In 1981, the U.S. economy was in a recession, and research-and-development jobs were declining throughout the country. In response, Congress passed the Economic Recovery Tax Act of 1981, which included the Research and Development Tax Credit Program (hereinafter “RTCP” or “RTC”), enacted into the IRC.  Congress intended the RTCP to be a temporary measure to encourage businesses, through tax incentives, to invest in research-and-development efforts in the United States. The aim was to increase the number of  research-and-development jobs across the country, stem the flow of such jobs to other countries, and ultimately stimulate economic growth.

As it turned out, the RTCP proved to be far from temporary; the program has successfully been extended over the past thirty-plus years with only one exception.
For those historically familiar with the RTCP, it should be duly recalled that only once since the RTCP’s inception—from July 1, 1995 through June 30, 1996—was there a one-year “gap” from when the RTCP expired and when it was reinstated without being retroactively applied. Most recently, on Dec. 18, 2015, the Protecting Americans from Tax Hikes Act of 2015 significantly enhanced the RTCP on a myriad of levels by making the RTCP a permanent provision within the IRC and considerably restructured the program to:

• allow eligible “small businesses” (i.e., $50 million or less in gross receipts) to claim the RTC against the Alternative Minimum Tax (hereinafter “AMT”) for tax years beginning after Dec. 31, 2015
• allow eligible “start-up companies” (i.e., those with less than $5 million in gross receipts and earning revenue for less than five years) to claim up to $250,000 of the RTC against the company’s federal payroll tax for tax years beginning after Dec. 31, 2015.

 While the RTCP serves as a highly advantageous tax incentive program for business entities of all sizes, ranging from start-up companies to Fortune 100 companies that conduct qualified research and development activities, it is imperative that the RTC be methodically documented on a contemporaneous basis from both a qualitative and quantitative perspective. This is to ensure a sustainable tax return filing position should an IRS examination come to fruition. It is critical that the design and implementation of the methodology for the RTC analysis be in full compliance with all applicable statutory, administrative, and judicial interpretations. This article will serve as a practical guide to identifying, gathering, and documenting a sustainable RTC claim.

Identifying, Gathering, and Documenting Qualified Research Activities (QRAs)

In order to identify and qualify research and experimentation activities for purposes of the RTCP, the subsequent four criteria must be satisfied and documented on a contemporaneous basis as set forth pursuant to IRC section 41(d) and Treasury Regulations section 1.41-4:

Technological in Nature Requirement

The research must be technological in nature. As provided in Treasury Regulations section 1.41-4(a)(4), information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.

A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement. The regulations further provide that a taxpayer need not seek to obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering. Nor is the taxpayer required to succeed in developing a new or improved business component as set forth under Treasury Regulations section 1.41-4(a)(3)(ii).

Process of Experimentation Requirement
Substantially all (meaning 80% or greater) of the activities must constitute or be deemed to constitute elements of a process of experimentation for a qualified purpose pursuant to IRC section 41(d)(1)(3). As clarified in Treasury Regulations section 1.41-4(a)(5), a process of experimentation “is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving the result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.”

The so-called “core elements” of a process of experimentation require that the taxpayer
(either directly or through another party acting on its behalf):

• fundamentally rely on principles of the physical or biological sciences, engineering, or computer science;
• identify uncertainty concerning the development or improvement of a business component;
• identify one or more alternatives intended to eliminate that uncertainty; and
• identify and conduct a process for evaluating the alternatives.

The regulations provide that such a process might involve, for example, modeling, simulation, or a systematic trial and error methodology. The regulations under Treasury Regulations section 1.41-4(a)(5) further provide: “A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.”

Technical Uncertainty Requirement

Expenditures attributable to research activities must be eligible to be treated as research expenses under IRC section174. As described under Treasury Regulations section 1.174-2(a), expenditures are costs “incurred in connection with the taxpayer’s trade or business that represent research and development costs in the experimental or laboratory sense.” Pursuant to IRC section 174(c), expenditures generally include all costs incident to the development or improvement of a product, but not expenditures for the acquisition or improvement of land or depreciable property.

Permitted Purpose Requirement
A process of experimentation is conducted for a qualified purpose if the research relates to:

• a new or improved function;
• increased performance;
• enhanced reliability; or
• enhanced quality.

Pursuant to IIRC section 41(D)(3), research is not considered to be conducted for a “Qualified
Purpose” if it relates to style, taste, cosmetic, or seasonal deign factors commonly referred to as mere aesthetics.

