&D.
The form accommodates the “regular credit” (Section A), the “alternative simplified credit” (Section B), calculation of the current year credit (Section C), and the Qualified Small Business Payroll Tax Election and Payroll Tax Credit.” The latest form, which doesn’t carry a tax year designation, is dated December 2020.
The thrust of the tax incentive is to encourage increasing R&D expenditures, hence the form’s name – “Credit for Increasing Research Activities.” The underlying concept is focused on increasing research activity, but also increasing R&D in relation to one’s size.
As you better understand how the form flows, it will help you identify clients who may have significant R&D credit. The first main focus is line 16, which sums lines 1, 4 and 14.
Line 1 is amounts paid or incurred to energy consortia. The instructions here caveat to only enter such amounts in this one place and note the scope is primarily payments to Section 501(c)(3) organizations that conduct energy research.
Line 4 focuses on the amounts paid for basic research to qualified research organizations over the qualified organization base period amount looking to the 3 preceding years (Sec. 41(e)). The focus here is on such payments as to a qualified university or research organization.
Helping clients with R&D usually focuses on internal research, such that lines 1 and 4 will often not be a concern. Line 14 is usually the main focus.
R&D computed initially as lines 5-8 focuses on: wages, supplies, rentals or lease costs of computers plus an applicable percentage of contract research costs. Rentals or lease costs of computers applies to computers off the taxpayer’s premises. Contract research costs don’t get quite as high a benefit as do qualifying in-house research costs.
Wages can’t include pay used in figuring the work opportunity credit. The focus here is such payments as workers getting assistance, certain veterans, ex-felons, others. (See “Work Opportunity Tax Credit,” irs.gov). The self-employed are not left out; see the definition of “wages” as possibly including self-employment earnings (Sec. 41(b)(2)(D)(ii)).
Contract research is generally 65 percent of contract payments to outside groups; i.e., research that is not “in-house.” (See “Audit Technique Guide: Credit for Increasing Research Activities (i.e., Research Tax Credit) IRC Section 41* - Qualified Research Expenses.” IRS.gov, June 2005).
Contract payments to non-in-house researchers can qualify to the extent of 65 percent, but less so than internal costs. The 65 percent can instead be 75 percent in the case of a research consortium (See Sec. 41(b)(3)). To this point, the tax professional will have quantified total qualified research expenses, line 9.
Line 10 asks for a fixed-base percentage, not to exceed 16 percent. (See generally Regs. 1.41-3, and the form’s instructions for line 10). The instructions here distinguish a non-start-up (an “existing company”) telling such company to divide aggregate qualified research expenses for years beginning after 1983 and before 1989 by the aggregate gross receipts for such years. A start-up is defined as a company having fewer than three taxable years beginning after 1983 and before 1989, or having gross receipts and qualified research expenses for the first time beginning after 1983.
The R&D deduction will basically be the lesser of two figures. The fixed-base percentage (not over 16%) times relatively recent average annual gross receipts needs to exceed the current total qualified research expenses.
The relatively recent period is the four years preceding the current year. This is one limitation. The other limitation is 50 percent of 20 percent of qualified research expenses; i.e., 10 percent of current qualified expenses. It is not uncommon that the math will yield a 10 percent deduction of qualified R&D expenses.
There are other subsets of choices and elections. For example, there is the alternative simplified method, plus issues of the credit reducing the deduction or capitalized amount (See the United States overview in KPMG’s “Global R&D Incentives Guide,” 2021).
The computations may need to focus on a controlled group, using a more than 50 percent common ownership rule. The result would then be allocated among members of the group.
Managing the Client’s R&D Deduction and Credit
Pre-2022 rules permit qualifying R&D to be deducted, although there is also a rule focusing on amortization over not less than sixty months. The Tax Cuts and Jobs Act caused R&D costs after 2021 to be capitalized and amortized over five years, or longer if the work is done outside of the U.S. and its possessions.
The importance of identifying qualifying R&D expenditures has historically been focused on extraordinary benefits. However, after 2021, the issue becomes a more rudimentary one of identifying expenditures that may need to be capitalized for tax purposes.
Despite the new federal capitalization rules, the R&D credit rules are continuing incentives. The R&D credit had a history of periodic extensions, a one-year lapse many years ago, but then it was made permanent with the Protecting Americans from Tax Hikes (PATH) Act of 2015. (“Research and Experimentation (R&E) Credit,” U.S. Department of the Treasury, Office of Tax Analysis, 10/12/16, p. 1 of 22).
The R&D credit (aka the “R&E credit”) is almost certainly here to stay, despite the surprising legislative retreat from current deductibility. The IRS concern about R&D substantiation has manifested with added support being required for refund claims filed after January 10, 2022. (IR-2021-203, 10/15/21; see “Research Credit Claims (Section 41) on Amended Returns Frequently Asked Questions,” IRS.gov).
The nature of the topic, R&D, is basically investigative, as is the tax professional’s work in helping the affected client. Questions of scope of the tax benefits (federal and state) and qualification may also be complex.
There is the surprising new post-2021 rule limiting the current deductibility of R&D. In rare cases, the complexity and scope of benefits may justify hiring an R&D specialist. In general, it is recommended that the tax professional’s scope of R&D review questions encompass not only the current year, but prior years as it has become not at all uncommon for R&D to arise in amended returns for your clients.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...