The Research & Development (R&D) Tax Credit is one of the most lucrative tax incentives that companies can take advantage of to lower their federal and state tax liability or offset their quarterly payroll taxes (i.e., FICA, Medicare). To properly calculate the R&D tax credit, you must calculate the total amount of U.S.-based qualified research expenses your company has for the credit year. IRC § 41(b) defines research expenses as:
- Any "wages" paid or incurred to an employee for "qualified services" performed by such employee;
- 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research (i.e., contractor payments);
- Any amount paid or incurred for "supplies" used in the conduct of "qualified research”; and
- Any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.
Contract Research
The R&D tax credit is a “Wages” or “People” driven credit. Not only can you qualify in-house employees toward the credit, but you can also qualify third-party contractors that are performing research and development activities on behalf of the taxpayer within the United States. The IRS states the following regarding contract research:
A contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person, other than an employee of the taxpayer, for the performance on behalf of the taxpayer of qualified research, or services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B). Treas. Reg. § 1.41-2(e)(1). If any contract research expense is attributable to qualified research to be conducted after the close of the taxable year, it shall be treated as paid or incurred when the qualified research is conducted. I.R.C. § 41(b)(3)(B). Thus, prepaid research expenditures are not eligible for the credit until the services are performed.
This states that if an individual or company (1099 or invoiced contractor) is performing research and development activities on the taxpayer’s behalf, they may qualify as a contractor and add to the total research and development Qualified Research Expenditures (“QRE’s”). The R&D Tax Credit is a tax incentive that encourages businesses to keep their research and development activities in the United States. It does this by providing a tax credit for research expenses. Thus, anyone that is performing contract research on the taxpayer’s behalf must be located and performing their research and development activities within the United States or a United States territory. If you are paying an invoiced contractor located in California, but their workers performing the work are based out of India, they would not qualify towards the R&D tax credit calculation, as the work is actually being performed outside the United States or a United States territory. When calculating each contractor QRE’s, Code § 41 requires the taxpayer to take a 35% reduction of the qualified amount, making contact research less lucrative than in-house employees performing research and development activities.
Once all potentially qualified contractors have been identified, contractual agreements must be evaluated between the taxpayer and all associated contractors. These contractual agreements must be reviewed to determine who owns the rights to the work being performed and who bears the financial risk.
Financial Risk
Pursuant to Treas. Reg. § 1.41-2(e)(2)(iii), the taxpayer must bear the expense of the research even if the research is not successful. If an expense is paid or incurred pursuant to an agreement under which payment is contingent on the success of the research, then the expense would not qualify, as this payment agreement is paying for a successful final product rather than for work the contractor has completed. The amounts payable under any agreement that are not contingent on the success of the research (paid for the product or result of the research) are potentially qualified contract research.
The best way to determine whether the taxpayer has financial risk is to consider if the taxpayer bears the research costs upon failure. An example of financial risk can be found in the foundational case of Fairchild Industries, Inc. v. United States.
Rights
As defined by Treas. Reg. § 1.41-2(e)(3), qualified research is performed on behalf of the taxpayer if the taxpayer has a right to the research results. Qualified research can be performed on behalf of the taxpayer, notwithstanding the fact that the taxpayer does not have exclusive rights to the results. Therefore, if a taxpayer obtains more than incidental rights in the research conducted by the contractor, even if the contractor also has rights, expenses incurred for such research will satisfy this requirement to be treated as qualified contract research for purposes of IRC §41(b)(3).
The best way to determine if a taxpayer owns the rights to the work being performed by a contactor is to identify if the taxpayer has the right to use the process of technology developed and intends to use the process or technology in their trade or business. An example of rights can be found in Lockheed Martin Corporation v. United States.
How Withum Can Help?
Uncovering the proper data/support for specific taxpayers is a challenging undertaking that should only be performed by qualified R&D tax credit specialists. Withum’s R&D Tax Credit Services Team has performed R&D studies (as well as supporting those claims on audits) for all industries and sizes of taxpayers ranging from start-ups and beyond. Please reach out to schedule a free R&D tax credit assessment.
Authors: Austin Jensen, MBA | [email protected] and Tyler Collins, CPA, MACC, Partner | [email protected]
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