Introduction

Many real estate investors and business property owners are improving cash flow and finding immediate tax savings from their business properties through Cost Segregation Analysis (hereinafter “CSA”). CSA enables taxpayers to enjoy significant tax benefits from taking accelerated depreciation deductions for commercial and investment properties by reclassifying real property to personal property. CSA’s are supported by an abundance of judicial interpretations (i.e., well over two hundred court cases); and countless administrative authorities (i.e., including, but certainly not limited to, treasury regulations, revenue ruling and revenue procedures), that provide guidance on required methodologies to best ensure the analysis is rendered correctly and that the taxpayer’s tax return filing position (i.e., preferably at “More Likely Than Not” or higher) is sustainable under examination by the Internal Revenue Service (hereinafter the “Service”).

CSAs are an IRS-sanctioned technique (i.e., consult the IRS Cost Segregation Audit Techniques Guide located on the Service’s website at www.irs.sov) that enables business entity taxpayers (i.e., corporations and partnerships) to accelerate depreciation on their property, plant and equipment. Although the Service does not prescribe one specific methodology, the Service’s aforementioned Cost Segregation Audit Techniques Guide enumerates several methods and considers the detailed engineering approach from actual cost records as “the most methodical and accurate approach.” This approach consists of meticulously examining all contemporaneous documentation including both construction records and accounting records. Reasonable estimates or approximations are used to support the actual cost detail when the existing detail is not sufficient for the analysis. Noting, it is always prudent to have an engagement team comprised of individuals with specific and necessary fields of expertise (i.e., both accountants and engineers that are well trained in this area of the tax law) to ensure this analysis is properly rendered and that the tax benefits obtained in a CSA are sustainable under examination by the Service.

 A Historical Overview of CSA

The process of identifying assets within a business entity taxpayer’s property, plant and equipment on the taxpayer’s Balance Sheet for accelerating depreciation has been around in some form for literally decades. Courts have ruled in favor of this tax planning strategy since 1959 (i.e., consult Shainberg v. Commissioner). Whether it was referred to as an Investment Tax Credit (hereinafter “ITC”), component depreciation, or cost segregation, the primary objective has always been increased cash flow. The ITC and component depreciation were eliminated and replaced by MACRS under the historical Tax Reform Act of 1986. Cost segregation stemmed from taxpayers following MACRS without a methodology prescribed by the Service. Most tax professionals relied on methodologies similar to those used under the ITC.

In 1997, the U.S. Tax Court ruled in favor of the Hospital Corporation of America (i.e., HCA v. Commissioner), signifying a landmark judicial decision for cost segregation. The court ruled that I.R.C. § 1245 property is to be broadly construed in the same manner as I.R.C. § 38 property under the ITC, and that the “component depreciation” prohibition does not apply to I.R.C. § 1245 building components, but rather only to I.R.C. § 1250 building components. The Service acquiesced to HCA, holding that the ITC tests may be used to identify I.R.C. § 1245 property. Since then, dozens of court cases and revenue rulings have legitimized this tax planning strategy.

 Tax Aspects of a CSA

CSAs enable costs to be recovered over a shorter period of time and consequently business entity taxpayers can potentially enjoy substantial tax savings. In accordance with the Modified Accelerated Cost Recovery System (hereinafter “MACRS”), applicable judicial interpretations, and applicable administrative authority, a CSA can allocate total building costs between I.R.C. § 1250 real property (i.e., generally 27.5 to 39 year useful life property) and I.R.C. § 1250 personal property (i.e., generally 5 to 15 year useful life property). The reallocated personal property typically amounts to 15% to 35% of the tot.al construction costs. Depending on the type of property (i.e., personal property with a useful life of 5, 7 or 15 year property versus real property with a useful life of 39 years), this percentage can be higher. Additionally, business entity taxpayers may also find significant property tax savings (i.e., state and local real estate tax savings) from a CSA. The subsequent example illustrates the benefits of depreciation utilizing a CSA versus the traditional and conventional method:

Converting the Gain to Cash

In the aforementioned example, utilizing the CSA alternative would have reduced taxable income by $ 1,307,692 for a cash savings of $ 457,692 at a 35% tax rate. I f the building was placed into service in prior years, a taxpayer could amend prior-years tax returns for a refund, or could take an I.R.C. § 481(a) catch-up adjustment to reduce taxable income in the year of the CSA. For a new building being placed into service in the same year as a CSA, the cash savings utilizing the CSA methodology over straight-line deprecation would be $ 91,538 per year.

