In part 3 of our series, we will be looking more closely at the third component allowed as a qualified research expenditure (QRE)-contract research. While many companies use outside assistance to conduct research on their behalf, understanding some of the specific requirements may help secure these expenses under audit. Companies may use outside programmers, testing companies, prototype modeling companies and many other types of consultants. It goes without saying that the work completed by an outside consultant must be performed in the United States in order to qualify.
The third expense item included as part of QREs is Contract Research conducted on behalf of the taxpayer by someone other than an employee. The services performed must be for qualified research or must be services that would constitute qualified research if performed by the taxpayer’s employees. The amount allowed under the Internal Revenue Code is 65% of the costs incurred rather than 100% as in the case of in-house wages or supplies. Additionally, the research conducted by the outside party must be performed on behalf of the taxpayer where the taxpayer has the rights to the research results. Conversely, it follows that if a taxpayer retains no substantial rights in the research or pays the outside party on a contingent fee basis (for the results), that research may not be taken into account by the taxpayer as qualified research (IRS Regs 1.41-2(a)(3)). Finally, prepayments to an outside contractor for work performed in a future tax year are considered paid in the year the research in conducted (IRC Section 41(b)(3)(B).
Qualifying an Outside Expense
In order to qualify an outside expense as paid for the performance of qualified research, a number of conditions must be met;
First, the qualified research must be paid or incurred pursuant to an agreement entered into prior to the performance of the research, where the work is performed on behalf of the taxpayer and the taxpayer bears the expense of the research regardless of outcome (payment may not be contingent upon success) (Reg. 1.41-2(e)(2)).
NOTE: While the regulations do not specifically require that an agreement with an outside researcher be written, it is strongly recommended that some sort of written document detailing the work to be completed and confirmation of payment terms and rights to research be completed prior to commencing work.
Second, the taxpayer must retain substantial rights to the results of the research (Reg 1.41-2(a)(3)(ii)).
Third, the contract research performed must be pursuant to carrying on a trade or business (Reg. 1.41-2(a)(1)).
Contract research expenses related to a new business may not be included in qualified research costs for purposes of the R&D tax credit under IRC Section 41 (Reg. 1.41-2(a)(2)) but may potentially be deducted under IRC Section 174.
75% is better than 65%
There are certain instances in which the standard 65% deduction can be increased to 75% if the contract research is completed by a qualified research consortium and the research is conducted for the taxpayer and one or more other unrelated taxpayers. A qualified research consortium is defined as any organization described under IRC 501(c)(3) or 501(c)(6) and exempt from tax under 501(a), or an organization organized primarily for scientific research and is not a private foundation.
Is your head spinning yet? I hope not, as we have only covered the first of the 5 critical items to document, namely, qualified research expenses. In part 4, we will be looking at project information and the items within an individual project that should be documented contemporaneously.
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.