The Tax Benefits of Research and Development Expenses (IRC Section 41)

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Gray Reed

“No problem can withstand the assault of sustained thinking.”

— Voltaire

Businesses are started with good ideas and a lot of hard work. Companies are sustained by applying that same hard work to the challenges and problems they face along the way.  The Internal Revenue Code benefits businesses for dedicating funds to the pursuit of new and improved business components. Section 41 of the Internal Revenue Code provides a tax credit of 20 percent of a taxpayer’s Qualified Research Expenses (QREs) over a base amount related to previous research expenses.  Essentially, it rewards taxpayers for increasing the amount of money they spend on research and development to improve of develop new business components that will benefit the economy and their customers. However, as with any tax benefit, there are strings attached.  In order to qualify, taxpayers must meet a four part test and certain identified expenses don’t count. Also, the IRS has scrutinized these credit claims regularly during audit and, if necessary, forced taxpayers into court to defend their claims. Preparation and documentation is key to surviving IRS scrutiny and, if necessary, prevailing in any subsequent litigation.

Calculating the Proper Base Amount

The tax credit is for “increasing” research activities and not just engaging in research.  Therefore, the first thing a taxpayer must prove is that the expenses are an increase over historical funding. The fixed based percentage is generally obtained by dividing the taxpayer’s aggregate QREs for the tax years 1984-1988 by the aggregate gross receipts for those years. However, there are alternatives for when a taxpayer qualifies as a “start-up company” but this requires that the first year they have gross receipts and QREs is after 1983 and there are fewer than three tax years during the 1984-1988 period. This is an important first step because, if wrong, a court could deny the credit claim just for failure to substantiate that any increase occurred. See US v. Quebe, 2017 WL 279539 (S.D. Ohio).

Satisfying the Four Part Test

Qualified Research must, essentially, satisfy four tests (1) The Section 174 Test – experimental in the laboratory sense to eliminate uncertainty, (2) Technological in Nature Test – experimentation relies on principles of physical or biological sciences, engineering, or computer science, (3) Process of Experimentation Test – substantially all of the research activities involve a process of experimentation for a qualified purpose and (4) Business Component Test – the research must be done to develop a new or improved business component of the taxpayer. On the surface, these test may seem self-explanatory but are layered with nuance outlined in the Internal Revenue Code, the accompanying regulations, and many cases discussing where the lines are drawn. The mere presence of science or scientific processes may not be sufficient if those processes don’t show a clear laboratory type method requiring the scientific knowledge used. Also, substantially all is interpreted as at least 80 percent and so if the process of experimentation is only a portion of the total activities done it might not be enough.  This is in addition to specific exclusions from the definition of “qualified research” outlined in Section 41(d)(4) (e.g. adaptation or duplication of existing business components). Therefore, a thorough analysis of the client’s specific fact is necessary to determine if the type of research involved qualifies for the credit.  If it does, the next step is gathering the evidence to support the claim.

Substantiation and Documentation is Key

Conducting research to improve or develop a new business component is a potentially profitable endeavor regardless of tax benefits. Therefore, many companies engage in research activities without thinking about potential tax benefits. These taxpayers can amend their returns to claim these unforeseen benefits, but amending a return to seek a refund is likely to increase the chances the IRS will audit the return. Although this scrutiny is unwelcome, it will not invalidate a credit if the proper documentation and legal explanations are provided. If a taxpayer doesn’t have a tax lawyer before the audit, it should probably hire one to handle the audit.  A tax lawyer isn’t always necessary for every IRS dispute, but Section 41 tax credits are usually won and lost on the strength of the legal arguments that the taxpayer’s facts qualify. The good news is that several cases have allowed taxpayers to use estimates, so long as they are reasonable, when documentation isn’t available.  See McFerrin v. United States, 570 F.3d 672 (5th Cir. 2009)(stating that estimates are permissible under the Cohan Rule) ; but see Shami v. Comm’r, 741 F.3d 560 (5th Cir. 2014)(disallowing estimates because of insufficient support for estimates). Further, taxpayers can use testimony of employees to support qualification of the research activities and the amounts involved.  See Suder v. Comm’r, TC Memo 2014-201. Therefore, a lack of some information supporting the claims is not necessarily fatal but should be evaluated carefully.

Although the IRS scrutinizes these tax credits, it is still a substantial benefit that should not be overlooked by companies as they manage the costs of research expenditures. Also, companies should not fear amending returns to claim benefits they missed, so long as they are prepared to document their entitlement. A qualified tax advisor can help companies gather and evaluate the documentation and a tax lawyer can help with any defense of those claims during audit and, if necessary, in court.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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