AndreTaxCo, PLLC

Research Wages

Research wages constitute the taxable wages paid to an employee relating to qualifying research activities. If an employee had performed both qualifying services and non-qualifying services, only the amount of wages allocated to the performance of qualifying research activities constitutes an in-house research expense.

​

§ 41(b)(2)(B) and Treas. Reg. § 1.41-2(c) identifies three types of qualified services:

​

(1) Engaging in qualified research (Treas. Reg. § 1.41-2(c)(1);

• The term "engaging in qualified research" means the actual conduct of qualified research, as in the case of a scientist conducting laboratory experiments.

​

(2) Directly supervising qualified research (Treas. Reg. § 1.41-2(c)(2); or

• The term "direct supervision" means the immediate supervision (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“. 

  • However, the IRS acknowledges, 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 generally may only represent a minor fraction of their overall work activities. See Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Qualified Research Expenses (June 2005) (Page Last Reviewed or Updated: 29-Jan-2019)

  • In Suder v. Comm’r, T.C. Memo. 2014-201, the U.S. Tax Court held that high-level executives with technical degrees may perform or directly supervise research, which effectively broaden the scope of eligible supervisory activities.

  • Because the hierarchy of technical departments are often very flat, higher level management and directors of technical departments may be heavily involved in actual research and the direct supervision of research. Some examples of qualified research activities include the following:

    • Brainstorming and technical problem solving

    • Attending technical and design review meetings

    • Participating in concept and process development

    • Designing experiments and tests and documenting research results

    • Directly supervising first-line managers who also perform research

 

(3) Directly supporting qualified research (Treas. Reg. § 1.41-2(c)(3).

• The term "direct support" means services in the direct support of either (1) persons engaging in the actual conduct of qualified research, or (2) persons who are directly supervising persons engaging in the actual conduct of qualified research.  This would include the services of a machinist for machining a part of an experimental model used in qualified research. ​

• For example, direct support of research includes the services of the following:

  • (1) a secretary for typing reports describing laboratory results derived from qualified research; 

  • (2) of a laboratory worker for cleaning equipment used in qualified research; 

  • (3) of a clerk for compiling research data; and

  • (4) of a machinist for machining a part of an experimental model used in qualified research.

• Direct support of research activities does not include general administrative services, or other services only indirectly of benefit to research activities. Treas. Reg. § 1.41-2(c)(3).

  • For example, the following general administrative activities does not qualify as direct support of research services and applies whether the personnel are part of the research department or in a separate department:

    • (1) payroll personnel in preparing salary checks of laboratory scientists; 

    • (2) an accountant for accounting for research expenses; 

    • (3) a janitor for general cleaning of a research laboratory; or

    • (4) officers engaged in supervising financial or personnel matters.  

• Direct support does not include supervision. See above for direct support qualified activities.

​

Research Supply Expenses

Research supply expenses relate to those supplies consumed (or destroyed) while carrying out qualifying research activities.  IRC § 41(b)(2)(C) defines the term "supply" to mean any tangible property other than (1) land or improvements to land, and (2) property of a character subject to the allowance for depreciation. 

​

Treas. Reg. § 1.41-2(b)(1) further defines supplies and personal property are used in the conduct of qualified research if they are used in the performance of qualified services (as defined in § 41(b)(2)(B) by an employee of the taxpayer (or by a person acting in a capacity similar to that of an employee of the taxpayer. Expenditures for supplies or for the use of personal property that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses.

​

For example, overhead, license fees and costs for leasing assets are not tangible property, therefore not supplies. Expenses for property used in general and administrative activities are also not QREs. Other examples of costs that are NOT supply QREs include:

• travel, meals or entertainment

• telephone expenses of researchers

• relocation or rental/lease expense

• professional dues or royalty/license expenses 

​

Utility expenses are typically classified as general and administrative expenses and non-qualified for the R&D tax credit. However, if you can prove the research required an extraordinary amount of utilities, you may include an appropriate amount. See "Extraordinary Utility Expenses" section below for additional details.

