Overview of the Research Tax Credit

The research tax credit is often thought of as one tax credit. It is actually four distinct tax credits.1 These tax credits include the regular research tax credit,2 alternative simplified tax credit (ASC),3 basic research tax credit,4 and energy research tax credit.5 For tax years beginning after June 30, 1996, and ending before December 31, 2008, the research tax credit also included an alternative incremental research tax credit (AIRC). The AIRC provided taxpayers with a simplified method for computing the research tax credit. Taxpayers could elect to take an AIRC instead of a regular research tax credit. Congress repealed the AIRC in 2008 and essentially replaced it with the ASC. The taxpayer can qualify for either of the first two tax credits (i.e., the regular research tax credit and ASC) and the last two credits in any one tax year. As depicted in Figure 2.01, the regular research tax credit and the ASC/AIRC make up a majority of research spending.6 The basic research and energy research tax credits make up a very small portion of research spending. They are for research payments made to certain nonprofit entities. This book only addresses the basic research and energy research tax credits in passing. This book focuses on the regular research tax credit and, where noted, the ASC and AIRC. Unless otherwise noted, the term research tax credit is used to describe the regular research tax credit. Figure 2.01

1 2 3 4 5 6

See Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-343, 122 Stat. 3765 (2008). I.R.C. 41(a)(1). I.R.C. 41(c)(4)(A). I.R.C. 41(a)(2), (e). I.R.C. 41(a)(3).

See SOI Tax Stats - Corporation Research Credit, Table 1, Corporations Claiming a Credit, by Industrial Sector, available at http://www.irs.gov/taxstats/article/0,,id=164402,00.html (last updated May 13, 2011). For example, in tax year 2008, taxpayers claimed $102,336,652,000 for wage QREs for the regular research tax credit, ASC, and AIRC. During this same time, taxpayers only claimed $320,712,000 in basic research tax payments and $165,009,000 in payments to energy consortia. Id.

Typical Taxpayer Profile One way to understand the research tax credit is to consider who typically benefits from the credit. IRS statistics show that the research tax credit primarily benefits manufacturers, technical consultants, and companies with in-house research projects. Manufacturers Manufacturers are the largest group of taxpayers who file research tax credits.7 Nearly 42 percent of all taxpayers who claimed research tax credits in 2008 were manufacturers.8 IRS statistics also show that manufacturers in the following sectors filed the most research tax credits: Computer and electronics; Chemicals; Machinery; Miscellaneous manufacturing; Electrical equipment, appliances, and components; Fabricated metal products; Transportation equipment; Plastics and rubber; Food; Primary metals; Nonmetallic mineral products; Furniture and related products; Paper; Apparel; Petroleum and coal products; Printing and related support activities; Textile mills and textile products; Beverage and tobacco products; Wood products; and Leather and allied products.9
7 8 9

Id. Id. Id.

Of these manufacturing sectors, manufacturers in the first three sectors made up approximately half of all claimants.10 While it is not reflected in IRS statistics, manufacturers within these sectors can also be categorized by the scale of their manufacturing activities. This refers to whether they manufacture highend products, mass-produced products, or low-end products. Figure 2.02 High End Products
Quantity per project Projects per year

Mass Produced Products Many Few

Low End Products Few Many

Few Few

Manufacturers who make high-end products tend to work on a small number of projects in any one year. They make custom-designed products that are to be sold individually or in small quantities. The products require highly innovative research. The research is tailored to very specific uses, applications, or features of the product. The bulk of the research involves designing concepts as well as developing and testing prototypes to achieve certain specifications or results. Taxpayers who design and develop new equipmentsuch as aircraft or missile systems, specialized computer systems, or heavy machineryare examples of this type of manufacturer. Manufacturers who make products that are to be mass-produced also qualify for the research tax credit. As with manufactures that make high-end products, manufacturers who make massproduced products tend to work on a small number of projects in any one year. The difference between the two types of manufacturers is that, with the latter, their projects involve making products that are sold in large quantities. For these manufacturers, the bulk of the research activities focus on making sure the design of the end product is technically correct and functions as intended before considerable resources are expended to mass produce the products. The research also focuses on designing and developing the means of production to produce large quantities of quality products. The goal of the research is often to ensure that the product design and manufacturing process are complete, so that the manufacturer only has to add supplies and monitor the process to ensure that the products are being manufactured properly. A manufacturer who designs new car engine parts is an example of this type of manufacturer. Manufacturers who make low-end products also qualify for the research tax credit. Low-end products are sold individually or in small quantities. Manufacturers who make low-end products often work on hundreds or even thousands of projects every year. For these manufacturers, the research often involves designing and manufacturing custom parts for individual applications. The custom parts can be made for a single client or, if the product warrants, it can be marketed to a group of existing or prospective clients. The nature of research is usually less scientifically technical
10

