PORTFOLIO

Research and Development Expenditures (Portfolio 556)

Congress has enacted two important incentives for a business to invest in research activities in the United States: the ability to elect to deduct such expenditures currently and the ability to claim a credit for increasing research expenditures. Tax Management Portfolio, Research and Development Expenditures, No. 556-2nd, analyzes each of these incentive provisions. In 1954, Congress enacted §174 allowing taxpayers, for expenditures incurred after December 31, 1953, to elect either to deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business or to amortize these costs over a period of not less than 60 months. Eligible research costs include research conducted by the taxpayer as well as research conducted on the taxpayer's behalf.

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DESCRIPTION

Congress has enacted two important incentives for a business to invest in research activities in the United States: the ability to elect to deduct such expenditures currently and the ability to claim a credit for increasing research expenditures. Tax Management Portfolio, Research and Development Expenditures, No. 556-2nd, analyzes each of these incentive provisions. In 1954, Congress enacted §174 allowing taxpayers, for expenditures incurred after December 31, 1953, to elect either to deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business or to amortize these costs over a period of not less than 60 months. Eligible research costs include research conducted by the taxpayer as well as research conducted on the taxpayer's behalf.


The purpose of this provision was to encourage taxpayers to carry on research and experimental expenditures by eliminating the uncertainty concerning the tax treatment of these expenditures. Prior to the enactment of §174, there was no specific treatment authorized for research and experimental expenditures. To the extent ordinary and necessary they were deductible; to the extent capital in nature they were to be capitalized and amortized over useful life. Losses were permitted where amounts had been capitalized in connection with abandoned projects. However, where projects were not abandoned or where a useful life could not be definitely determined, taxpayers had no means of amortizing research expenditures.


Research and experimentation are basic activities that must precede (1) the development and application to production of new techniques and equipment, and (2) the development and manufacture of new products. In 1981, concerned that spending for these activities was not adequate and was in fact declining, Congress enacted a substantial tax credit for incremental research expenditures in order to overcome the reluctance of many ongoing companies to bear the significant costs of staffing and supplies that must be incurred to conduct research programs in a trade or business.


The credit is incremental in nature, in order to encourage enlarged research efforts by companies which already may be engaged in some research activities. Because of perceived difficulties for taxpayers and the IRS in distinguishing research expenditures from non-research expenditures, and in order to limit the credit to the principal types of research expenditures which distinctly reflect the extent of increased research activities, Congress limited eligible expenditures to certain direct wage, supply, and equipment research expenditures (or a specified percentage of contract research expenditures). The credit is not allowed for indirect, administrative, or overhead expenditures.


The original legislation contained a sunset provision providing for the credit to expire in 1985 in order for Congress to be able study the effectiveness of the credit. The areas of focus were whether categories of qualifying research expenditures were too broad or narrow; whether taxpayers and the IRS had been able accurately to distinguish qualifying research expenditures from non-qualifying research-related expenditures, such as indirect, overhead, or administrative wage expenditures, and from non-research expenditures, such as costs of market research, quality control, or production; whether the base period computation rules were appropriate; and whether the restrictions and limitations on the availability and use of the credit (e.g., the “carrying on” requirement) were effective to accomplish the Congressional intent.


Satisfied that the credit was effective in incentivizing business to increase research expenditures, the credit has been extended by Congress numerous times. When extending the credit in 1988 Congress stated “[R]esearch is the life-blood of our economic progress and effective tax incentives for research and development must be a fundamental element of America's competitive strategy.” Over the years, the credit has undergone substantive modifications in how the credit is calculated and clarification of the definition of qualified research.


Because of the interaction between the R&D expensing provisions and the tax credit, this Portfolio discusses these two issues in parallel. It first considers what types of activities give rise to expenditures which qualify as research and experimental expenditures for current expensing purposes and then, what types of activities can give rise to expenditures eligible for the R&D tax credit. It then analyzes the specific expenditures eligible for expensing and the credit relating to those activities. The Portfolio also discusses several practical and technical issues in claiming the credit, the basic research R&D tax credit and various miscellaneous matters.


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AUTHORS

KENDALL B. FOX
Kendall B. Fox, B.A., Michigan State University (1983); MST, Walsh College (1987); Certified Public Accountant, Michigan and California; member, American Institute of Certified Public Accountants; member Michigan Association of Certified Public Accountants; and member, California.

JIM BOWERS
Jim Bowers B.S., Eastern Illinois University (1976), Certified Public Accountant, New York and Illinois; American Institute of Certified Public Accountants; member Illinois Certified Public Accountants Society.

JAMES R. SHANAHAN, JR.
James R. Shanahan, Jr., B.B.A., University of Notre Dame (1975); J.D., Southwestern Law School (1982); Certified Public Accountant, California and District of Columbia; member District of Columbia Bar; member, American Institute of Certified Public Accountants; member California Association of Certified Public Accountants; member District of Columbia Association of Certified Public Accountants .