The Best Time to Render a CSA

The best time a CSA should be performed is in or near the year that the building and / or building improvement is placed in service. This allows for a thorough examination of contemporaneous documentation and maximizes the tax-deferred benefits from this analysis. Business entity taxpayers who failed to perform a CSA in prior years may still benefit from having a CSA conducted. Taxpayers may “catch-up” on the depreciation that should have been taken in previous years, known as an I.R.C. § 481 catch-up adjustment. The Service now allows I.R.C. § 481(a) adjustments to be claimed entirely in the first year; previous rulings required taxpayers to spread the catch-up adjustment over a four-year period. An investor can also improve the benefits of a CSA by beginning the analysis prior to breaking ground of the new building. Construction Tax Planning (hereinafter “CTP”) is potentially beneficial in three primary ways. Firstly, by tailoring the specificity of a contractor’s cost detail, improved results may be realized at a potentially reduced cost. Secondly, conversations with an architect and engineer may lead to better labeling of dedicated systems and improved auditability. Thirdly and finally, elements of a building that can be designed to qualify for accelerated deprecation can be identified before construction that ultimately will maximize potential areas of opportunity for accelerated depreciation.

Conclusion

A CSA is clearly an area of opportunity for many business entity taxpayers that have significant property,  plant and equipment on their Balance Sheets. As always, however, when engaged in rendering this highly technical and specialized tax service offering please consult applicable subject matter specialists (i.e., both accountants and engineers that are well trained in this area of the tax law) as needed and act in good faith in trying to ascertain your client’s tax return filing position (i.e., preferably at “More Likely Than Not” or  higher) as many of these claims are frequently audited by the Service.

About the Author

Mr. Peter J . Scalise, B.S., M.S.,

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished and long-standing member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP. Peter is a frequent keynote speaker for the AICPA, ABA, ASTP, NATP, TEI & AIA on specialty tax incentives and legislative updates from Capitol Hill.

Web link here: Tax Research Methodology

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By Peter J. Scalise, B.S., M.S.

In addition to the federal-level Research and Development Tax Credit pursuant to I.R.C. § 41, there are thirty three states that offer research tax incentives (i.e., whether in the form of a credit, deduction or grant) similar to the federal level research and development tax credit and these states generally follow the federal statutory, administrative and judicial interpretations on what constitutes qualified research expenses (QREs) with the notable exception of states such as Connecticut which lowers the threshold to utilize the Section 174 research and experimental expenditures definition for QREs.

It should be duly noted that state level research tax incentives can be much more lucrative than the federal tax credit because states often provide generous research tax incentives to encourage taxpayers to perform research and other business activities within their respective states. As a caveat, there are clearly distinctions in other state research and development incentive programs as well, such as California which generally follows the federal rules, but utilizes a different gross receipts calculation to include only sales of real, tangible, or intangible property held for sale to customers in the ordinary course of the taxpayer’s trade or business delivered or shipped to a purchaser within California, but does not include service-related receipts, rents or interest.

Furthermore, in addition to offering a research incentive, some states may allow an entity in a loss position (i.e., without a current tax liability in which to utilize the credit against) to immediately monetize their credit (i.e., “cash-in” the credit at a discounted selling price) with the state (e.g., Connecticut) or transfer it to a third party that may be able to utilize it (e.g., New Jersey), rather than carry it forward to a future year when a company has a tax liability to utilize it against.

The scope and application of our February Edition of The ETS SALT Tax Alert will showcase the State of Connecticut’s Research Tax Incentive Programs.

Incremental Research and Experimental Expenditures Credit

A corporation business tax credit is allowed for increases in incremental research and experimental expenditures (as defined in IRC §174) conducted in Connecticut.

