The Research & Experimentation Tax Credit or R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States.
To be eligible claimant's must satisfy a four part test:
The eligible expenses or qualified research expenditures include four types of expenses:
Wages for in-house research and development activities usually constitute the majority of expenses eligible for the credit. The research expenditure is only eligible if the wage is paid to the employee for the performance of a qualified service, consisting of:
Companies must provide contemporaneous documentation that links an employee's time directly to a project or activity. This documentation takes the form of two methods; Project Approach and Departmental Approach. The project approach relies on a taxpayer's time tracking documentation to directly link an employee's hours to a specific qualified R&D project. The departmental approach relies on oral testimony, contemporaneous engineering documentation, job descriptions, educational background, and other information to develop a time estimate.
The following do not constitute qualified research:
- Research conducted after the beginning of commercial production of the business component
- Adaptation of existing business components
- Duplication of existing business components
- Reverse Engineering
- Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control
- Software developed for internal use
- Foreign research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States
- Research related to social sciences, arts, or humanities
- Research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)
The legislation defines the term supply to mean any tangible property other than land or land improvements, and property subject to depreciation. Supply expense must be directly linked to qualified research activities using the taxpayer's accounting system. This can include using general ledgers or job summary reports. Qualified supplies include prototypes and testing materials. The taxpayer cannot include travel, shipping, or royalty expenses as supply expenses.
3. Contract Research
A third party is required to perform a qualified research service on behalf of the taxpayer; and requires the taxpayer to make payment to the third party regardless of success. The "on behalf of" requires the taxpayer to have rights into the research results. The contract research payments are included at 65% of the actual expense.
4. Basic Research Payments
Basic research payments made to qualified non-profit organizations and institutions. Basic research refers to fundamental research that focuses on evaluating theories and hypotheses regardless of an application. Basic research payments are included at 75% of the actual expense.
How is the US R&D Tax Credit Calculated?
The R&D Tax Credit allows for three calculation methods based on the taxpayer's date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation. The Traditional Credit Calculation and Start-Up Credit Calculation provide a credit of 20% of the taxpayers qualified research expenditures that exceed a calculated base amount. The Alternative Simplified Credit base amount is equal 14% of the taxpayers qualified research expenditures that exceed a calculated base amount. Regardless of calculation method the base amount cannot be less than 50% of the taxpayer's current year qualified expenditures. The following sections describe the three calculation methods; Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.
Traditional Credit Calculation
The legislation establishes a fixed-base percentage calculation for companies that incorporated prior to January 1, 1984 and had 3 or more tax years with qualified research expenditures and revenue between January 1, 1984 and December 31, 1988. The fixed-base percentage is calculated by dividing the taxpayers aggregate qualified research expenses by the aggregate gross receipts for taxable years beginning after December 31, 1983, and before January 1, 1989. For purposes of the calculation, the resulting fixed-base percentage is multiplied by the average of the taxpayer's gross revenue for the 4 years prior to the calculation year. The fixed-base percentage should only change for purposes of meeting the consistency rule or adjusting for an acquisition or disposition.
Alternative Simplified Credit
For those companies that cannot adequately substantiate qualified research expenditures for the Traditional or Start-Up calculation methods, or generate fixed-base-percentages that significantly limit the credit, the I.R.C. 41(c)(5) provides an alternative calculation method. This calculation provides a credit equal to 14 percent of the current year qualified research expenses that exceed 50 percent of the average qualified research expenses for the 3 preceding taxable years. As of January 1, 2009, this calculation supplanted the Alternative Incremental Research Credit election.
Since this calculation method is an election, a taxpayer may not apply for this calculation method retroactively. Additionally, I.R.C. 41(c)(5)(C) states this election applies to all of the taxpayer's future claims unless revoked with the consent of the Secretary.
To further supplement the calculation methods and definitions of qualified research and experimentation, the R&D Tax Credit provides special rules for various situations. The following sections briefly describe some of these special rules.
In order to accurately calculate a credit, the taxpayer is required to define qualified research expenditures the same from year to year, per I.R.C. 41(c)(5)(A). If a taxpayer changes their definition of qualified expenditures due to the results of an audit, tax court case ruling, or publication of an IRS document, the tax payer must accordingly change their definition for prior years that will affect the results of one of the three calculation methods.
I.R.C. 280C election
Allows the taxpayer to elect a reduced credit amount thereby eliminating the requirement to deduct qualified research expenditures claimed for the R&D Tax Credit. This election can only be made on a timely return.
A group of corporations that maintain more than 50% common ownership are treated as one taxpayer for purposes of the R&D Tax Credit. Special brother/sister and spouse rules factor into determining ownership.
Carry-forward and Carry-back
The credits generated can be carried forward 20 years and may be carried back 1 year.