The aforementioned requirements described above are applied separately to each business component. IRC section 41(d)(2)(c) provides that any plant, process, machinery, or technique for commercial production of a business shall be treated as a separate business component and not as part of the business component (e.g., inventory) being produced. In cases involving development of both a product and a manufacturing process improvement for that product, research activities relating to the product are not “qualified research” unless the requirements described above are met for the research activities to the product without taking into account the activities related to their development or the manufacturing process improvement as discussed under Treasury Regulations section 1.41-4(b).

Treasury Regulations section 1.41-4(a)(6) provides that if 80% or more of a taxpayer’s research activities with respect to a business component constitutes elements of a process of experimentation for a qualified purpose, the substantially all requirement is satisfied even if the remaining 20% or less of a taxpayer’s research activities with respect to that business component does not constitute elements of a process of experimentation for a qualified purpose. In no event, however, may activities be treated as “qualified research” if such activities do not fall within the scope of IRC section 174 or if such activities are specifically excluded under IRC section 41-(d)(4).

If the requirement of qualified research cannot be satisfied when applied first at the level of the product or process that is to be held for sale, lease, license, or used by the taxpayer in its own trade or business, then such requirements should be applied at the most significant subset of elements of the product or process. This “shrinking back” of the business component is continued until either a subset of elements of the business that satisfies the requirement of “qualified research” is reached, or the most basic element of the product is reached and the requirements of  “qualified research” are not met as set forth under Treasury Regulations section 1.41-4(b)(2). To that end, even though a taxpayer’s research activities, viewed in their entirety, for a new or improved product (e.g., military aircraft) may not satisfy the “substantially all” test or other requirements for “Qualified Research,” activities related to developing or improving a portion of the product (e.g., the flight actuation systems; actuators and servo-actuators; gyroscopes; among others) might still be eligible for the RTCP.

Statutorily Excluded Activities

IRC section 41(d)(4) specifically excludes the subsequent activities from being treated as “qualified research” and therefore are ineligible for the RTCP:

Research After Commercial Production

Activities conducted after the beginning of commercial production of a business component generally do not constitute qualified research if such activities are conducted after the component is developed to the point where it is ready for commercial sale or use. Even after a product meets the taxpayer’s basic functional requirements, however, activities relating to the manufacturing process still may constitute qualified research under Treasury Regulations section 1.41-4(c)(2).

Adaptation of Existing Business Component

Activities related to adapting an existing business component to a particular customer’s requirements are ineligible for the RTC. As set forth under Treasury Regulations section 1.41-4(c)(3), this exclusion does not apply, however, merely because a business component is intended for a specific client.

Duplication of Existing Business Component

As illustrated under Treasury Regulations section 1.41-4(c)(4), qualified research does not include activities relating to reproducing an existing business component (i.e., reverse engineering) from a physical examination of the component itself or from blueprints or detailed specifications drawings.

Surveys and Studies

Excluded from qualified research are activities in connection to:

• efficiency surveys;
• management functions or techniques;
• market research;
• routine data collections; and
• ·ordinary testing or inspections for quality control.

Foreign Research
Research conducted outside the United States or its possessions (e.g., the U.S. Virgin Islands, Puerto Rico, Guam, among others) may not be treated as qualified research.

Funded Research

To the extent research is funded by another person or government entity (i.e., by grant, contract, or otherwise), it may not be treated as qualified research. There are limited exceptions to this general rule in cases where overtures are incurred that are not funded. For example, let’s say an aerospace & defense company (hereinafter “A&D Company”) had a cost plus contract with a client, and this contract was funded up to $5 million to develop a flight actuation system. If the A&D Company incurred $6 million to develop the flight actuation system, then the $1 million overture could potentially be claimed as part of RTC, assuming the A&D Company had substantially all of the rights to the research (i.e., not needing to make a royalty payment to use that technology on a carry-forward basis to the company that originally funded the research) and had the economic risk of loss.

Identifying, Gathering and Documenting Qualified Research Expenditures (QREs)

Expenditures that qualify for the RTC generally include: (1) in-house research expenses for wages paid to employees for supervising, conducting and supporting qualified research and development services; (2) amounts paid for supplies that were consumed or destroyed in the performance of qualified research and development services; and (3) amounts paid for third-party contractors conducting qualified research and development services. The term “qualified research and development services” includes the services of employees who are actually engaged in qualified research and the services of employees who are engaged in direct support or the first level of research activities that constitute qualified research.

