Research Tax Credit: Basic Concepts Steve Pashley, CPA, LL.M.

Transcription

1 Research Tax Credit: Basic Concepts Steve Pashley, CPA, LL.M. Senior Manager, Credits and Incentives November 10, 2015

2 Topics covered 1. Learning objectives 2. The IRC section 41 research tax credit 3. What is the current status of the credit 4. Who claims the credit? 5. Calculating the credit 6. Qualified research activities 7. Shrink-back rule 8. What activities do not qualify? 2

3 Topics covered 9. Software development 10. Qualified research expenses 11. Wage issues 12. Supply issues 13. Contract research issues 14. Base period issues 15. Credit utilization rules 16. Recommended documentation practices 3

4 Learning objectives By the end of this course, you should have a solid understanding of the following: - Types of activities qualifying for the research tax credit - Types of taxpayers commonly benefiting from the credit - Three most common costs qualifying for the credit - Two methods for calculating the credit 4

5 The Sec. 41 Research Tax Credit 5

6 How does our government incentivize technological innovation? The federal research credit is one of two federal tax incentives associated with research and development. - Under IRC Sec. 174, taxpayers are allowed an unlimited deduction for qualified research spending (this has been around since 1954). - The IRC Sec. 41 credit is nonrefundable and limited to expenditures in excess of a base amount (first enacted in 1981). 6

7 Research tax credit: What is the status of the credit? The credit expired at the end of 2014, but has existed for the past 34 years Very likely to be extended again In July 2015, the Senate Finance Committee proposed increasing the credit and making changes that will make the credit more available to start-up companies and small businesses 7

8 Research tax credit: Who claims the credit? $10.8 billion in credits claimed annually Latest available data for tax year 2012 Wide range of taxpayers claim the credit Gross Receipts Number of Taxpayers Under $25,000 2,176 $25,000 - $1 million 1,774 $1 million - $10 million 4,155 $10 million - $100 million 4,416 Over $100 million 3,351 Total 15,872 (14,672 in 2011) 8

9 Research tax credit: Who claims the credit? Business sector Number of Taxpayers Agriculture, forestry, fishing 59 Mining 81 Utilities 67 Construction 240 Manufacturing 6,219 Wholesale and retail 1,071 Information 1,583 Finance & Insurance 304 Professional, scientific and technical services 5,280 Other 969 Total 15,873 9

10 Research tax credit: Who claims the credit? Manufacturing subsector Number of Taxpayers Food manufacturing 235 Textiles 51 Apparel manufacturing 27 Paper manufacturing 78 Chemical manufacturing 703 Plastics and rubber manufacturing 278 Metal product manufacturing 620 Machinery manufacturing 886 Computer and electronics mfg. 1,179 Electrical equipment/appliances 660 Other 1,502 Total 6,219 10

11 Calculation of the Research Tax Credit 11

12 Research Tax Credit: How much is the credit? Two ways to calculate the credit - Regular credit: 20% of increase in qualified research expenditures over a base amount Base amount is determined from historical research spending and gross receipts - Alternative simplified credit: Easier to determine but can lead to smaller credit 14% of current year R&D spending 50% of average R&D spending for prior 3 years 12

13 Research Tax Credit: Recent developments Alternative simplified method simplified! - Under prior law, the ASC method could only be claimed on an original tax return (including extensions) - In 2014, the IRS issued regulations allowing taxpayers to use the ASC method on amended returns This should open the door for taxpayers to claim research tax credits using the ASC method for all open tax years. 13

14 Qualified Research Activities 14

15 Research Tax Credit: What activities qualify? Generally, must meet all parts of a four-part test Part 1: Developing a new or improved product or process - Includes inventions, techniques, formulas, software (Sec. 174 regs) - Improvement must be related to function, performance, reliability or quality Part 2: Work has technological component - Work must be based on hard sciences Physical, biological, chemical, computer sciences Engineering 15

16 Research Tax Credit: What activities qualify? Part 3: Work intended to eliminate technical uncertainty - Capability, methodology or appropriateness of product design Part 4: Process of experimentation - Process designed to evaluate one or more alternatives - Evidence of process of experimentation? Patents, modeling, prototypes, designs of experiments, test results 16

17 Shrinking back rule ( (b)(2)) The research credit can be applied to a smaller piece of larger non-qualifying projects. Example: Motorcycle engine builder develops a new carburetor for the engine. If you view the motorcycle as the business component, the work on the carburetor may not be enough to qualify for the credit. If you shrink back to the view the carburetor as the business component, now the development work may qualify. 17

18 What activities do not qualify? Research after commercial production (What about iphone version 6, version 6S?) Adapting business component to a particular customer s need Reverse engineering a competitor s product Bug fixing 18

19 What activities do not qualify? Efficiency surveys Activities related to management function or technique Market research, testing, development Routine data collection Routine testing or inspection for quality control 19

20 What activities do not qualify? In general, computer software is considered an excluded activity, however, so many exceptions exist software development often qualifies, including: Research outside the U.S. Research in social sciences, arts and humanities. Research funded by another person (important!) Research related to cosmetic, style, taste or seasonal design factors. 20