JOSEPH F. MASELLI
Joseph F. Maselli, B.A., Rutgers University (1970); J.D., Rutgers-Camden School of Law (1973), member New York and New Jersey Bar.

TABLE OF CONTENTS

Detailed Analysis

I. Overview

A. Deduction of Research or Experimental Expenditures

B. Tax Credit for Qualified Research Expenses

1. 1981 Economic Recovery Tax Act Provision

2. 1986 Tax Reform Act Credit Extension

3. 1988 Technical and Miscellaneous Revenue Act Credit Extension

4. 1989 Revenue Reconciliation Act Credit Extension and Modifications

5. 1990 Revenue Reconciliation Act Credit Extension

6. 1991 Tax Extension Act

7. Revenue Reconciliation Act of 1993

8. 1996 Small Business Job Act

9. Taxpayer Relief Act of 1997

10. 1998 Tax Extension Act

11. The Ticket to Work Incentive Improvements Act of 1999

12. 2004 Working Families Tax Relief Act

13. 2005 Energy Act

14. Tax Relief and Health Care Act of 2006

15. 2008 Housing and Economic Recovery Act

16. 2008 Tax Extenders and Alternative Minimum Tax Relief Act

17. 2009 American Recovery and Reinvestment Act

II. Nature of Eligible Research Expenditures

A. In General

1. Background

2. Research or Experimental Expenditures Under § 174

a. Lack of Statutory Definition

b. The 1957 Regulations

c. The 1983 Proposed Regulations

d. The 1989 Proposed Regulations

e. The 1993 Proposed Regulations

f. The 1994 Regulations

3. Section 41(d): Technological Research Undertaken Through a Process of Experimentation for a Permitted Purpose

B. Subject Matter of the Research

1. Section 174: “Research or Experimental” as Scientific Research

a. In General

b. Treatment of Prepublication Expenses

2. “Qualified Research:” Additional Section 41 Requirements Under the 1981 ERTA and 1986 TRA

a. In General

b. Suspension of the Effective Date of the 2001 Final Regulations

(1) The Discovery Test

(2) The Discovery Test in the Courts

(3) Documentation Requirements

c. Undertaken for the Purpose of Discovering Information that Is Technological in Nature

d. Useful in the Development of a New or Improved Business Component

e. Process of Experimentation

(1) The “Uncertainty” Requirement

(2) Experimentation for a Permitted Purpose

f. Application of Above Tests

g. Research Specifically Treated as Being “Qualified Research”

h. Research Specifically Excluded from Being “Qualified Research”

(1) Research After Commercial Production

(2) Adaptation of Existing Business Components

(3) Duplication of an Existing Business Component

(4) Surveys, Studies, Research Relating to Management Functions, Etc.

(5) Research Funded by Grant, Contract, or Otherwise

(6) Research Performed Outside the United States

(7) Research in Social Sciences and Humanities

i. Documentation Requirements

C. Nature and Extent of Improvement Required

1. Section 174

2. Section 41(d)

D. Adaptation of Existing Products

1. Section 174

2. Section 41(d)

E. Research Versus Manufacturing Start-up and Commercial Production

1. Section 174

a. General Standard of Research and Experimental: Developing the “Concept of the Product”

b. Basic Test: Development to the Point of a Finished Product

c. Issues Relating to Prototypes

(1) Prototypes Sold to Customers

(2) Multiple Prototypes

(3) Demonstration Plants Constructed on a Commercial Scale

d. Treatment of “Debugging” Activities

2. Section 41(d)

F. Development of the Process for Commercial Production of a New Product

1. Section 174

2. Section 41(d)

G. Treatment of Computer Software Development Costs

1. Taxable Years Ending Prior to December 1, 2000: Rev. Proc. 69-21

2. Taxable Years Ending on or After December 1, 2000: Rev. Proc. 2000-50

3. 1981 ERTA Treatment of Computer Software Development Costs for R& D Credit Purposes