​

Supplies are used in the conduct of qualified research if they are used in the performance of "qualified services" by an employee of the taxpayer (or person acting in the capacity of an employee). In general, examples of research supply expenses may include the following used in the experimental or laboratory sense to evaluate and resolve technical uncertainty (i.e. appropriate design):

• Materials, chemicals, or other consumable components utilized during experimental testing and qualified research activities

• Models and/or components developed for prototype products and systems testing 

• Experimental production tooling

​

However, in 2014, Treas. Regs. § 1.174-2 (July 22, 2014) modifications were finalized that provided favorable treatment of costs incurred to produce a “pilot model” (i.e., a prototype) as research or experimental expenditures pursuant to IRC § 174, to evaluate and include qualified research expenses under IRC § 41, to claim the R&D tax credit. Treas. Reg. § 1.174-2(a)(4) defines "pilot model" to mean any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product. The term includes a fully-functional representation or model of the product or a component of the product.

​

Treas. Reg. § 1.174-2(a)(1) also provide that the “ultimate success, failure, sale, or use of the product is not relevant” so long as sufficient uncertainty exists with respect to the technical feasibility of the prototype. As such, qualified supply costs may now be claimed for a prototype irrespective of whether the item is scrapped or sold to a customer. These supply costs may be claimed in addition to the labor used to develop the prototype

​

Moreover, taxpayers that use supplies in their R&D efforts should reevaluate the costs they include in their R&D credit computations in light of a recent tax court decisions. Some noteworthy court decision examples are listed below for additional background. 

​

• Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010)

  • The U.S. district court held that the taxpayer (Trinity) is entitled to the research tax credit for qualified research expenditures (QREs) for activities relating to the design, development, and construction of new types/classes of ships. Trinity considered these first-in-class ships to be prototypes because the specific designs had never been previously attempted and, once validated and proven to meet their objectives, would be duplicated and commercially produced.

• TG Missouri v. Comm'r, 133 T.C. No. 13 (2009)

  • The tax court rejected the IRS' prior stance on whether depreciable property can qualify as a supply expense under IRC § 41. Here, the court held that production molds of an automobile parts manufacturer purchased from third parties, and later sold to customers, were not assets subject to depreciation under IRC §§ 174 and 41. The taxpayer properly included costs of the molds as supply expenses in determining its research credit.

  • The ruling has helped expand potential benefits to certain taxpayers claiming the R&D credit, in particular, those that purchase supplies during their R&D efforts for prototypes, products, or equipment that are later sold to customers.

• Union Carbide v. Commissioner, TC Memo. 2009-50

  Overall the Union Carbide holding is especially taxpayer friendly to those who may not be conducting new product research, but instead are improving their overall production processes. 

  • The court confirmed that qualified research can occur as part of the production process of goods for sale to customers. Here, the tax court held that production process improvements should be analyzed separately from new product research. The decision allowed direct costs incurred during qualified process improvement research to be claimed as qualified research expenditures.
  • The court maintained that the research credit qualification tests should be applied separately to the improvement or development of a production process for a particular product. However, Union Carbide’s attempt to include a portion of the production supply costs as qualifying research expenditures was rejected because the business component under development was a process, not a product.

• TSK v. Commissioner (Docket No. 2018-35060); 2018 TNT 169-6​ 

  • TSK of America Inc. (“TSK”), a Michigan automotive parts supplier, included tooling costs for metal stamping and plastic injection molding in its 2013 research tax credit. TSK purchased the tools from a third party with the intention of using the tools in its production process. Typically, TSK’s customers required TSK to sell any unique tools produced to the customers, while TSK retained possession of the tool to produce the part. Tooling purchased from a third-party supplier was not guaranteed to meet TSK specifications and production requirements. TSK argued that it undertook a thorough trial-and-error process to ensure the tools performed as designed and could meet its needs for efficiency, accuracy and economic productivity.

  • The IRS disallowed tooling QREs on the grounds that (1) there was not significant uncertainty surrounding the development of the tooling and (2) the tooling was for production purposes, not research purposes.