Id.

and more mechanically technical. It can include building and destroying prototypes and live testing. A local machine shop and tool and die company that manufactures and fabricates parts is an example of this type of manufacturer. Technical Consultants Technical consultants are the second group of taxpayers who file research tax credits.11 They account for 31 percent of research tax credits filed in 2008.12 Technical consultants provide specialized expertise to third parties. This often consists of designing products or processes, or solving particular problems. Technical consultants can design and develop just about any type of product or property, such as innovative equipment, structures, or computer software. Technical consultants can also provide services that result in intangible assets, such as trade secrets and knowhow. In other cases, technical consultants are hired to produce a specific result.13 These taxpayers typically have an educated staff with specialized training or licensing.14 Engineering, computer software design, architectural, and environmental consulting firms are examples. Companies with In-house Projects Companies who undertake one-off projects to be used in their own businesses can also qualify for the research tax credit. The work can be completed in-house or by outside consultants. For these companies, the research activities relate to efforts to design new computer applications, facilities, or other capital-intensive projects. Financial companies, who filed nearly two percent of all claims in 2008,15 that design new computer software to be used in-house are an example. Manufacturers who redesign their manufacturing or assembly plants or equipment are another example. REQUIREMENTS: QUALIFIED RESEARCH AND EXPENSES Another way to understand the research tax credit is to consider the requirements to qualify for the credit. The research tax credit is set out in one section in the Internal Revenue Code (I.R.C. or Code). The research tax credit is determined by examining all of the taxpayers activities and expenses and whittling them down to just qualified activities and expenses. This limits the research tax credit to those few research activities and expenses for which Congress intended to have the credit reward.

11 12 13

Id. Id.

I.R.C. 41(d)(2)(B) defines a business component as any product, process, computer software, technique, formula, or invention.
14 However, industry licenses are not required. See, e.g., Kraatz & Craig Surveying, Inc. v. Comm r, 134 T.C. 8 (2010) (concluding that land surveying firms services were services in the field of engineering, even though the surveying firm, and its employees performing the services, were not licensed engineers).

See SOI Tax Stats - Corporation Research Credit, Table 1. Corporations Claiming a Credit, by Industrial Sector, available at http://www.irs.gov/ taxstats/article/0,,id=164402,00.html (last visited May 13, 2011).

15

Qualified Research Activities To understand what constitutes qualified research, one must understand what constitutes research. One would think that the term research would be defined in the Code or regulations. It is not. Indeed, prior attempts to come up with a definition have generated quite a bit of controversy.16 When the Code does not define a term, the plain-meaning rule says that one can use the plain meaning to understand the definition of a term.17 This is a fancy way of saying that one should apply the best fitting definition found in the dictionary. One dictionary defines research as the critical and exhaustive investigation or experimentation having for its aim the discovery of new facts and their correct interpretation, the revision of accepted conclusions, theories or laws in the light of newly discovered facts, or the practical applications of such new or revised conclusions, theories or laws.18 This is a fitting definition for the research tax credit. It highlights that research is an activity initiated and, for the most part, carried out by people. It also highlights that research involves discovering something new. The research tax credit incorporates these principles. Research is based on the activities of individuals to discover new products or processes. The term can have a more specific meaning to researchers, such as scientists and engineers. Scientists and engineers define research in terms of basic and non-basic research. The distinction between the two does not describe the technical level of the underlying research; rather, it describes the underlying motive for performing the research. Basic research is research that does not have a commercial objective; non-basic research has a commercial objective.19 Theoretical research performed by nonprofit organizations and universities is an example of basic research. Research to design and develop a specific product for a customer is an example of non-basic research. The research tax credit follows this basic versus non-basic framework by providing for two separate tax credits: the basic research tax credit and the regular research tax credit. The regular research tax credit, which is the tax credit addressed in this book, rewards taxpayers for performing research that has a commercial objective.20 Thus, the term research can be defined as a systematic undertaking to gain knowledge or understanding, that is initiated or carried out by people, and that has a commercial objective. With this understanding of what can count as research, we can now consider what constitutes qualified research for purposes of the research tax credit. The term qualified research is

