With the passage of the Tax Relief and Reconciliation Act of 2006, a new method of calculating the R&D credit is available for R&D expenses incurred after December 31, 2006. This new method, which is called the Alternative Simplified Credit, is equal to 12 percent of the qualified research expenses for the taxable year in excess of 50 percent of the average qualified research expenses for the 3 prior taxable years.

This method may result in a greater credit for those taxpayers who have been limited under the Regular Method due to the amount of their gross receipts or the inability to calculate the fixed-based percentage, which is based on the R&D expenses to gross receipts from the taxable years 1984-1988.

If this new method is elected, the taxpayer must continue to use this method unless it gets consent from the IRS to change back to the regular method.

Overview of the Research and Development Credit

Internal Revenue Code (IRC) Section 41 enables a taxpayer to claim a tax credit for qualified research expenses paid or incurred by the taxpayer during the taxable year in carrying on any trade or business.  The availability of this tax credit hinges upon the definition of qualified research expenses as defined by IRC Section 41 and the regulations under IRC Section 174.  Indiana income tax law also permits an Indiana tax credit for qualified research expenses.

Qualified Research Activities

Expenditures qualifying for the tax credit are referred to as qualified research expenses (QRE) and are defined solely by IRC Sections 41 and 174.  Federal income tax law's definition of a QRE is often different than accounting or engineering definitions of research and development expenses.  Under IRC Sections 41 and 174 there are essentially two tests which must be met in order for an expenditure to constitute a QRE:  Purpose Test and Elimination of Uncertainty Test.

Purpose Test

1. General Purpose-Technological Information Test

The research must be performed for the purpose of discovering information which is technological in nature; i.e., it must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.  Discovery is defined as gaining information new to the taxpayer which is not freely available to the general public.  Research is not qualified research if its purpose relates to style, taste, cosmetic, or seasonal factors.

2. Specific Purpose-New or Improved Business Component

The research must be undertaken to discover information intended to be useful in the development of a new or improved business component.  Business component is a product, process, technique, formula, invention, or software item.  Substantially all of the research must constitute elements of experimentation (trial and error testing) relating to new or improved function, reliability, or quality.  The improvement need not be significant.

Elimination of Uncertainty Test

The expenditures must eliminate uncertainty concerning the development or improvement of a business component.  The required uncertainty exists if the information available to the taxpayer does not establish either:
  • the capability or method for developing or improving the product, or
  • the appropriate design of the product.

The elimination of uncertainty is done through a process of experimentation involving more than one alternative at the outset of the project.

It appears unnecessary that there be uncertainty as to whether the product or improvement can be designed at all.  It is sufficient merely that the specific design be uncertain at the outset.

Qualified Research Expenses

Expenditures which qualify for the research credit (QRE) as defined above are the total of in-houses research expenses and contract research expenses.

In-House Research Expenses (IHRE)

1. Wages Paid For Qualified Research Services

IHRE include wages paid to employees engaged in qualified research or engaging in the direct support or supervision of qualified research activities.  Wages do not include:
  • 401(k)
  • Nontaxable fringe benefits
  • Overhead
  • Selling, general and administrative allocations

If at least 80% of an employee's time is spent on qualified research activities, then 100% of the employee's annual wage is eligible for the research credit.

2. Supplies Used In Qualified Research

IHRE include any tangible personal property, other than land or depreciable property (including annual depreciation thereof), purchased for direct use in qualified research activities.

3. Computer Leasing

IHRE include amounts to other persons for the right to use computers in the conduct of qualified research activities.

Contract Research Expenses

Contract Research Expenses (CRE) paid or incurred to any person, other than an employee of the taxpayer, for qualified research are qualified expenses.  CRE expenses are limited to 65% of the amount paid and the taxpayer must bear the expense even if the research project is unsuccessful (risk of failure).  The percentage increases to 75% of amounts paid or incurred for qualified research performed by a qualified research consortium.

Expenses that do NOT qualify for the R&D Credit

IRC Sections 41 and 174 and associated regulations specifically exclude expenditures on the following from eligibility for the research credit:
  • The ordinary testing or inspection of materials or products for:
    • quality control
    • efficiency surveys
    • management studies
    • consumer surveys
    • adverting or promotion
    • the acquisition of another's patent, model, production, or process
    • research in connection with literary, historical or similar project
  • Activities relating to management functions or techniques developed primarily for internal use of the taxpayer in its trade or business and not generally intended for sale to customers, including customer surveys and studies.
  • Activities not directed at the functional aspects of a product including expenses relating to style, taste, cosmetic, or seasonal factors.
  • Activities relating to the implementation of commercial production or research conducted after successful development of a business component.
  • The construction of duplicate prototypes used for marketing test purposes or held for sale.
  • The adaptation of an existing capability to a particular requirement or customer's needs.
  • Research related to certain internal use software unless such is highly innovative, the development of which involves significant economic risk, and such is commercially unavailable for use by the taxpayer.  Significant software modification may qualify for the research credit.
  • Research conducted outside the U.S., the Commonwealth of Puerto Rico, or any possession of the U.S.
  • Research in the social sciences, arts, or humanities.
  • Any research to the extent funded by grant, contract, or by any other personal or government entity.

Please feel free to contact  Baden, Gage & Schroeder at (260) 422-2551 if you need further clarification or assistance with the credit.
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