The Research and Development (R&D) credit has become an integral part of tax planning for businesses in the United States since its inception almost forty years ago. The credit was originally enacted to help spur competitiveness and creativity for the United States compared to other countries. Policymakers of the early 1980s feared that the United States was falling behind its world competitors and sought to create incentives for U.S. companies who invested money into technological innovation. The answer came with the Economic Recovery Tax Act of 1981 and was aimed at inspiring and pushing businesses to put money into technology and inventions to stay competitive in the world market. The credit, initially only being temporary, was extended 16 times before the Protecting Americans from Tax Hikes (PATH) Act made it permanent in 2015. 

The Tax Cuts and Jobs Act (TCJA) signed into law in 2017 was a major revision of the U.S. tax code overall and also impacted several existing areas of the credit. One of the most widely known changes under the TCJA is the lowered corporate and individual tax rates. The modified corporate tax rate increases the value of the R&D credit for both corporate and noncorporate taxpayers when claiming the reduced credit. The corporate tax rate was lowered from a highest rate 35% to a flat rate of 21%, increasing the net benefit from its previous amount of 65% to 79% under the new law. IRC Section 280C(c) was enacted to prevent a double benefit for research-related expenses to taxpayers. The provision requires that taxpayers either reduce their deduction for Sec. 174 allowable expenses by the amount of the Research Credit or elect a reduced credit that is equal to the Research Credit minus the product of the maximum corporate rate and the credit. Prior to the TCJA, taxpayers reduced the amount of the credit by 35% which allowed them a tax credit benefit of 65% of the credit determined under Sec. 41(a). However, with the lowered 21% corporate rate, that allows taxpayers a benefit that equates to 79% of the credit that is determined under Sec. 41(a).

There were several modifications to Sec. 174 under the newly enacted tax law. Prior to the TCJA, and through 2022, taxpayers can deduct research or experimental expenditures immediately in the current period under Sec. 174(a) or can treat the expenditures as deferred costs and amortize the costs over a period of not less than 60 months beginning in the month that benefits are first realized from the expenses under Sec. 174(b). For tax years beginning after December 31, 2021 these provisions will remain except for the option to deduct R&D expenses in the current period. The TCJA eliminates that option; and taxpayers will be required to record these expenses into a capital account and amortize them over five years. The amortization period begins with the midpoint of the year in which the qualified research expenditures are incurred or paid. This requirement is more favorable compared to the current Sec. 174(b) option that does not allow amortization to begin until the first month of the year in which the expenditures provide a benefit to the firm. In addition, qualifying research expenditures incurred outside the United States would be amortized over a period of 15 years, also beginning with the midpoint of the year in which the expenses are paid or incurred. These amendments to Sec. 174 deny an immediate deduction for the case of retired, abandoned, or disposed property that was specified as research expenditures. Instead of immediate deduction, the expenditures must continue to be amortized over the remaining time period.

Another benefit of the TCJA is the elimination of the corporate Alternative Minimum Tax (AMT) provisions. Generally, corporations were not able to use the R&D credit to offset their AMT, but only ordinary income tax liability. After the 2017 tax year, corporate taxpayers will be subject to a credit limitation under Sec. 38(c)(1), allowing the R&D credit to reduce tax liability down to 25% of the taxpayers net regular tax liability over $25,000. For individual taxpayers, the AMT exemption, as well as the phaseout amount, have increased for tax years beginning after Dec. 31, 2017, until 2026, which will undoubtedly allow individuals to utilize more of the R&D credit. Additionally, the new law limits the amount of Net Operating Losses (NOLs) allowable to be used to offset taxable income. NOLs are restricted to the lesser of 80% of taxable income or aggregate of these losses carried to the tax year plus the NOL carrybacks to the tax year. Due to the new 80% rule, more taxpayers may find the R&D credit helpful in offsetting their tax liability.

While the changes under the TCJA has been mostly taxpayer friendly, two recent court cases have not been as kind and should give CPA firms caution in claiming these credits alone absent a proper study and documentation. Siemer Milling Company v. Commissioner (T.C. Memo 2019-37) was decided in April by the United States Tax Court which held that the taxpayer did not properly substantiate their claim for the R&D Credit under section 41 and, thus, completely disallowed credits of $122,424 and $116,246 claimed for fiscal years ending May 31, 2011 and 2012, respectively. The R&D credit study was prepared by the taxpayer’s CPA firm who touted previous experience preparing credit studies for many years and for company’s operating in various industries. These studies were prepared by using a combination of interviews of Siemer Milling Company (Siemer) employees and documents provided by the taxpayer relating to the research and development expenditures.