21 Software development ( 41(d)(4)(E)) All computer software developed by (or for the benefit of) the taxpayer must meet the IRS four-part test. If the software is considered internal-use software, it must meet an additional three-part high threshold of innovation test. 21

22 High threshold of innovation test Software that is intended to result in a substantial reduction in cost, improvement in speed, or other improvement that is substantial and economically significant The software development that involves significant economic risk (Taxpayer commits substantial economic resources and there is substantial uncertainty that resources will be recovered in a reasonable time) Software not commercially available off the shelf without significant modifications 22

23 Internal-use software So what is internal-use software? - Prior to 2015, no clear definition - January 2015, new proposed regulations issued limiting internal-use software to: Financial management - Accounts payable and receivable, inventory management, budgeting Human resource management - Hiring, training, payroll, benefits Support services - Data processing, facility services, marketing, security services, government compliance services 23

24 Why is this a big deal? Many companies have developed software that would have been considered internal-use software under the old rules. Going forward, the new proposed regs will open the door for many more taxpayers to claim the credit - Banks - Insurance companies - Any company developing software to interact with customers 24

25 Caveat The one major downside of the new proposed regs is that they are prospective only; the new rules only apply to tax years ending on or after January 16, For any earlier years, taxpayers can choose to apply all of the internal-use software provisions contained in the 2001 final or 2001 proposed regulations. 25

26 Qualified Research Expenses 26

27 Research Tax Credit: What costs can be included? Most research credit claims are based on three categories of costs: 1. Employee wages 2. Supplies 3. Outside contract research 27

28 1. Employee wages 1. Employee wages Box 1 W-2 wages of: - Employees performing the research - Supervisors overseeing the research - Support personnel Includes guaranteed payments to partners If someone spends at least 80% of their time performing qualified research, you can include all of their wages for purposes of the credit 28

29 Research tax credit: What are wages for owners? Suder case (TC Memo ) illustrates some challenges with determining wages for the owner of the company: - An inventor started a business out of his garage selling telephone switching equipment, eventually growing the business to over $38 million in annual revenues. - IRS tried to argue the research was routine and not innovative enough to qualify for the credit. - The Court examined 12 projects and concluded that 11 out of 12 qualified for the research tax credit. - Executive compensation was only unfavorable aspect of the decision. Compare to Shami facts (highly compensated employees) 29

30 2. Supplies 2. Supplies Tangible property other than land or land improvements or depreciable property In very limited circumstances, can count extraordinary utilities as a supply cost Examples: Lab supplies, costs to design manufacturing molds Trinity case: Entire ship was prototype Union Carbide: Testing new processes to reduce toxic byproducts. Did not qualify because would have been used regardless of research motive. TG Missouri: Molds to make auto parts were eligible even if depreciable in hands of customer 30

31 3. Outside contract research 3. Outside contract research If you use outside service providers to provide research assistance, include 65% of amounts paid or incurred to the contractor. Percentage goes up to 75% for amounts paid to qualified research consortia. 31

32 Contract research issues When you hire someone else to perform research on your behalf many issues can arise: - Are you paying them for their best efforts regardless of outcome of research? - Will they get paid only upon delivery of satisfactory product? - Who owns the intellectual property? - Who insures the property? 32

33 Important contract research cases Geosyntec Consultants: Careful review of contract terms was key (contrast fixed price and cost plus with no cap). Lockheed Martin: Developed rocket launchers for U.S. government. Taxpayer could use research results without paying government. These were substantial rights. Fairchild: Developed new pilot training aircraft for U.S. government. The government only had to pay if it accepted work performed. 33

34 Other issues Base period may need to be adjusted for acquisitions/dispositions Consistency rule - Trinity benefited from this rule Pass-through treatment Statistical sampling State credits 34

35 Credit utilization rules Many taxpayers perform qualifying research only to discover they can t utilize the credits due to credit utilization rules: - Step 1: Determine regular tax liability - Step 2: Subtract $25,000 from regular tax liability and multiply result by 25% - Step 3: Determine tentative minimum tax liability - Step 4: Take the greater amount from Step 2 or 3 above - Step 5: Subtract amount from Step 4 from Step 1 amount This is research credit that can be utilized in current year Unused credits can be carried back 1 or forward 20 years 35

36 Documenting the credit Attempt to tie individuals wages to specific projects Collect relevant documentation supporting supplies expenses Review contracts to identify potential funded research issues Collect contemporaneous supporting documentation showing the research taking place 36

37 Questions & Answers

38 Steve Pashley, CPA, LL.M. Phone: Website: Elliott Davis Decosimo ranks among the top 30 CPA firms in the U.S. With sixteen offices across seven states, the firm provides clients across a wide range of industries with smart, customized solutions. Elliott Davis Decosimo is an independent firm associated with Moore Stephens International Limited, one of the world's largest CPA firm associations with resources in every major market around the globe. For more information, please visit elliottdavis.com. Elliott Davis Decosimo, LLC Elliott Davis Decosimo, PLLC