QRE Wages
Compensation for the performance of qualified research activities should include only compensation treated as wages for income tax withholding purposes. Therefore, in addition to regular wages, the allocation of compensation to research projects should include bonuses and the compensation element recognized on the exercise of nonqualified stock options, but should not include payments to qualified pension and profit sharing plans, including employee IRC section 401(k) contributions and nontaxable fringe benefits. Practically speaking, you should be including each employee’s wages as documented on Form W-2, Box 1, and then properly multiplying it by a “Direct Qualifying Labor Wage Percentage.” This direct qualifying labor wage percentage for each person should be calculated as a numerator that is directly linked to qualifying research and development projects by hour and a fixed denominator of 2,080 hours, which can be further reduced for paid holidays and vacation or sick time. It is imperative to ensure proper and clear nexus between QRAs and QREs at this stage so that an IRS agent is able to understand the nexus between qualified research activities by hour (i.e., on a project basis) to person (i.e., supervising, conducting, and supporting the research and development efforts) to qualified research expenditures being claimed (i.e., wages, supplies, and contract research).

It should also be duly noted that under a special safe-harbor rule, if at least 80% of the services performed by an employee during the taxable year constitutes “qualified services”, then all 100% of services performed by the employee during the taxable year may be treated as “qualified services.” In all cases, each employee and title or rank within the company should also be documented so that an IRS agent can determine whether that employee was supervising the research (e.g., a pharmaceutical product development practice leader for a life sciences company), conducting the research (e.g., a biochemist researcher for a life sciences company), or supporting the research (e.g., a lab technician supporting qualified experimentation for a life sciences company). Note, however, that an employee’s titles are not inclusive indicators in determining whether the activities performed by that employee qualify for the RTC. Always remember the substance-over-form doctrine when making these determinations as it is a strictly facts-and-circumstances test on a company-by-company basis.

QRE Supplies
In general, QRE supply costs can be claimed if the supplies are consumed or destroyed in the research and development process. The term “supplies” is broadly defined to include any tangible property other than land, improvements to land, and depreciable property. Expenditures for supplies that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses. For example, amounts paid for electricity used for general laboratory lighting are treated as general and administrative expenses, although amounts paid for electricity used in operating high-energy equipment for qualified research (e.g., a laser for nuclear research) may be treated as expenditures for supplies in the conduct of qualified research as illustrated under Treasury Regulations section 1.41-2(b)(2)(ii).

It is critical to bifurcate and extrapolate out from the RTC any supply costs utilized in “production trials” as opposed to “experimental batch trials” as the costs must be consumed or destroyed in the research and development process. In certain circumstances, a company may attempt to salvage select supply costs in a failed experimental batch trial (i.e., recapture and refine precious metals from a failed experiment). Only the cost of refinement may be potentially included if the salvaged supply costs are placed back into inventory for a future production or experimental batch trial. In the event—from a process engineering perspective—that the refinement costs can’t be accurately compiled, then the company must forgo the supply costs—including the refinement phase, because it can’t be properly substantiated.

QRE Contract Research

The amount of third-party contractor costs eligible for the RTC is computed at up to 65%—or 75% in cases for payments to select research consortia or universities—of amounts paid to persons other than employees for services that, if performed by an employee, would constitute qualified services under IRC section 41(b)(3) and Treasury Regulations section 1.41-2(e)(1). Contract research performed on behalf of a taxpayer is also qualified research only if it is incurred pursuant to an agreement (i.e., either oral or written), is entered into prior to the performance of the research, and requires the taxpayer to bear the expenses even if the research is not successful. Any payment made by the taxpayer to a third party that is contingent upon the success of the research is considered paid for the product or result, not the performance of the research. Thus, it may not be treated as qualified research expenses under Treasury Regulations section 1.41-2(e)(2).

Gathering Contemporaneous Documentation to Properly Support a RTC Claim

As set forth pursuant to Treasury Regulations section 1.41-4(d), taxpayers must retain records in sufficiently usable form (i.e., in an IRS audit-ready format per the IRS Audit Technique Guidelines for RTC claims, which are bifurcated for many leading industries, including pharmaceuticals, A&D, and computer science, among others). They must also provide details to substantiate claimed QREs (i.e., wages, supplies, and contract research) and QRAs (i.e., at the project level). To that effect, it is critical that sufficient contemporaneous documentation be identified, gathered, properly compiled, and retained to ensure that the IRS does not disallow the merits of the RTC claim should an examination come to fruition.

