User:Donahuepm/IRC Section 41 Research & Experimentation Tax Credit

Internal Revenue Code §41 known as the Research & Experimentation Tax Credit or the R&D Tax Credit is a general business tax credit for companies that are incurring R&D expenses in the United States. The R&D Tax Credit was originally introduced in the Economic Recovery Tax Act of 1981 sponsored by U.S. Representative Jack Kemp and U.S. Senator William Roth. Since the credit's original expiration date of December 31, 1985, the credit has expired eight times and has been extended thirteen times. The current extension is set to expire December 31, 2009.

Definition of Qualified Research and Experimentation
Congress intends the credit to reward companies for incurring expenses in the development of new and improved products and processes. The Tax Reform Act of 1986 established the original qualifying activities definition. Since then the definition has evolved to include a four-part-test that is refined by specific exclusions.

Four-Part-Test

 * Technological in Nature - I.R.C. §41(d)(1)(B)(i) – The final regulations establish that a research and development activity must fundamentally rely on the principles of physics, biology, chemistry, mathematics, and computer science. This test excludes activities related to the social sciences, psychology, arts, and humanities.
 * Level of Technological Uncertainty - I.R.C. §41(d)(1)(A) - Often referred to as "The Section 174 Test" by the IRS, this test requires the research and development activities have an associated level of uncertainty related to the development or improvement of a product. The required level of uncertainty exists if information available to the taxpayer does not establish a method for determining the ultimate design.
 * Process of Experimentation – I.R.C. §41(d)(1)(C) - A process of experimentation is the direct result of risk or uncertainty associated with a design.  This test requires that the company incorporates a process of theoretical and physical evaluation designed to evaluate one or more design alternatives.  The process should show progression from theoretical calculations and sketches, to renderings and prototypes that are physically evaluated.
 * Permitted Purpose – I.R.C. §41(d)(1)(B)(ii) - The final test requires that the goal of the activity is to improve the fit, form, or function of a product or process for a business component. The IRS defines a "business component" as any product, process, computer software, technique, formula, or invention.  This does not include development related to aesthetic changes or technology that does not build on the company’s knowledge base.

Exclusions

 * Research performed outside the United States, Puerto Rico, or any possession of the United States
 * Research and development that is funded by a third party
 * Research performed after commercial production begins
 * Adaptation of a product or process for a particular customer
 * Duplication of an existing product or process
 * Efficiency surveys
 * [[ISO] certification

Research & Experimentation Tax Credit Calculation
The Research and Experimentation Tax Credit hinges on the quantification of eligible expenses during one of three possible base periods. The three base period calculation methods are referred to as the Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.

Eligible Expenses
The eligible expenses or qualified research expenditures include four types of expenses. The quantification of each of these varies based on each companies' accounting methodologies.

Wages

 * 41(b)(2)(D)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.  Qualified Services consist of:


 * engaging in qualified research
 * directly supervising qualified research
 * supporting qualified research


 * "Engaging in qualified research" means the direct conduct of research and development. "Directly supervising qualified research" is the first-line supervision of qualified research.  This does not include the higher-level managers to whom the first-line supervisors report.  "Supporting qualified research" includes an employees time spent aiding the direct conduct of research and development.  This includes data recording, prototype building, and performing test/trials.


 * 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.

Supplies

 * I.R.C. §41(b)(2)(C) 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.

Contract Research

 * I.R.C. §41(b)(2)(B) and Treasury Regulation §1.41-2(e) requires a third party 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" is refined by I.R.C. §1.41-2(e)(3), which requires the taxpayer to have rights into the research results.  The contract research payments are included at 65% of the actual expense.

Basic Research Payments

 * I.R.C. §41(e)(2) qualifies 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.

Credit Calculation
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. Regarless 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
I.R.C. §41(c)(3)(A) 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 a acquisition or disposition.

Start-Up Credit Calculation
I.R.C. §41(c)(3)(B) establishes a fixed-base percentage calculation for companies that incorporated after December 31, 1983, or had fewer than 3 years with qualified research expenditures and revenue between January 1, 1984 and December 31, 1988. The fixed-base percentage is calculated according to the code as follows.