The credit is equal to 20% of the amount by which research and experimental expenditures in Connecticut in the current income year exceed research and experimental expenditures in the preceding income year.

To capture the credit, Form CT-1120 RC, Research and Experimental Expenditures Credit, and CT-1120K, Business Tax Credit Summary, must be filed with the taxpayer’s return.

The credit may be carried forward for 15 years but may not be carried back. A qualified small business (i.e., an entity with gross income in the previous year that did not exceed $70 million and that has not met the gross income test through transactions with a related person) that cannot claim the credit because it has no tax liability (not including minimum tax or capital base tax) may carry forward the credit or it may obtain a refund of 65% of credit value (up to $1.5 million).

The Connecticut credit includes all costs incidental to the development or improvement of a product, including any pilot model, process, formula, invention, technique, patent, or similar property. However, overhead and other expenses, such as general and administrative expenses that do contribute directly to the research and development effort do not qualify. In addition, Connecticut allows companies without a current tax liability to monetize their credit at a discounted selling price.

There is no sunset date for this credit.

Non-Incremental Research and Development Expenditures Credit

A corporation business tax credit is allowed for research and development expenses incurred in Connecticut. “Research and development expenses” are expenses that may be deducted under IRC §174 (as in effect on May 28, 1993) and basic research payments as defined in IRC §41 if the expenditures are incurred for research and experimentation and basic research conducted in Connecticut and not funded (as provided in IRC §41(d)(4)(H)) as in effect on May 28, 1993) by any person or governmental entity other than the taxpayer or a person included on a combined return with the taxpayer.

The credit percentage is based, in part, on the amount of R&D expenses incurred:

• For taxpayers with expenses of $50 million or less, the credit is equal to 1% of expenditures;
• For taxpayers with more than $50 million but no more than $100 million, the credit is equal to $500,000 plus 2% of expenses over $50 million;
• Companies headquartered in an Enterprise Zone with 2,500 or more employees and revenues in excess of $3 billion may elect to compute the credit based on 3.5% of research and development expenses;
• The credit allowed to a qualified small business (i.e., a business with gross income in the previous year that did not exceed $100 million and that has not met the gross income test through transactions with a related person) is 6% of expenses;

Taxpayers that incur more than $200 million in R&D expenses in an income year must reduce credit amount by specified percentages if workforce reductions exceed a certain level.

The Connecticut credit includes all costs incidental to the development or improvement of a product, including any pilot model, process, formula, invention, technique, patent, or similar property. However, overhead and other expenses, such as general and administrative expenses that do contribute directly to the research and development effort do not qualify. In addition, Connecticut allows companies without a current tax liability to monetize their credit at a discounted selling price.

To capture the credit, Form CT-1120 RDC, Research and Development Credit, Form CT-1120K, Business Tax Credit Summary, and certain attachments must be filed with the taxpayer’s return.

This credit may be carried forward indefinitely but may not be carried back. Taxpayers that also claim the research and experimental expenditures credit or the credit for research and development grants to institutions of higher education cannot claim the credit for the same expenditures.

There is no sunset date for this credit.

Research and Development Credit for Grants to Institutions of Higher Education

A corporation business tax credit is allowed for the incremental increase in amounts spent by a taxpayer on grants to a Connecticut institution of higher learning for the purposes of research and development related to advancements in technology. “Research and development related to advancements in technology” means development of new products or new uses for existing products and improving methods for producing products. The term does not include testing or inspection for quality control purposes; efficiency surveys, management studies, consumer surveys, or other market research; advertising or promotional activities; or research in connection with literary, historical, or similar projects.

The credit is equal to 25% of the amount by which qualifying grants made in the current income year exceed the average qualifying grants made in the three immediately preceding income years. Total corporation business tax credits cannot exceed 70% of tax due prior to application of credits and cannot be applied against the minimum tax.

To capture the credit, Form CT-1120 GC, Tax Credit for Research and Development Grants to Institutions of Higher Education, and Form 1120-K, Business Tax Credit Summary, must be filed with the taxpayer’s return.