Siemer is an Illinois-based company engaged in the business of milling and selling wheat flour. During the course of the two tax years in question, the company claimed to have engaged in seven projects that qualified for the R&D tax credit. The tax courts applied the section 41 research credit rules to each project separately. Under section 41, to qualify for the research credit, an activity or project must meet a four-part test; section 174 (permitted purpose) test, the technological information test, the business component test, and the process of experimentation test.

Per the IRS Audit Techniques Guide: Credit for Increasing Research Activities (i.e., Research Tax Credit) IRC § 41* - Qualified Research Activities

1. Section 174 (Permitted Purpose) Test—the expenditure must (1) be incurred in connection with the taxpayer’s trade or business, and (2) represent a research and development cost in the experimental or laboratory sense.
   
   Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
   
   
2. Technological Information Test—to satisfy the technological in nature requirement for qualified research, the process of experimentation used to discover information must fundamentally rely 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.
   
   
3. Business Component Test—taxpayer must intend to apply the information being discovered to develop a new or improved business component of the taxpayer.  A business component is any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer. 
   
   
4. Process of Experimentation Test—requires that qualified research be research “substantially all of the activities of which constitute elements of a process of experimentation.”

The final regulations articulate the core elements of a process of experimentation.  In addition to requiring that the research be undertaken for the purpose of discovering information that is technological in nature, the taxpayer must:

• Identify the uncertainty regarding the development or improvement of a business component that is the object of the taxpayer’s research activities;
• Identify one or more alternatives intended to eliminate that uncertainty; and
• Identify and conduct a process of evaluating the alternatives.

In its ruling, the courts held that the taxpayer failed to meet the four-part test in all seven projects. All seven projects failed on the process of experimentation test with the majority failing in additional tests as well. Essentially, at least three of the projects were simply denied due to inability of the taxpayer to identify and substantiate all the requirements under the process of experimentation test with proper documentation. In the Court’s finding, they note that according to the Commissioner the “record is devoid of evidence that petitioner formulated or tested hypothesis, or engaged in modeling, simulation, or systematic trial and error. Nor is there any evidence that petitioner evaluated alternatives.” Additionally, the Commissioner, with whom the Court agreed, did not find documentation of specific scientific principles necessary to meet the four-part test and thus rightfully claim the R&D credit.

Another recent case, United States v. Quebe, again dealt with the IRS disallowing and the courts agreeing that the taxpayer was not entitled to R&D credits claimed under the start-up company method. The key factors at hand in this case again circled around lack of proper documentation and an inappropriate method for developing the base period for qualified research expenses (QREs).

While these cases should not deter qualified companies from taking the credit, they do provide cautionary guidelines to conduct and document an R&D study. Essentially, the bottom line is that there needs to be detailed information developed and documented to quantify and qualify projects and employee activities towards the credit. There are now more than 30 court opinions directly addressing Section 41 R&D tax credits and it seems clear that the IRS is looking for more.

“These cases underscore just how extremely difficult it is to know all of the forms of documentation, testimony, and evidence that will be needed in an examination or review of an R&D Tax Credit claim for any particular industry, let alone all of the potential industries that you might encounter as a tax practitioner. They also show that you really need industry veterans who have experience with the unique circumstances particular to the taxpayer’s space along with tax controversy specialists who know the R&D Tax Credit laws and have represented taxpayers across a variety of industries,” said Darren Labrie, CPA, MST Principal at Corporate Tax Incentives (CTI), LLC, a national tax consulting firm specializing in helping businesses take full advantage of the tax credits and incentives.

Highly technical credit studies, such as those necessary to quantify research and development expenditures under the Sec. 41 four-part test, should have CPAs, as trusted advisors, strongly considering partnering with those proven experts in the fields. It not only protects CPAs, as well as their clients, but will most certainly help maximize the credits available to researchers and others seeking R&D credits.

Kaylei E. Russell is a Staff Accountant at Brock Schechter & Polakoff CPAs and Consultants in Buffalo, NY.