4. The 1983 Proposed Regulations

a. Operational Feasibility Standard

b. The Requirement of New Programming Techniques

c. Definition of Qualifying Software Development Costs

5. Notice 87-12

6. The 1989 Proposed Regulations

7. The 1994 Regulations

8. Treatment of Software Development Costs Under § 41(d)

a. In General

b. Definition of Internal Use Software

c. Internal Use Software that Is Eligible for the R& D Credit

(1) Software Used in Qualified Research

(2) Software Developed for Use in a Plant Process

(3) Qualification of Internal Use Software Under Regulations

(4) Court Decisions Preceding the Regulations

d. Internal Use Software Qualifying Under the Regulations

(1) Software Developed as Part of an Integrated Hardware-Software Product

(2) Software Used in the Provision of Services

(3) High Threshold of Innovation Test

(a) Unique or Novel

(b) Significant Economic Risk

(c) Commercial Availability

III. Types of Research Related Expenditures Qualifying for the § 174 R& D Deduction and § 41 R& D Credit

Introductory Material

A. Types of Research Expenditures Qualifying for the § 174 Deduction

1. In-House Expenditures

a. Direct v. Indirect Research Costs

b. Depreciable Property Used in the Conduct of Research

c. Depreciable Property Produced in the Research of the Taxpayer

(1) In General

(2) Treatment Under Deferred Expense Method

d. Costs of Obtaining a Patent and Acquiring a Patented Product

2. Costs of Research Carried On in the Taxpayer's Behalf by Another Person

a. In General

b. Expenditures with Respect to Depreciable Property Used or Constructed by Another on the Taxpayer's Behalf

(1) Depreciable Property Used by Another in the Conduct of Research on the Taxpayer's Behalf

(2) Research Cost of Depreciable Property Constructed by Another Person for Use by the Taxpayer in a Trade or Business

c. Contract Research Through Intermediary Entities

d. Cost Sharing Arrangements

B. Qualified Research Expenses for Purposes of the R& D Tax Credit

1. In-House Research Expenditures

a. Wages Paid to Employees for Qualified Research Services

(1) Definition of Wages

(2) Qualified Research Services

(3) Allocation of Wages Between Qualified and Non-qualified Services

b. Supplies

c. Leasing Costs

(1) Expenditures for Leased Property Under the 1986 Act

(2) Expenditures on Leased Property Before the 1986 TRA (1981-1985)

(a) Safe Harbor Leasing

(b) Sale-Leaseback of Existing R& D Equipment

(3) Licensing of Patent Rights

d. Intercompany Charges for Leasing and Supplies

2. Contract Research Expenditures

a. In General

b. Prepayment Limitation

c. Examples of Eligible Contract Research Expenditures

d. Effect of Requirement of Aggregation of Research Expenditures Among Related Taxpayers

e. Research Funded by Another Person Under Contract, Grant, or Other Arrangement

(1) In General

(2) Taxpayers Performing the Research and Retaining No Rights to the Research Results

(3) Taxpayers Performing the Research and Retaining Significant Rights to the Research Results - the General Allocation Rule

(4) Independent Research and Development (IR& D)

(5) Extent of Funding by Another Person Determinable Only in Subsequent Taxable Year

IV. Trade or Business Requirement Under § 174 R& D Deduction and the § 41 R& D Credit

Introductory Material

A. Section 174 Deduction

1. In Connection with a Trade or Business

a. Qualification of Pre-Operating Expenditures

b. Qualification of an Unrelated Trade or Business

2. Trade or Business Requirement (Passive vs. Active)

a. Trade or Business Where Taxpayer Contracts Out the R& D Activities

b. Trade or Business Where Research Results Are Transferred to Others for Commercial Exploitation

c. Trade or Business Versus Hobby

d. Trade or Business Versus Tax Avoidance Partnerships

B. Section 41 R& D Credit

1. Trade or Business Requirement Under § 162

a. In General

b. Financing Activity as a Trade or Business

2. “In Carrying On” a Trade or Business

a. Expenditures Relating to an Expanded Trade or Business

b. Partnership Expenditures

(1) Application of Test at Partnership Level

(2) Special Exception for Qualifying Joint Ventures

V. Computation of Section 174 Deduction

A. In General

1. Current Expense v. Deferred Expense

2. Election to Claim Reduced Credit

B. Current Expense Method

1. Election of Current Expense Method During First Taxable Year of Research and Experimental Expenditures

2. Importance of Coordinating the Timing of Expenditures with Deductions

3. Electing the Current Expense Method on Subsequent Return

C. Deferred Expense Method

1. Eligibility

2. Electing the Deferred Expense Method

3. Circumstances in Which Use of Deferred Expense Method Should Be Considered

4. Period of Amortization Under Deferred Expense Method

5. Electing the Deferred Expense Method on Subsequent Returns

D. Treatment of § 174 Expenses Under the Alternative Minimum Tax

E. Recapturing Deductions

F. Allocation and Apportionment of Research or Experimental Expenditures

1. In General

2. The Allocation and Apportionment Regulations Under § 861

a. Allocation of Research or Experimental Expenditures Among Product Categories

(1) General Allocation Rule

(2) Exception to the General Allocation Rule

b. Apportionment of Research or Experimental Expenditures

(1) Sales Method

(a) Exclusive Apportionment

(b) Apportionment of Remaining Research or Experimental Expenditures

(2) Gross Income Method

(a) Option One

(b) Option Two

c. Special Rules for Partnerships

d. Modification and Suspension of Application of Regs. § 1.861-8(e)(3)