The credit may not be carried forward or back. Credits may only be claimed by the entity that earned the credit.

There is no sunset date for this credit.

About The Author

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished and long-standing member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP. Peter is a frequent keynote speaker for the AICPA, ABA, ASTP, NATP, TEI & AIA on specialty tax incentives and legislative updates from Capitol Hill.

ETS Disclaimer

The article is designed to provide authoritative information on the subject matter covered. However, it is distributed with the understanding that the publisher, editors, and authors are not engaged in rendering legal, accounting, or other related professional services for your client base. Consequently, it is your responsibility to exercise all of the necessary measures to ensure proper tax preparation and tax advisory services for your client base.

Circular 230 Disclaimer

In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

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The U.S. General Services Administration (GSA) has published a request for comment on which green building rating systems should be used by the federal government.

Every five years, the GSA is required to evaluate green building certifications for government use and offer recommendations to the U.S. Department of Energy (DOE). To date, the DOE has not chosen a certification standard.

The GSA is recommending a choice from three certification standards: Green Building Initiative’s Green Globes, the U.S. Green Building Council’s Leadership in Energy and Environmental Design, and the International Living Building Institute’s Living Building Challenge. The GSA will accept public comments until April 1.

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Yahya is an international tax planning advisor for a major oilfield services company and is responsible for rendering value-added services through the identification, evaluation, and recommendation of tax planning strategies, with the ultimate goal of reducing effective tax rates. He is also responsible for evaluating the impact and implications of new legislation on existing international tax treaties.
His experience and expertise adds strength to each department within Engineered Tax Services and with every Research & Development Tax Credit, Repair & Maintenance evaluation and Premium Cost Segregation study issued by Engineered Tax Services.

“It is an absolute pleasure to on-board Yahya Basheer to our highly prestigious Advisory Board and we look forward to his thought leadership and excellence in client service” says Peter J. Scalise, National Partner-in-Charge and Federal Tax Practice Leader for Engineered Tax Services.

Engineered Tax Services (ETS) is the only qualified professional engineering firm that has its own licensed engineers, including LEED Accredited Professionals, as well as tax experts, from CPAs to a former senior IRS executive, on staff. We marry the science of engineering with the principles of tax and accounting to arrive at financial solutions that result in increased cash flow, minimized tax payments and maximum return on investment and energy. These IRS-sanctioned services include Energy Tax Credits, Energy Policy Act Certifications (179D Studies), Cost Segregation Studies, Research and Development Studies, Repair and Maintenance Studies,  Historic Tax Credits Studies, Engineering Insurance Appraisals, Energy and Carbon Audits. Our attention to detail is second to none.

Introduction

The Research and Experimentation Tax Credit (hereinafter “RTC”) was added to the Internal Revenue Code (hereinafter “the Code”) in 1981 as a temporary provision at a time when research and development based jobs were significantly declining in the United States due to these jobs being moved overseas where labor rates and overall operating costs were considerably less. For this very reason, the RTC was introduced into the Code to motivate business entity taxpayers to incur qualifying research and development expenditures with the high expectations that such an advantageous tax incentive would facilitate in stimulating job growth and investment in the United States and prevent further jobs from going overseas.

Although passed into law in 1981 as a temporary provision within the Code, the RTC has successfully been extended over the past thirty two years with only one exception. For those historically familiar with the RTC, it should be duly recalled that only once from July 1, 1995 through June 30, 1996 was there a “gap” from when the RTC expired and when it was reinstated without being retroactively applied since the RTC’s inception. The RTC was recently extended for a two year period through The American Taxpayer Relief Act of 2012 resulting in the RTC being retroactively reinstated to cover calendar year 2012 and prospectively extended to cover calendar year 2013.

