In our last two blogs, we looked at important qualitative components of the R&D tax credit that should be documented as well as the timing for documentation (See How can you substantiate an R&D Credit claim under audit (
n our last two blogs, we looked at important qualitative components of the R&D tax credit that should be documented as well as the timing for documentation (See How can you substantiate an R&D Credit claim under audit (part 1) & (part 2)?).
Today we will wrap up the discussion on the more significant items of an R&D tax credit that are at risk during an audit with a discussion on both Supply Costs and Contract Research Costs.
This is part three of a three part series.
Let’s take a look:
Supply Costs – Expense versus capital
The regulations are pretty clear when it comes to supply costs and when they can be included as a qualified research expenditure for the R&D tax credit. At least they seemed clear to most taxpayers. In general, a supply cost cannot be an expenditure that may be capitalized and depreciated. This rule came into play in a court case several years ago when TG Missouri included in their research tax credit calculation costs incurred for mold development that were then sold to their customers. The physical molds were kept onsite at TG Missouri for use in the injection molding process but were owned by the customer following development (for a full discussion of the court case see TG Missouri v Commissioner on our website).
The IRS argued that because the molds were a capital asset to the customer, the development costs could not be included in TG Missouri’s R&D tax credit calculation. The court, however, found that Congress intended that only costs that are capitalizable in the hands of the taxpayer would be excluded from the definition of Supplies. Because the mold costs were considered inventory to TG Missouri rather than a capital asset, they could be considered supplies and were included.
In terms of documenting supply costs used during prototyping and testing, it is important to document the purpose of the prototype.
If a company routinely sells its prototypes, the IRS may consider all prototype costs inventory and exclude them from qualified Supplies. If, on the other hand, an occasional sale of a prototype happens but clear documentation exists to show that prototypes are developed for the purpose of proving out concepts, it would seem appropriate that these costs would qualify for inclusion in the R&D tax credit calculation.
In any event, supply costs should be clearly linked to the development project they are connected to when used.
Contract Research Costs – US Based only
Outside or Contract Research costs are included at 65% of the cost as qualified research expenditures. As is the case with employee time, contractors used during the development process such as computer programmers or engineers, should be linked to the projects they work on.
Typically, the proper documentation for contract research costs is a 1099 for the year and/or invoice provided by the outside party. Taxpayers would be prudent to ask vendors or contractors to list the projects they worked on specifically on their invoices when provided. Where possible, additional information such as tasks completed would also be beneficial when requested during an audit.
Under Regulation Section 1.41(e)(2), contract research must meet three conditions; (1) an agreement is entered into for the performance of qualified research, (2) the agreement provides that the research is performed on behalf of the taxpayer and (3) that the taxpayer bears the cost of the research regardless of the results.
Neither Code Section 41 nor the Regulations require the agreement to be written. However, it would be advisable for the taxpayer to have some type of written agreement with the outside contractor, testing agency or other group performing qualified research that is explicit regarding the above requirements.
While there are a number of other factors that come into play during an R&D tax credit audit, the items we have discussed will assist in securing your R&D tax credits if audited.
What say you my friends?
How are you tracking and linking your supply costs to projects?
Do you routinely sell your prototypes and if so, are you including those costs in your R&D incorrectly?
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.