This article originally appeared in the June 27, 2018 issue of the Silicon Valley Business Journal. To view the original article, click here.
The American economy depends on research and development activities to produce the new technologies and ideas that keep the whole system from stagnating. Current tax policy reflects the importance of these activities, offering large tax credits under Section 41 of the tax code for companies that increase the amount of research they do.
However, as with many tax rules, determining what kind of spending qualifies for the credit hasn’t always been easy for many businesses. In a memo last September providing new guidance to examiners in its large business and international division, the IRS itself noted that “independently determining the correct amount of Research Credits claimed by LB&I taxpayers imposes a significant burden on those taxpayers and LB&I examiners.”
The new guidance simplifies that process, allowing taxpayers to take advantage of a “safe harbor” under which an adjusted amount of their R&D costs is considered sufficient evidence of qualified research expenses (QRE) for the Section 41 credit. If a taxpayer complies with the requirements of the directive, LB&I examiners have been instructed not to challenge certain QRE amounts. In a sense, this is a “promise” to shield corporate taxpayers from lengthy audits of QREs used in the calculation of the credit filed.
The new LB&I directive is neither a law nor a requirement — it’s merely a guidance for IRS examiners to process taxpayer claims. That means that taxpayers meeting the standards may take advantage of the directive but are certainly not required to apply it.
If your business’s assets are equal to or greater than $10 million and your organization follows U.S. GAAP to prepare its certified audited financial statements, then you might qualify. Businesses must also show the amount of the currently-expensed ASC Financial Statement R&D (ASC 730) as a separate line item on the income statement included in their certified audited financial statements (or in a separately stated note) to qualify.
What expenses qualify?
- Wage QREs: Wage QREs are determined by reporting levels and department organization structure, not by job title. Companies may include 95 percent of taxable wages paid to “qualified individual contributors” and “1st-level supervisor managers” conducting R&D in the U.S. Qualified individual contributors are essentially R&D employees with no direct reports, while 1st- level supervisor managers are those with only one level of employees below them and whose wages are charged to ASC 730 cost centers. QREs for “upper level managers”— those who directly supervise any employees other than qualified individual contributors and whose wages are charged to ASC 730 cost centers — are capped at 10 percent of the amount computed for qualified individual contributors plus 1st-level supervisors.
- Computer rentals and leases: Amounts paid by the taxpayer to another party for the right to use computers during the conduct of qualified research reflected in ASC 730 cost centers can be included.
- Supplies QREs: R&D supply accounts and amounts expensed for supplies that are consumed in the U.S. (pursuant to ASC 730) can also be included.
It’s also important to note that contract research expenses are not eligible for safe harbor inclusion, because they aren’t reflected in ASC 730 cost centers.
What are some pros and cons of using the safe harbor?
Two major upsides to the safe harbor are that industry doesn’t matter and there’s no max threshold for applying. Another attractive feature is that taxpayers choosing to follow the directive may still claim additional QREs from expenses outside those eligible for safe harbor treatment. However, those expenses will be subject to risk assessment and possible examination as they have been in the past.
On the other hand, for taxpayers whose credit is driven by contract research, following the directive will result in a significant reduction to the benefit of the R&D credit, since third-party expenses are not eligible for safe harbor. Similarly, if high-level employees with significant compensation are major contributors to wage QREs amounts, then following the directive will result in a significant reduction in benefit due to the cap for upper level managers.
Furthermore, “grey area” departments such as quality assurance, production, manufacturing, marketing, and sales are not eligible. And finally, although the directive provides an administrative solution to defining sufficient evidence of QREs and shielding taxpayers from audits of QRE amounts, other elements of the R&D tax credit, such as base amounts, gross receipts, and projects qualification can be still subject to audit.
For many businesses, the IRS’s new R&D credit guidance represents a potential opportunity to significantly lower tax liability. However, these businesses should always conduct hybrid and feasibility studies to determine their best course of action.
The professionals with BPM’s life science industry group have the expertise and the experience to help your business navigate not just the R&D tax credit, but the full range of operational and financial challenges that impact your business. For more information contact Julie West at JWest@bpmcpa.com or (650) 855-6881 or Lisa Colton at LColton@bpmcpa.com or (650) 855-6805.