  • TSK filed a petition with the U.S. Tax Court to dispute the IRS ruling. After discovery was conducted, the IRS notified TSK in August 2018, that it would not dispute TSK’s credit claim and concede its case in U.S. Tax Court. While the court case was not ruled on, and therefore can’t be cited as precedent, it provides helpful insight for manufacturers currently claiming tooling expenses.

​

In general, it is often essential to bifurcate supply costs utilized in “production trials” as opposed to “experimental batch trials” to determine which costs were consumed or destroyed during the research and development process in substantiating qualified supply expenses to calculate the credit. For example, during an attempt to reprocess specific supply costs in a failed experimental batch trial, generally only the cost of refinement may be potentially included, in consideration of pilot model (prototype) applicability, if the reprocessed supply costs are placed back into inventory for a future production or experimental batch trial.

​​

Extraordinary Utility Expenses

​Treas. Reg. § 1.41-2(b)(2)(i) provides that, in general, amounts paid or incurred for utilities such as water, electricity, and natural gas used in the building in which qualified research is performed are treated as expenditures for general and administrative expenses (non-qualified for the R&D credit).

 

However, Treas. Reg. § 1.41-2(b)(2)(ii) provides a limited exception, to the extent the taxpayer can establish that the special character of the qualified research required additional extraordinary expenditures for utilities, the additional expenditures shall be treated as amounts paid or incurred for supplies used in the conduct of qualified research as defined in I.RC. § 41(b). Thus, to qualify for this limited exception, a taxpayer must establish the following:

​

• (1) that the qualified research is of a "special character,"

• (2) that the special character of the qualified research "required" the utilities expenses, and

• (3) that the required utilities expenses are both "additional" and "extraordinary."

• Treas. Reg. § 1.41-2(b)(2)(ii) provides, in relevant part, the following example to illustrate this limited exception:[A]mounts paid for electricity used in operating high energy equipment for qualified research (such as laser or nuclear research) may be treated as expenditures for supplies used in the conduct of qualified research to the extent the taxpayer can establish that the special character of the research required an extraordinary additional expenditure for electricity. 

 

As such, amounts paid for electricity used for general laboratory lighting are generally treated as general and administrative expenses (non-qualified), but amounts paid for electricity used in operating high energy equipment for qualified research (such as laser or nuclear research) may be treated as qualified expenditures for supplies used in the conduct of qualified research to the extent the taxpayer can establish that the special character of the research required an extraordinary additional expenditure for electricity. 

​

Every industry uses energy, but three industries account for most of the total U.S. industrial sector energy consumption. The U.S. Energy Information Administration estimates that in 2018, (1) the bulk chemical industry (the largest industrial consumer of energy), (2) the refining industry, and (3) the mining industry combined accounted for about 58% of total U.S. industrial sector energy consumption.

​

In 2018, the industrial sector accounted for about 32% of total U.S. energy consumption according to the U.S. Energy Information Administration (EIA). See "Use of energy explained, Energy use in industry"U.S. Energy Information Administration (Last updated: May 9, 2019) (https://www.eia.gov/energyexplained/use-of-energy/industry.php)

​

The following industrial sectors below have been also identified as "energy-intensive manufacturing" industries by the EIA (see U.S. Energy Information Administration | International Energy Outlook 2016), thus may be reasonable candidates to claim "extraordinary utility expenses" as qualified supplies to calculate their R&D tax credit claim. 

​

• Food - Food, beverage, and tobacco product manufacturing;

• Pulp and paper - Paper manufacturing, printing and related support activities;

• Basic chemicals - Inorganic chemicals, organic chemicals (e.g., ethylene propylene), resins, and agricultural chemicals; includes chemical feedstocks;

• Refining - Petroleum refineries and coal products manufacturing, including coal and natural gas used as feedstocks;

• Iron and steel - Iron and steel manufacturing, including coke ovens;

• Nonferrous metals - Primarily aluminum and other nonferrous metals, such as copper, zinc, and tin; and

• Nonmetallic minerals - Primarily cement and other nonmetallic minerals, such as glass, lime, gypsum, and clay products.