16

See Mark L. McConaghy & Richard B. Ruge, Congressional Intent, Long-standing Authorities Support Broad Reading of Section 174, 58 TAX NOTES 639 (Feb. 1, 1993); David S. Hudson, The Tax Concept of Research or Experimentation, 45 TAX LAWYER 85 (1991). See, e.g., Yellow Freight Sys., Inc. v. United States, 24 Cl. Ct. 804 (1991); CBS, Inc. v. Prime Time 24 Joint Venture, 245 F.3d 1217, 1223 (11th Cir. 2001).
18 19 20 17

Yellow Freight Sys., Inc., 24 Cl. Ct. at 807 (citing WEBSTERS THIRD NEW INTERNATIONAL DICTIONARY (1976)). I.R.C. 41(e)(7)(A).

Basic research generally does not qualify for the regular research tax credit. There is a limited exception to this rule. The payment for some basic research can qualify corporate taxpayers for the basic research tax credit. These expenses are treated as contract research expenses for purposes of the regular research tax credit pursuant to I.R.C. 41(e).

defined in the Code. The Code defines the term using a four-part test.21 The four parts of the test are as follows: The expenses are research and experimental expenditures and they can be expensed under I.R.C. 174; The research is for the purpose of discovering technological information; The research is useful in the development of a new or improved business component; and The research involves elements of a process of experimentation. These rules may sound cryptic. They are. They have generated quite a bit of controversy between taxpayers and the Service. Even the courts and Congress have had difficulty with these rules. These rules are further explained in 9.01 of this book. For now, suffice it to say that the fourpart test limits the research tax credit to research activities in the hard sciences that are carried out scientifically. This means that the research involves formulating and testing hypotheses that result in the development of products, manufacturing processes, or achieving certain results. Before we move on, the following are a few examples of qualified research from some of the court cases, regulations, and administrative rulings: A car parts manufacturer designing molds to be used to produce car parts; A tire manufacturer designs a new belt to use in its manufacturing process to produce a tire that retains more heat in the manufacturing process; A valve manufacturer acquiring and modifying equipment to meet its manufacturing specific needs; A shipbuilder designing a new type or class of ships; A postal delivery company designing computer software that is capable of processing data given an extremely large number of transactions; A cabinet manufacturer designing new cabinetry; A defense contractor designing a new missile system; A defense contractor designing a new airplane and flight simulator; A bank designing a new computer software program; A food manufacturer designing a new shredding blade to add to its production line to be able to produce a modified version of an existing food product; A food manufacturer designing a new food product; A shoe manufacturer designing a new athletic shoe; A chemical manufacturer designing a process to treat plant equipment to produce chemicals more efficiently; A scientist who designed a rapid modeling to fabricate plastic objects directly from instructions provided by a computer-aided design system;
21

I.R.C. 41(d)(1).

 A mineral producer improving an existing drilling method and perfecting a new hydraulic mining method; A mining company designing prototype mining equipment and perfecting a new metallurgical process.

In addition to the four-part test, a number of rules exclude various activities or projects. These rules exclude the following research: For taste, cosmetic, or seasonal design factors; Performed after the start of commercial production; For adapting an existing business component; For existing products; Involving various surveys or studies; To develop some types of internal-use computer software; Performed outside of the U.S., Puerto Rico, or other U.S. possessions; In the social sciences, arts, or humanities (including literary, historical and similar projects); and Considered to be funded by another party. Expenses associated with these excluded activities or projects are not qualified research and, therefore, expenses associated with the activities or projects cannot be QREs. Qualified Research Expenses (QRE) QREs include certain expenses for qualified research. Several types of expenses can qualify as QREs.22 These expenses include amounts paid: To self-employed taxpayers and paid to the taxpayers employees as wages (wage expenses); For supplies used in the research (supply expenses); To rent computers to carry out the research (computer rental expenses); and To third-party contractors to carry out research on behalf of the taxpayer (contract expenses).23 As with qualified research activities, there are a number of rules that exclude specific types of expenses. The following excluded expenses are those for: Expenses to acquire or improve depreciable property or land; Ore or mineral exploration (including oil and gas) expenses; and Unreasonable expenses.