While the RTC serves as a highly valuable tax incentive for business entities conducting qualified research activities it is imperative that the RTC be methodically documented from both a qualitative and quantitative perspective to ensure a sustainable result on Internal Revenue Service (hereinafter “the Service”) examination. It is critical that the design, implementation and execution 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 Qualified Research Activities (QRAs)

In order to identify and qualify research and experimentation activities for purposes of the RTC the subsequent four criteria must be satisfied and documented on a contemporaneous basis as set forth pursuant to I.R.C. § 41(d) and Treas. Reg. § 1.41-4:

Technological in Nature Requirement

The research must be undertaken for the purposes of discovering information that is technological in nature. As provided in Treas. Reg. § 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 exceed, 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 Treas. Reg. § 1.41-4(a)(3)(ii).

Process of Experimentation Requirement

Substantially all (i.e., 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 I.R.C. § 41(d)(1)(3). As clarified in Treas. Reg. § 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 (i.e., 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 may involve, for example, modeling, simulation, or a systematic trial and error methodology. The regulations under Treas. Reg. § 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 I.R.C. § 174. As described under Treas. Reg. § 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 I.R.C. § 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 I.R.C § 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.

Identifying, Gathering and Documenting QRAs

The aforementioned requirements described above are applied separately to each business component. Noting, I.R.C. § 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 (i.e., 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 of the manufacturing process improvement as discussed under Treas. Reg. § 1.41-4(b).

Treas. Reg. § 1.41-4(a)(6) provides that, if 80% or more of a taxpayer’s research activities with respect to a business component constitute 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. However, in no event may activities be treated as “qualified research” if such activities do not fall within the scope of I.R.C. § 174 or if such activities are specifically excluded under I.R.C. § 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, or 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 Treas. Reg. § 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 (i.e., an 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 (i.e., the flight actuation system) may still be eligible for the RTC.

Statutorily Excluded Activities

I.R.C. § 41(d)(4) specifically excludes the subsequent activities from being treated as “qualified research” and therefore are ineligible for the RTC.

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. However, even after a product meets the taxpayer’s basic functional requirements, activities relating to the manufacturing process still may constitute qualified research under Treas. Reg. § 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 Treas. Reg. § 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 Treas. Reg. § 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 and / 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 such as Puerto Rico and Guam 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), such research may not be treated as qualified research. There are limited exceptions to this rule in cases where overtures are incurred that are not funded. For example, if an Aerospace Company had a Cost Plus Contract with a client and was funded up to $ 5 Million to develop a flight actuation system and that aerospace 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 aerospace company had substantially all of the rights to the research (i.e., not needing to make a royalty payment to use that technology in the future) 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 the performance of “qualified services”; (2) amounts paid for supplies used in the performance of qualified services; and (3) certain “qualified research expenses” paid to third parties. The term “qualified 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 services 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 I.R.C. § 401(k) contributions and nontaxable fringe benefits. Practically speaking, you should be including each employee wage as documented on Form W-2, Box 1 and then 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 tied to qualifying research projects by hour and a fixed denominator of 2,080 hours which can be further reduced for paid holidays and vacation / 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 see the link between qualified research hours by project to person to expenditures.

In addition, it should 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 constitute “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 / rank within the company should also be documented so that an IRS agent can determine at a high level whether that employee was supervising the research (i.e., Oncology Practice Leader), conducting the research (i.e., Bio-Chemist Researcher), or supporting the research (i.e., Lab Technician supporting oncology experimentation). It should be noted, however, that employee’s titles are not exclusive indicators in determining whether the activities performed by that employee qualify for the RTC.

QRE Supplies

In general, QRE Supply costs can be claimed if the supplies are consumed or destroyed in the research 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., such as a laser for nuclear research) may be treated as expenditures for supplies in the conduct of qualified research as illustrated under Treas. Reg. § 1.41-2(b)(2)(ii).

QRE Contract Research

The amount of third party contractor costs eligible for the RTC is computed at 65%, or 75% in cases for payments to select research consortia’s, of amounts paid to persons other than employees for services that, if performed by an employee, would constitute qualified services under I.R.C. § 41(b)(3) and Treas. Reg. § 1.41-2(e)(1). Additionally, contract research performed on behalf of a taxpayer is qualified research only if incurred pursuant to an agreement (i.e., either oral or written), entered into prior to the performance of the research, and requiring the taxpayer to bear the expenses even if the research is not successful. Any payment made by the taxpayer to a third party which is contingent upon the success of the research is considered to be paid for the product or result rather than the performance of the research, and thus, may not be treated as qualified research expenses under Treas. Reg. § 1.41-2(e)(2).