​

Note, the IRS has held attempting to establish that on a square foot basis additional utilities were consumed in the research buildings does not itself establish that the additional utilities were actually used in the conduct of qualifying research pursuant to Treas. Reg. § 1.41-2(b)(2)(ii); I.R.C. § 41 (b)(2)(A)(ii); and Lockheed Martin Corp. v. United States, 49 Fed. CI. 241 (2001).  See IRS APPEALS SETTLEMENT GUIDELINES, Qualified Research Expenses - Extraordinary Expenditures for Utilities, UIL: 41.51-01 (3/18/2010)

​

As such additional documentation (outside of pure accounting records) supporting your activities facts and circumstances meeting the additional 3-prong test pursuant to Treas. Reg. § 1.41-2(b)(2)(ii) are essential to substantiating your claim.

​

Contract Research Expenses

Examples of contracted research expenses may include invoiced fees regarding engineering consultants, subcontractors used to develop and/or evaluate developmental prototype process systems, temporary 1099 contractors performing qualified research, or contracted test labs (e.g. UL, CE, CSA, FDA, NEMA, FCC) utilized during experimental testing and/or developmental.

​

IRC § 41(b)(3)(A) and Treas. Reg. § 1.41-2(e)(1) defines, in general, allowable “contract research expenses” to calculate the R&D credit includes 65% of any amount paid or incurred in carrying on a trade or business by the taxpayer to any person (other than an employee of the taxpayer) for the performance on behalf of the taxpayer of 

• (i) Qualified research as defined in § 1.41-4 or 1.41-4A, whichever is applicable, or

• (ii)Services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of IRC § 41(b)(2)(B).

​

Treas. Reg. § 1.41-4(c)(9) states qualified research does not include any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity). To determine the extent to which research is so funded, § 1.41-4A(d) applies. Research is considered to be funded (non-qualified) if either of the following two circumstances are not retained by the taxpayer as set forth in Reg. Sec. 1.41-4A(d):

​

(1) Risk – If a taxpayer receives payment that is contingent on the success of the research, the research is not funded and the taxpayer may generally include these expenses for the research credit. The taxpayer must retain financial risk through either a success-based fee or fixed-fee contract. If a contract provides the researcher is required to return funds, or incur additional costs beyond what the client is contractually obligated to pay, the researcher may also be at financial risk.  Generally, the research process begins during the pre-award ("bid and proposal") preliminary research phase. Similar to internal R&D, pre-award work is typically self-funded, and research expenses associated with these efforts may qualify towards the R&D tax credit.

​​

• Fairchild Indus., lncorp. v. United States , 71 F.3d 868, 872-73 (Fed. Cir. 1995)

  • The Court of Appeals held the ​taxpayer's fixed price contract with the Air Force to develop an aircraft, with payments subject to meeting government milestones was not funded and qualified for the R&D tax credit. The Court found "the inquiry turns on who bears the research costs upon failure, not on whether the researcher is likely to succeed in performing the project." 

  • Key contract clauses noted by the Court to evaluate whether the payment is contingent on the success of the research:

    • All work subject to inspection and testing before acceptance.

    • Contract required the taxpayer to meet specific design, construction, quality, and performance standards.

    • Payment under contract made only after acceptance. Although progress payments were made, the taxpayer did not have the right to retain unless contract line items were delivered and accepted.

    • The government could terminate the contract for default or for convenience of the government.

• Dynetics, Inc. and Subsidiaries v. United States, 12-576 (FED. CL. 2015)

  • Court of Federal Claims held that research performed by the taxpayer was “funded research” because payment was not contingent on the success of the research and the taxpayer did not retain substantial rights in the research results. The Court found, unlike the contractor in Fairchild (see above), the taxpayer made no assertion that it expressly accepted contractual responsibility for producing any product or meeting contract specifications. The Court followed the ruling in Lockheed Martin v. U.S., 210 F. 3d 1338 (Fed. Cir. 2000), in that any determination of risk must be made solely on the “research agreement” between the parties, with no consideration of external statutes not otherwise expressly incorporated into that agreement.

• Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015) 

  • The Court held that research expenses incurred by a taxpayer under fixed-price contracts do not fall within the “funded research” exclusion and, as such, are eligible for the R&D tax credit. The Court also ruled that research expenses incurred under “capped contracts” or “cost plus subject to a maximum” fall within the “funded research” exclusion and are not eligible for the research credit as the taxpayer does not bear financial risk.

​

(2) Rights – If a taxpayer performing research for another person or governmental entity retains no substantial rights in the research, the research is funded and the taxpayer is precluded from including these expenses for the R&D credit. For example, if the contract states that another person holds exclusive rights to exploit the results of the research, the taxpayer may not retain substantial rights.

• Lockheed Martin Corp. v. U.S., 210 F. 3d 1366 (Fed. Cir. 2000)

  • ​The Court held that the right to prevent unauthorized use or disclosure and the discretion to terminate the transfer of property were substantial rights, in the subject matter, even when others do as well. However, whether a retained right is substantial depends on the circumstances and the commercial or practical value of the retained right. Substantial rights are maintained by an entity conducting research as long as that entity does not have to pay for the use of the resulting knowledge.​

​

Contract Research - Research Performed on Behalf of the Taxpayer

Treas. Reg. § 1.41-2(e)(2) further defines the performance of qualified research as an expense only to the extent paid or incurred for the performance of qualified research pursuant to an agreement that meets the following:

​

• (i) Is entered into prior to the performance of the qualified research;

• (ii) Provides that research be performed on behalf of the taxpayer; and

  • Treas. Reg. § 1.41-2(e)(3) provides 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.​ ​​

• (iii) Requires the taxpayer to bear the expense 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 is considered paid for the product or result rather than the performance of the research, and the payment is not a contract research expense. The previous sentence applies only to that portion of a payment which is contingent on the success of the research.

  • Treas. Reg. § 1.41-4A(d)(1) provides amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research (see § 1.41-2(e)(2)) are not treated as funding. For special rules regarding funding between commonly controlled businesses, see § 1.41-6(e).​​ All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded. Id.

​

Funded Research - Research Performed by the Taxpayer on Behalf of Other(s)

Treas. Reg. § 1.41-2(a)(3) provides guidance regarding research performed through the following analysis:

​

• (i)Taxpayer not entitled to results. If the taxpayer performs research on behalf of another person and retains no substantial rights in the research, that research shall not be taken into account by the taxpayer for purposes of section 41. ​

• Treas. Reg. § 1.41-4A(d)(2) states If a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded, and no expenses paid or incurred by the taxpayer in performing the research are qualified research expenses.

  • For example, if the taxpayer performs research under an agreement that confers on another person the exclusive right to exploit the results of the research, the taxpayer is not performing qualified research because the research is treated as fully funded.

  • Incidental benefits to the taxpayer from performance of the research (e.g., increased experience in a field of research) do not constitute substantial rights in the research.

  • If a taxpayer performing research for another person retains no substantial rights in the research and if the payments to the researcher are contingent upon the success of the research, neither the performer nor the person paying for the research is entitled to treat any portion of the expenditures as qualified research expenditures.

• Treas. Reg. § 1.41-2(a)(1) states for purposes of section 41, a contract research expense of the taxpayer is not a qualified research expense if the product or result of the research is intended to be transferred to another in return for license or royalty payments and the taxpayer does not use the product of the research in the taxpayer's trade or business.

• (ii)Taxpayer entitled to results. If the taxpayer in carrying on a trade or business performs research on behalf of other persons but retains substantial rights in the research, the taxpayer shall take otherwise qualified expenses for that research into account for purposes of section 41 to the extent provided in § 1.41-4A(d)(3).