Section 41 defines wage, supply, and computer rental costs as in-house research expenses and contract expenses as contract research expenses. I.R.C. 41(b)(1).
22 23

See I.R.C. 41(b)(1).

Expenses that fit within these rules do not qualify as QREs. These expenses cannot be used to compute the taxpayers research tax credit. The expenses that survive after applying these rules are used to compute the taxpayers research tax credit. Figure 2.03

THE COMPUTATION Another way to understand the research tax credit is to consider how the credit is computed. The computation is deceptively simple. It is based on two inputs: the taxpayers QREs and gross receipts. These two inputs are tallied at two different points in time, namely, the current year and the base period tax years. By comparing these two inputs at different times, the computation focuses on the increase in the taxpayers QREs during the time between the current and base period tax years. The base period tax years are usually 1984 through 1988. Later years are used if the taxpayers business did not exist or if it did not engage in research during these years. The computation also factors in the taxpayers gross receipts for the four tax years immediately preceding the current tax year and the base period tax years. Gross receipts were added to the computation in response to concerns that continually spending more each year to qualify for the credit discourages taxpayers from factoring the credit into their research spending plans.24 Congress thought this would undermine the very purpose of the credit.25

24

TECHNOLOGY ASSESSMENT REPORT TO CONGRESS: THE EFFECTIVENESS OF RESEARCH AND EXPERIMENTATION TAX CREDITS, 12 (Sept. 1995), available at http://www.fas.org/ota/reports/9558.pdf (last visited May 13, 2011).
25

Id.

Other computation rules limit the amount of the credit. For example, the credit is limited to 50 percent of the taxpayers current year QREs.26 Taxpayers are to use the smaller of (1) the regular computation or (2) the taxpayers current year QREs multiplied by 50 percent. The product is multiplied by 20 percent to determine the amount of the taxpayers research tax credit. Thus, the computation is expressed by the following formula:

Note: the base period QREs divided by the base period gross receipts depicted in the diagram above is referred to in the Code as the fixed-base percentage. The diagram uses the elements that make up the fixed-base percentage in lieu of simply inserting the term fixed-base percentage to help the reader understand the computation. Given this computation, the taxpayers research tax credit will be larger if it has (1) a higher amount of QREs in the current tax year versus a lower amount of QREs in the base period tax years and (2) a lower amount of average gross receipts in the four prior tax years versus a higher amount of gross receipts in the base period tax years. Additional computation rules can apply in special circumstances. For example, there are rules for (1) computing the research tax credit for companies that acquire or dispose of businesses,27 (2) allocating the research tax credit to members of corporate groups,28 and (3) determining how the research tax credit is computed when the taxpayer is taxed as a flow-through entity.29 Several additional rules can reduce or eliminate the taxpayers research tax credit. For example, the amount of the total business tax credits that a taxpayer can benefit from in any one tax year
26 27 28 29

I.R.C. 41(f)(5)(A). I.R.C. 41(f)(3). I.R.C. 41(f)(1),(5). I.R.C. 41(f)(2).

is limited30 and the amount of the research tax credit can be limited to the amount of the taxpayers federal income tax liability.31 Taxpayers who run into these limitations may be able to carry the research tax credit back one year and forward for 20 years to offset past or future tax liabilities, which also factors into how the research tax credit is computed.32 Research tax credits that are not taken during the carryback and carryforward tax years, because of the federal income tax liability limitation, can be deducted in the year after the last carryforward year expires.33 If the taxpayer dies or its business ceases to exist, unused research tax credits can be deducted in the year in which the death or cessation occurs.34 CONCLUSION There are several ways to examine the research tax credit. One is to consider who typically qualifies for the credit. These taxpayers include manufacturers, technical consultants, and companies with in-house research projects. Another way to understand the research tax credit is to under-stand the qualification rules. The research tax credit rewards taxpayers for engaging in research activities and incurring research expenses. Not all activities and expenses qualify. Only activities that satisfy the four-part test qualify. Only expenses that are QREs qualify. The expenses that survive after applying these rules, along with the taxpayers gross receipts, factor into the computation for the research tax credit. This computation for the research tax credit is a third way to examine the research tax credit.

30 31 32 33 34

I.R.C. 38(b). I.R.C. 41(g)(4), 38(c). I.R.C. 39(a). I.R.C. 196(a). I.R.C. 196(b).