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Research and Experimentation Tax Credit


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Discover recent developments, three ways to engage in R&D, the documentation process, IRS' four-part test, Qualified Research Expenditures (AREs) and more.

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Research and Experimentation Tax Credit

  1. 1. Research and Experimentation Tax Credit May 17, 2016 Andrew E. Hill, JD
  2. 2. Agenda • Background • Recent Developments  • Three Ways to Engage in R&D • Documentation Process • Qualitative • Quantitative • IRS’ Four‐Part Test • Qualified Research Expenditures (QREs) • Calculating the Credit • Regular Research Credit (RRC) • Alternative Simplified Credit (ASC) • Where to Look • Software
  3. 3. Background •IRC § 41 – The Research and Experimentation Tax Credit  is commonly referred to as the R&D Tax Credit  •Enacted by Congress in to keep U.S. businesses  competitive in the global market and prevent job  outsourcing •Federal tax benefit between 4.5% and 6.5% per dollar of  Qualified Research Expenditures (QREs) •1 year carryback, 20 year carryforward
  4. 4. Background  •Primarily a wage‐based credit  •Subject to high level of scrutiny by IRS •Proper documentation is critical •Historically, the credit was renewed on a annual basis  since its inception in 1981 •The PATH Act of 2015 made the R&D Credit permanent •Any business, regardless of size, that develops products  or processes, including software, likely has R&D
  5. 5. Recent Developments • PATH ACT • Made the R&D Tax Credit permanent • Beginning in 2016, eligible small businesses (ESBs) and their owners can claim the credit against the Alternative Minimum Tax • ESBs are partnerships, sole proprietorships, and privately held corporations with average annual gross receipts under $50 million in preceding three years • Beginning in 2016, qualified small businesses (QSBs) – startups with less than $5 million in annual gross receipts and no more than 5 years in existence – can claim the credit against payroll taxes • Tennessee R&D Credits • Purchases of machinery and equipment, including parts, repairs and installation, that are for R&D purposes • Offset up to 50% of a company’s F&E taxes, 15 year carryforward
  6. 6. Three Ways to Engage in R&D •Classic R&D • Resulting from a deliberate decision to develop new – or improve upon existing – products or services • Typically conducted by an R&D department or team •Contingent R&D • Beginning a project while being uncertain as to how to complete it • Knowing that some development is necessary because existing expertise is insufficient to fill order •Unplanned R&D • Arising from a sudden discovery during the process of filing the order • Realizing that existing technology is inadequate and that unplanned development is necessary
  7. 7. Documentation Process • Qualitative • Determine if the taxpayer is performing qualified R&D • Four-Part Test – IRS Reg. § 1.41-4(a) • Quantitative  • QREs • Calculating the credit • Documentation is Critical  • Best evidence of credit comes from supporting records and documents that are contemporaneous with the research activities • Project lists and descriptions • Preliminary specifications, drawings, notes, emails • Drawing/design iterations, engineering change orders, testing data • Patents, final drawings, specifications
  8. 8. Four‐Part Test  IRS Reg. 1.41‐4(a) •The activity must be technological in nature • Based on the principles of hard sciences: physical or biological sciences, engineering, computer science •The activity must be for a permitted purpose • Develop a new – or improve an existing – product, process, or component •The activity must involve the elimination of  uncertainty • Uncertainty exists if the capability, method, or design is unknown at the start of the project •The activity must involve a process of experimentation • Evaluating alternatives; testing and modeling; simulation; trial and error; examining and analyzing hypotheses
  9. 9. Qualified Research Expenditures •QREs arise from activities performed during the  experimentation process discussed in Four‐Part Test •In‐house research • Determined based on W-2, Box 1 wages •Supplies • Materials used during the course of the development process and are not subject to depreciation •Contract research • Performed by third party within the U.S. • Up to 65% of contract amount may qualify
  10. 10. Calculating the Credit •Regular Research Credit • Amount subject to credit: lesser of 50% of QREs or QREs over base amount • Credit is 20% times that lesser amount • Base amount calculation may involve going as far back as 1984 to establish historical QREs •Alternative Simplified Credit • Amount subject to credit: Current-year QREs minus the base amount • Credit is 14% times amount • Base amount is 50% of the average QREs from preceding three years
  11. 11. Where to Look • High Occurrence • Research and Development • Engineering • Programming • Technical/Industrial Design • Medium Occurrence • Quality Control/Quality Assurance • Testing • Implementation • Direct Support/Direct Supervision • Low Occurrence • Sales and Customer Service • Marketing • High-level Executives • Business Administration
  12. 12. Software •Internal‐Use Software • Software developed primarily for internal use is currently excluded from QREs and not eligible for federal R&D Tax Credit • Proposed IRS regulations would exclude only software developed for general and administrative functions such as financial management, HR, or support services •Dual‐Function Software  • Primarily for internal use, but functionality enables interaction with external third parties • Proposed safe harbor would allow the portion that enables third-party functionality to qualify for federal R&D Tax Credit •Software Developed for Commercial Market • The development or improvement of a commercial software product is eligible for the federal R&D Tax Credit
  13. 13. Speaker Contact Info Andrew E. Hill, JD Senior, Credits and Incentives LBMC, PC 615.309.2685