  • Treas. Reg. § 1.41-4A(d)(3) provides in general, if a taxpayer performing research for another person retains substantial rights in the research under the agreement providing for the research, the research is funded to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research. A taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. In general, the taxpayer shall reduce the amount paid or incurred by the taxpayer for the research that would constitute qualified research expenses of the taxpayer by the amount of funding determined.​

  • Treas. Reg. § 1.41-4A(d)(3)(ii) provides a pro rata allocation may apply if the taxpayer can establish to the satisfaction of the district director -

    • (A) The total amount of research expenses,

    • (B) That the total amount of research expenses exceed the funding, and

    • (C) That the otherwise qualified research expenses (that is, the expenses which would be qualified research expenses if there were no funding) exceed 65 percent of the funding, then the taxpayer may allocate the funding pro rata to nonqualified and otherwise qualified research expenses, rather than allocating it 100 percent to otherwise qualified research expenses (as provided in paragraph (d)(3)(i) of this section). In no event, however, shall less than 65 percent of the funding be applied against the otherwise qualified research expenses.

    • (iii)Project-by-project determination. The provisions of this paragraph (d)(3) shall be applied separately to each research project undertaken by the taxpayer.

​

Funded Research - Evaluation and Allocation Rules

Treas. Reg. § 1.41-4A(d)(5) states if at the time the taxpayer files its return for a taxable year, it is impossible to determine to what extent particular research performed by the taxpayer during that year may be funded, then the taxpayer shall treat the research as completely funded for purposes of completing that return. When the amount of funding is finally determined, the taxpayer should amend the return and any interim returns to reflect the proper amount of funding. As such, funding is generally determinable only in subsequent taxable year(s).

​

Treas. Reg. § 1.41-2(e)(4) provides if any contract research expense paid or incurred during any taxable year ("prepaid") is attributable to qualified research to be conducted after the close of such taxable year, the expense so attributable shall be treated for purposes of section 41(b)(1)(B) as paid or incurred during the period during which the qualified research is conducted.

​

Treas. Reg. § 1.41-4A(b(2) provides if contract research is performed partly within the United States and partly without, only 65% of the portion of the contract amount that is attributable to the research performed within the United States can qualify as contract research expense (even if 80% or more of the contract amount was for research performed in the United States). As such, the actual work regarding contracted research must be performed in the United States and its territories.

​​​

Rental or Lease Costs of Computers:

When qualified research expense for computer rental or leasing category was initially enacted, many companies during the 1980s and early 1990s incurred substantial computer and server costs to handle high volumes of data and storage capabilities, which was often cost prohibitive for all but the largest companies and universities.

​

As such, the computer rental expense category was included to enable more companies to utilize higher computing technologies and to avoid companies from being resource inhibited with R&D related to software development. Historically, computers of this magnitude and processing power were necessary to reduce software solutions’ time to market as well as the investment by the taxpayer. However, when this category was added, the owners (e.g. IBM) of these computers were then also able to provide access to several lessees and reduce their costs to the end users.

​

Today, access to cloud-computing servers through cloud service provider (e.g. "Amazon Web Services") is generally recognized as the modern equivalent, eligible as a qualified research expense.  Subject to the the requirements for qualified activities under Sec. 41(d)(1), the associated cloud server rental expenses may fall also within the classification of rental or lease costs of computers under Sec. 41(b)(2)(A)(iii), which provides that “any amount paid or incurred to another person for the right to use computers in the conduct of qualified research” may qualify for the R&D tax credit.

​

Modern technology leveraged by cloud server providers may fall within the requirements of Treas. Reg. § 1.41-2(b)(4), which requires the following:

• (1) the computer be owned and operated by someone other than the taxpayer;

• (2) the computer be located off the taxpayer’s premises; and

• (3) the taxpayer not be the computer’s primary user.

​

In general, when a taxpayer rents from a cloud service provider, the servers are owned and operated by a party other than the taxpayer, the servers are located off the taxpayer’s premises, and the taxpayer is not the primary user of the servers. As such, cloud server expenses utilized during qualified research may be included for the R&D tax credit.