R&D Tax Credit - Need to know changes

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Posted by Randy Eickhoff on Sep 24, 2013 9:32:00 AM

Randy Eickhoff, CPA, President, Acena ConsultingTreasury and the IRS recently released taxpayer-friendly proposed regulations that clarify the definition of supply costs when part of research and development activities.



As a taxpayer, what do you need to know about these new proposed regulations?

FIRST, the proposed regulations are under Internal Revenue Code Section 174. This is the code section that allows taxpayers to elect to either expense or capitalize R&D expenditures.

SECOND, the proposed regulations provide four items that help define and clarify several points of contention between taxpayers and the IRS.

These items are:

  • Ultimate success or failure of a project (or other use) will have no bearing on determination of whether it is eligible under section 174.
    • This means that when a project meets the criteria for qualified research and development (See Navigating the R&D tax Credit minefield (Part 2)) it won’t matter if the resulting property is sold, used or failed. This is a significant departure from the position the IRS has taken in the past and is an important change favoring taxpayers.
  • The Depreciable Property Rule is an application of the general definition of research and development and should not be used to exclude otherwise eligible expenditures.
    • In TG Missouri v. Commissioner, the IRS argued that plastic molds owned by customers but used by the manufacturer to develop and then manufacture injection molded parts were depreciable property and not eligible for section 174 treatment. The court recognized that these molds were NOT depreciable in the hands of the manufacturer and allowed the mold costs to be included in both the section 174 costs AND calculation of the R&D tax credit. This change recognizes another shift in the position of the IRS.
  • Defined the term “pilot model” to mean any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product duringComponent development or improvement of the product. This term includes a fully-functioning representation or model of the product or component.
    • For taxpayers that routinely build capital equipment and take risks to innovate and attempt to build new machines, this is a significant win allowing the taxpayer to include all the supply costs associated with development. These costs (which include labor and contract research costs) can be included as section 174 costs until the uncertainty is resolved.
  • Clarify the general rule that the costs of producing a product after uncertainty concerning development or improvement of a product is eliminated are not eligible under section 174.
    • Simply put, once a taxpayer has resolved technical uncertainty in the development of the product, additional costs are not section 174 eligible.

What does this mean for taxpayers?

How your CPA or consultant defines supply costs as part of your R&D expenses and R&D tax credit has just changed for the better. Instead of simply including unused parts, materials or supply costs from failed projects, they can now include all the material and supply costs for a project that has technical uncertainty (as defined under the research credit rules) up and until the uncertainty is alleviated.

While the proposed regulations do not explicitly discuss how this new definition applies to the research and development tax credit (under section 41), the court case TG Missouri v. Commissioner connects the definitions from section 174 to those found in section 41. Given the proposed regulations reference this court case, it would be reasonable to assume the definitions will apply to the R&D credit as well.

Perhaps Treasury will make a more explicit reference to section 41 and suppy costs in the final regulations.

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What say you my friends?

How does this change your ability to include supply costs in your R&D Credit calculation?

Has the IRS and Treasury finally started following congressional intent?

What potential issues do you see with this change?

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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.

Acena Consulting, LLC

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