The Credit for Increasing Research Activities – What Expenditures Can I Include? Employee Wages Edition

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:

The R&D Tax Credit is a “Wages” or “People” driven credit and is primarily derived through employee wages. The IRS defines wages as the following:

“Wages paid to an employee constitute in-house research expenses only to the extent the wages were paid or incurred for “qualified services” performed by the employee. For purposes of section 41, the term “wages” means wages as defined in section 3401(a). This means all taxable wages as reported on Form W-2, including bonuses and stock option redemptions. It does not include amounts that are not subject to withholding, such as certain fringe benefits or non-taxed income, even if paid for research services performed by an employee.”

When analyzing which employees should be included as part of an R&D Tax Credit claim, you should include employees who are performing the following three types of activities:

Treasury Regulation section 1.41-2(c) provides further guidance on what it means to engage in qualifying research. The term “engaging in qualified research” means the actual conduct of qualified research, as in the case of a scientist conducting laboratory experiments.

The term “direct supervision” means the immediate supervision (i.e., first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments but who may not actually perform experiments). “Direct supervision” does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a “qualified research scientist.” Specific attention should be paid to individuals who do not “directly” supervise qualified research activities (i.e., management levels higher than first-line supervisors). In some cases, higher-level research managers may perform some qualified research or direct supervision of qualified research due to their technical background and expertise, but this usually amounts to an insignificant portion of their overall work activities.

The term “direct support” means services in the direct support of either persons engaging in the actual conduct of qualified research or persons who are directly supervising persons engaging in the actual conduct of qualified research. This would include, for example, the services of a machinist for machining a part of an experimental model used in qualified research. Direct support of research does not include general and administrative services or other services only indirectly of benefit to research activities. This is true whether general and administrative personnel are part of the research department or in a separate department.

The IRS has a substantially all rule that states if an employee is qualified at 80% or greater, then you can take 100% of the employee’s wage toward the credit. Employees who are typically qualified at 80% or greater are the ones who are directly engaging in qualified research. To properly document and substantiate employees’ time spent on new or improved R&D activities, the following must be gathered:

Uncovering wage 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 Team has performed R&D studies (as well as support those claims on audits) for all industries and sizes of taxpayers, 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, Principal | [email protected]