3. Section 864(g)

4. Rev. Proc. 92-56

VI. R& D Credit Computational Rules

A. Computing the Credit for Taxable Years Beginning Before 1990

1. General Rule

2. 1981 and 1982 Transition Rule

3. Short Determination or Base Period Years

4. New Taxpayers

B. Computing the Credit for Taxable Years Beginning After 1989

1. General Rule

2. Computing the Base Amount for Taxable Years Beginning Before January 3, 2001

3. Computing the Base Amount for Taxable Years Beginning On or After January 3, 2001

4. Start-Up Companies

a. In General

b. Taxable Years Beginning Before 1994

c. Taxable Years Beginning After 1993 But Before January 3, 2001

d. Taxable Years Beginning On or After January 3, 2001

5. Alternative Incremental Credit for Years Beginning After June 30, 1996

6. Alternative Simplified Research Credit for Taxable Years Ending After December 31, 2006

7. Computing the Energy Research Consortium Credit for Taxable Years Beginning After August 8, 2005

C. Aggregation of Expenditures

1. Controlled Group of Corporations

2. Trades or Businesses Under Common Control

3. Consolidated Group Rule

4. Tax Accounting Periods for Credit Computation Purposes

5. Membership in More Than One Group

6. Intra-Group Transactions

a. Research by One Member on Behalf of Another

b. Contracting for Research Outside the Group

c. Lease Payments

d. R& D Supply Costs Paid to Another Member

D. Allocation of Credit Among Controlled Entities

E. Effect of Changes in Ownership of a Trade or Business

F. Allocation of Credit Through Passthrough Entities

1. S Corporations

2. Estates or Trusts

3. Partnerships and Qualifying Joint Ventures

4. Taxable Year in Which Passthrough Is Taken into Account by Recipient

G. Limitation Based on Amount of Tax

H. Credit Carrybacks and Carryovers

I. Electing to Accelerate AMT or Research Credits in Lieu of Bonus Depreciation

VII. The Basic Research Credit

A. In General

B. Computation of the Basic Research Credit

1. Basic Research Payments

2. Qualified Organization Base Period Amount

C. Qualified Organizations

D. Relationship Between the Basic and Qualified Research Provisions


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Internal Revenue Service Audit Plan for Examination of Research Tax Credit

Worksheet 2 Internal Revenue Service Audit Plan for Examination of Research Tax Credit as Pertaining to Software Developed for Internal Use

Worksheet 3 Coordinated Issue Paper: Research Tax Credit - Qualified Research

Worksheet 4 Coordinated Issue Paper: Research Tax Credit - Internal Use Software

Worksheet 5 Coordinated Issue Paper: Biotech and Pharmaceutical Industries Legally Mandated R& E Expenses

Worksheet 6 Coordinated Issue Paper: Qualifying Wages under Section 41 in Determining the Tax Credit for Increasing Research Activities

Worksheet 7 Coordinated Issue Paper: Credit for Increasing Research Activities - Qualified Research Expenses

Worksheet 8 LMSB Directive on the Planning and Examination of Research Credit - Generic Drugs; LMSB Directive on the Examination of Legally Mandated Research and Experimentation Expenses in the Biotech and Pharmaceutical Industries

Worksheet 8A Coordinated Issue Paper: Nonrefundable Upfront Fees, Technology Access Fees, Milestone Payments, Royalties, Deferred Income Under Collaboration Agreement

Worksheet 9 Internal Revenue Code of 1954 (P.L. 591); H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. (1954)

Worksheet 10 General Explanation of the Economic Recovery Tax Act of 1981 by the Staff of the Joint Committee on Taxation (Dec. 29, 1981)

Worksheet 11 Deficit Reduction Act of 1984 (P.L. 98–369) Explanation of Provisions Approved by the Finance Committee on March 21, 1984 S. Prt. No. 169, Vol. I, 98th Cong., 2d Sess. 899-912 (1984)

Worksheet 12 Tax Reform Act of 1986 Conference Report to Accompany H.R. 3838, Vol. II H.R. Rep. No. 841, 99th Cong., 2d Sess. II–68–77 (1986)

Worksheet 13 Ticket to Work Incentive Improvement Act of 1999 (P.L. 106-170): Conference Report to Accompany H.R. 1180, H.R. Rep. 106-478, 106th Cong. 1st Sess. (1999)

Worksheet 14 Trade and Tax Relief Extension Act of 1998 H.R. Conf. Rep. No. 105-825

Worksheet 15 Deferred and Current Expense Methods - Example

Worksheet 16 Statement of Election to Treat Research or Experimental Expenditures as Deferred Expenses - Attachment to Form 1120

Worksheet 17 Examples from Regs. § 1.41-6 and Regs. § 1.41–6T (Computing and Allocating the Research Tax Credit for Controlled Groups)

Bibliography