What Costs Do Not Qualify for the Credit?

Costs for the following activities do not qualify for the R&D tax credit:

• Ordinary testing or inspection of materials or products for quality control;

• Surveys, management studies, advertising or promotions;

• Research in connection with literary or similar projects;

• Research conducted outside the United States;

• Acquisition of another’s patent, model or production process;

• Administrative costs;

• Costs for the acquisition of depreciable property;

• Wage fringe costs such as payroll taxes, vacation or holiday pay, deferred compensation, insurance, etc.;

• Any ordinary production activity; and

• All costs of selling.

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What Records are Needed?

The taxpayer should maintain records to substantiate the credit claimed. These records should include a detailed technical description of the activity underlying the claim for credit. This description should address all aspects showing how the activity satisfies the cost criteria addressed above.

The technical description can best be supported by time records of the involved employees. In many instances, particularly when a taxpayer applies for credit for prior open tax years, time records might not be available to the extent claimed, thereby accentuating the importance of the written technical description. Taxpayers would be wise to maintain time records in greater detail in subsequent years in an attempt to validate prior years’ claims. When applying for credit by amending prior years’ returns, documentation might be more sketchy than currently available. Hence, subsequent records might help prove prior year’s assertions.

In addition, invoices for supplies and for contracts with outside suppliers should be readily available and retained for all open years.

How Much is the Credit and How is It Calculated?

The credit is stated as 20 percent of R&D eligible costs. However, taking the 20 percent requires the taxpayer to reduce expenses by the credit amount in order to obtain the benefit. Presuming a 35-percent corporate tax rate, the tax cost of the expense reduction of 7 percent (35 percent by 0.2) produces a 13-percent effective credit.

An election is available to reduce the claimed credit from 20 to 13 percent, negating any reduction of expenses. Claiming the 13 percent also permits the taxpayer to eliminate the requirement to add the expense reduction to taxable state income, thereby increasing state-tax liability. As a result, other than in special circumstances, 13 percent is the effective credit before limitations.

The credit is calculated on the lower of 50 percent of qualifying costs or the product of a fixed base percentage of average annual gross receipts. For example, if qualifying costs were $2 million and 50 percent of that amount was lower than the gross receipts product, then the credit would be $130,000 ($2 million by 50 percent by 13 percent).

The base-year calculation is dependent upon the age of the company. The law also permits an Alternative Incremental Credit and an Alternative Simplified Credit after December 31, 2006. Both of these methods generally produce lower credits than that produced by the Regular Credit method.

How Can We Claim the Credit?

The credit is claimed on Form 6765, Credit for Increasing Research Activities, attached to the applicable tax return. Unused credits can be carried back to all open years and carried forward for the next 20 years. Generally, the three years prior to the current year are open for amendment by the taxpayer or the government. The credit is used as a reduction of any corporate tax due for a C corporation and for cash refunds to shareholders of an S corporation, subject to alternative minimum tax limitations. R&D credits flow through to S corporation shareholders and beneficiaries of trusts or estates.

What IRS Audit Techniques are Associated?

In the event of an audit, IRS agents will first examine the underlying expenses and then the underlying technology. They will examine work documents and determine whether alternative documentation is available. They will review the written descriptions of the project. They also will ask for the company’s instructions to employees and directly inquire of employees as to why certain costs are included as R&D and how that was determined. They might also ask for job descriptions, organizational charts, and materials and brochures promoting R&D activities to potential customers. The agent will determine if the activity meets the general criteria and will search for activities claimed that do not comply.

In the foregoing example, R&D costs of $2 million generated a credit of $130,000. Had the company then amended returns for the prior open three-year period and the current year, it would have generated credits totaling $520,000 ($130,000 by 4). That is serious money. It should not be a complex matter for any company to estimate its potential cash benefit from an R&D credit and proceed accordingly. MF

Technologies: Management

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