Gathering Contemporaneous Documentation to Support the RTC

As set forth pursuant to Treas. Reg. § 1.41-4(d), taxpayers must retain records in sufficiently usable form (i.e., in an audit friendly format per the IRS Audit Technique Guidelines for research tax credit claims) and detail to substantiate claimed QREs (i.e., Wages, Supplies, & 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 as forms of substantiation documentation to assist in ensuring that the Service does not disallow the merits of the RTC claim should an examination come to fruition.

In cases in which a company is government regulated such as with Life Science companies (i.e., Pharmaceuticals, Bio-Technology & Medical Devices) then the FDA record keeping requirements can be leveraged to support research activities. Another example, with Aerospace & Defense companies then the FAA and DCAA record keeping requirements can also be leveraged to support the research 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 qualified research documentation due to the inherently arduous process to apply for a patent.

From a Best Practice Tax Controversy Perspective, the subsequent list of forms of contemporaneous documentation provides several examples of key documents that the Service typically requests to review during the course of an examination including:

• Complete Project Lists identifying the Full Scope of Research Based Projects vs. the Actual Claimed Research Projects after Conducting Systematic Project Based 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;
• Ingredient Consumption Worksheets; and / or
• Raw Material Usage Records.

I highly recommend that the more contemporaneous documentation from the aforementioned list that can be obtained should be obtained and meticulously compiled in an audit-ready format as it will incontestably assist in strengthening the merits of the RTC claim and overall RTC filing position (i.e., always strive for “More Likely Than Not” or higher, but never file a claim unless you can get at least to “Substantial Authority”).

From a risk management perspective, in order to mitigate or avoid income tax return paid preparer penalties pursuant to I.R.C. § 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 your RTC 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. The “More-Likely-Than-Not” standard is the highest level of accuracy required for purposes of avoiding the accuracy-related penalties under I.R.C. 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 Service;
• “Reasonable Basis” Standard: Significantly higher than the “Not Frivolous” standard (i.e., that is, not deliberately improper) and lower than the “Realistic Possibility of Success” standard. The position must be reasonable based on at least one tax authority that can be cited as valid legal authority;
• “Non-Frivolous” Standard: Approximately a 10% chance of being upheld upon examination by the Service and accordingly under no circumstance should a tax professional ever render services with this level of comfort; and
• “Frivolous” Standard: Approximately a percentage less than a 10% chance of being upheld upon examination by the Service 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. Noting, 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”, “Non-Frivolous”, “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 scientifically 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 and consult a true subject matter expert in this area to ensure a strong tax return filing position and a sustainable result upon IRS examination.

About the Author

Peter J. Scalise serves as the National Partner-in-Charge and the Federal Tax Practice Leader for Engineered Tax Services. Peter is also a highly distinguished member of both the Board of Directors and Board of Editors for The American Society of Tax Professionals and is the Founding President and Chairman of The Northeastern Region Tax Roundtable, an Operating Division of ASTP.

ETS Disclaimer

The article is designed to provide authoritative information on the subject matter covered. However, it is distributed with the understanding that the publisher, editors, and authors are not engaged in rendering legal, accounting, or other related professional services for your client base. Consequently, it is your responsibility to exercise all of the necessary measures to ensure proper tax preparation and tax advisory services for your client base.

Circular 230 Disclaimer

Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

January 24, 2013

During his closing keynote of the Winning is Everything conference Jan. 16-18 in Las Vegas, Sir Ken Robinson, author, speaker and advisor on creativity and innovation, challenged attendees to reawaken something he said becomes dormant with adulthood.

“We underestimate the power of imagination,” elaborated Robinson, whose popular 2007 TED Talk on the fallibility of the education system has garnered nearly 4.3 million viewers on YouTube. “We haven’t applied it properly.”

Read this article in its entirety