 * §41(c)(3)(B)(ii)(I) 3 percent for each of the taxpayer's 1st 5 taxable years beginning after December 31, 1993, for which the taxpayer has qualified research expenses,


 * §41(c)(3)(B)(ii)(II) in the case of the taxpayer's 6th such taxable year, 1/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 4th and 5th such taxable years is of the aggregate gross receipts of the taxpayer for such years,


 * §41(c)(3)(B)(ii)(III) in the case of the taxpayer's 7th such taxable year, 1/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th and 6th such taxable years is of the aggregate gross receipts of the taxpayer for such years,


 * §41(c)(3)(B)(ii)(IV) in the case of the taxpayer's 8th such taxable year, 1/2 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, and 7th such taxable years is of the aggregate gross receipts of the taxpayer for such years,


 * §41(c)(3)(B)(ii)(V) in the case of the taxpayer's 9th such taxable year, 2/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, and 8th such taxable years is of the aggregate gross receipts of the taxpayer for such years,


 * §41(c)(3)(B)(ii)(VI) in the case of the taxpayer's 10th such taxable year, 5/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, 8th, and 9th such taxable years is of the aggregate gross receipts of the taxpayer for such years, and


 * §41(c)(3)(B)(ii)(VII) for taxable years thereafter, the percentage which the aggregate qualified research expenses for any 5 taxable years selected by the taxpayer from among the 5th through the 10th such taxable years is of the aggregate gross receipts of the taxpayer for such selected years.

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 a 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.

Special Rules
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.

Consistency Rule
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
I.R.C. §280C(c)(3) 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.

Controlled Groups
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 for the I.R.C. §41 can be carried forward 20 years and may be carried back 1 year.

IRS Regulation
In April of 2007 the IRS designated the I.R.C. §41 Research and Experimentation Tax Credit a tier 1 issue. This designation places the R&D Tax Credit among the most scrutinized tax credits. The initial directive has led the IRS to standardize their audit process by developing a standard information document request and focusing on issues such as the consistency rule, estimated qualified research percentages for employees, and the level of documentation.

Legislation
The legislative intent for the R&D Tax Credit is to increase R&D spending in the United States. Currently separate bills are being proposed in the House of Representatives and the Senate. The House of Representatives bill, cosponsored by U.S. Representatives Kendrick Meek and Kevin Brady, H.R. 422 proposes to make the credit permanent and increase the Alternative Simplified Credit from 14% to 20%. Senators Max Baucus and Orrin Hatchare cosponsoring bill S. 1203. This bill proposes to make the credit permanent, increase the Alternative Simplified Credit from 14% to 20%, and terminate the other calculation methods.

Economic Effect of the Credit
The magnitude of the R&D Tax Credit's economic effects are debated by many economists but a majority of them agree the credit does increase R&D spending in the United States. While measuring the actual effect of the credit is difficult, a 2005 by Ernst & Young measured the amount of dollars returned to companies in the form of the R&D Tax Credit.


 * 17,700 corporations claimed $6.6 billion in R&D Tax Credits on their tax returns in 2005. Approximately 11,300 C corporations and 6,400 S corporations claimed the credit.


 * Corporations claiming the R&D Tax Credit in 2005 divided up by size are 29% had $1 million in assets or less, 25% with assets of $1-$5 million, 25% with assets of $5-$25 million, and 21% with assets of $25 million or more.


 * 14,953 corporations with less than $50 million in total assets claimed more than $891 million in Federal Research and Experimentation Tax Credits.


 * 71.2% of these corporations had a Standard Industrial Classification in some type of Manufacturing, the remaining 28.8% include Services, Information, and Agriculture.

Relevant Tax Court Cases

 * Research, Inc. v. United States, 95-1 USTC ¶ 50,407 (D. Minn. 1995)
 * Norwest v. Commissioner, 110 T.C. 454 (1998)
 * Fairchild Industries, Inc. v. United States, 71 F.3d 868, 872 (Fed. Cir. 1995)
 * Lockheed Martin Corp. v. United States, 87 A.F.T.R.2d, ¶ 2001-812 (Ct. Cl. 2001)
 * Norfolk Southern Corp. v. Commissioner, 104 T.C. 13 (1995)
 * Apple Computer, Inc. v. Commissioner, 98 T.C. 232 (1992)
 * Eustace v. Commissioner. T.C. Memo 2001-66, aff’d 312 F.3d 1254 (7th Cir. 2002)
 * Union Carbide Corporation v. Commissioner TC Memo 2009-50
 * McFerrin v. Commissioner Civil Action No.H-05-3730