If a company is government regulated, such as with life science companies (e.g., pharmaceuticals, biotechnology, and medical devices), then the FDA recordkeeping requirements can be leveraged to support research activities. Similarly, as with A&D companies, the FAA and DCAA recordkeeping requirements can also be leveraged to support the research and development activities. In cases where companies apply for a patent or have a patent granted, then these forms of contemporaneous documentation serve as the strongest forms of documentation for qualified research activity due to the inherently arduous process of applying for a patent.

From an overall “Tax Controversy Best Practices” perspective, the subsequent forms of contemporaneous documentation illustrate key documents that the IRS typically requests during the course of an examination—including, but not limited to:

• complete project lists identifying the full scope of R&D-based projects versus the actual claimed R&D projects after conducting systematic project-based qualitative interviews;
• patents or patent applications;
• annual R&D or technology plans;
• research project authorization requests;
• internal and external correspondence on R&D;
• design requirements or functional specifications;
• testing scripts or testing logs;
• modifications reports or error logs;
• technical reports or plans;
• laboratory notebooks; or
• ingredient consumption/usage worksheets.

I highly recommend that the more contemporaneous documentation from the aforementioned list that can be obtained, the more that should be obtained and meticulously compiled in an IRS-audit ready format. It will incontestably assist in strengthening the merits of the RTC claim and overall RTC filing position Always strive for at least a “more likely than not” or higher tax return filing position, but never file a claim unless you can get at least to a “substantial authority” tax return filing position as required under Circular 230.

From a risk mitigation perspective, in order to optimally mitigate or avoid paid income tax return preparer penalties pursuant to IRC section 6694 (i.e., penalties that are assessed on both paid tax return preparers and tax advisers that are deemed paid tax return preparers due to their consulting on matters that constitute a substantial portion of their client’s tax returns, even if they were not engaged to prepare nor review the tax return), a “more likely than not” standard should be satisfied. The subsequent standards of the applicable levels of opinions should be scrupulously analyzed when assessing a RTC tax return filing position:

• “Will” Standard: generally, a 95% or greater probability of success if challenged by the IRS. A “will” opinion generally represents the highest level of assurance that can be provided by an opinion
• “Should” Standard: generally, a 70% or greater probability of success if challenged by the IRS. A “should” opinion provides a lower level of assurance than is provided by a “will” opinion, but a higher level of assurance than is provided by a “more likely than not” opinion
• “More Likely Than Not” Standard: a greater than 50% probability of success if challenged by the IRS. This standard is the highest level of accuracy required for purposes of avoiding the accuracy related penalties under IRC section 6662A
• “Substantial Authority” Standard: typically, greater than a “realistic possibility of success” standard and lower than “more likely than not” standard (i.e., 40% probability of success)
• “Realistic Possibility of Success” Standard: approximately a one-in-three or greater possibility of success if challenged by the IRS
• “Reasonable Basis” Standard: significantly higher than the “not frivolous” standard (i.e., not deliberately improper) and lower than the “realistic possibility of success” standard, must be reasonable based on at least one tax authority that can be cited as valid legal authority
• “Not Frivolous” Standard: approximately a 10% chance of being upheld upon examination by the IRS and accordingly under no circumstance should a tax professional ever render services with this level of comfort
• “Frivolous” Standard: approximately a percentage less than a 10% chance of being upheld upon examination by the IRS and accordingly under no circumstances should a tax professional ever render services with this level of comfort

It should be duly noted that each of the aforementioned standards above has a relevant meaning to both the taxpayers and tax professionals when evaluating a tax position and the related disclosure requirements. The percentages listed for “more likely than not” and “realistic possibility of success” are specifically provided for and discussed in the Treasury Regulations. In contrast, the percentages for “substantial authority,” “reasonable basis,” “not frivolous,” and “frivolous” have been developed based upon their relative importance in the hierarchy of standards of opinion as primarily provided for in congressional committee reports. Moreover, while not mathematically calculable, the percentages are still practical in demonstrating the relative strength of one level as opposed to another level.

Conclusion
When identifying, gathering, and documenting a RTC claim—both from a qualitative and quantitative perspective—be sure to adhere to all applicable statutory, administrative, and judicial interpretations. Consult a true subject matter expert in this area of the tax law with the depth and breadth of industry focus to ensure both a sustainable tax return filing position per Circular 230 and a sustainable financial statement reporting position per ASC 740 and FIN 48.