what is section 41 research credit

26 U.S. Code § 41 - Credit for increasing research activities

The term “ wages ” has the meaning given such term by section 3401(a).

In the case of an employee (within the meaning of section 401(c)(1) ), the term “wages” includes the earned income (as defined in section 401(c)(2)) of such employee.

The term “ wages ” shall not include any amount taken into account in determining the work opportunity credit under section 51(a).

The term “ contract research expenses ” means 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

If any contract research expenses paid or incurred during any taxable year are attributable to qualified research to be conducted after the close of such taxable year, such amount shall be treated as paid or incurred during the period during which the qualified research is conducted.

Subparagraph (A) shall be applied by substituting “75 percent” for “65 percent” with respect to amounts paid or incurred by the taxpayer to a qualified research consortium for qualified research on behalf of the taxpayer and 1 or more unrelated taxpayers. For purposes of the preceding sentence, all persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as related taxpayers.

The term “ small business ” means, with respect to any calendar year, any person if the annual average number of employees employed by such person during either of the 2 preceding calendar years was 500 or fewer. For purposes of the preceding sentence, a preceding calendar year may be taken into account only if the person was in existence throughout the year.

Rules similar to the rules of subparagraphs (B) and (D) of section 220(c)(4) shall apply for purposes of this clause.

For purposes of this subparagraph, the term “ Federal laboratory ” has the meaning given such term by section 4(6) of the Stevenson-Wydler Technology Innovation Act of 1980 ( 15 U.S.C. 3703(6) ), as in effect on the date of the enactment of the Energy Tax Incentives Act of 2005 .

In no event shall the base amount be less than 50 percent of the qualified research expenses for the credit year.

Except as otherwise provided in this paragraph, the fixed-base percentage is the percentage which the aggregate qualified research expenses of the taxpayer for taxable years beginning after December 31, 1983 , and before January 1, 1989 , is of the aggregate gross receipts of the taxpayer for such taxable years.

The Secretary may prescribe regulations providing that de minimis amounts of gross receipts and qualified research expenses shall be disregarded under clauses (i) and (ii).

In no event shall the fixed-base percentage exceed 16 percent.

The percentages determined under subparagraphs (A) and (B)(ii) shall be rounded to the nearest 1/100th of 1 percent.

At the election of the taxpayer, the credit determined under subsection (a)(1) shall be equal to 14 percent of so much of the qualified research expenses for the taxable year as exceeds 50 percent of the average qualified research expenses for the 3 taxable years preceding the taxable year for which the credit is being determined.

The credit under this paragraph shall be determined under this subparagraph if the taxpayer has no qualified research expenses in any one of the 3 taxable years preceding the taxable year for which the credit is being determined.

The credit determined under this subparagraph shall be equal to 6 percent of the qualified research expenses for the taxable year.

An election under this paragraph shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary.

Notwithstanding whether the period for filing a claim for credit or refund has expired for any taxable year taken into account in determining the fixed-base percentage, the qualified research expenses taken into account in computing such percentage shall be determined on a basis consistent with the determination of qualified research expenses for the credit year.

The Secretary may prescribe regulations to prevent distortions in calculating a taxpayer’s qualified research expenses or gross receipts caused by a change in accounting methods used by such taxpayer between the current year and a year taken into account in computing such taxpayer’s fixed-base percentage.

For purposes of this subsection, gross receipts for any taxable year shall be reduced by returns and allowances made during the taxable year. In the case of a foreign corporation, there shall be taken into account only gross receipts which are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico , or any possession of the United States.

Paragraph (1) shall be applied separately with respect to each business component of the taxpayer.

Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).

Research shall in no event be treated as conducted for a purpose described in this paragraph if it relates to style, taste, cosmetic, or seasonal design factors.

Any research conducted after the beginning of commercial production of the business component .

Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.

Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component .

Any research conducted outside the United States, the Commonwealth of Puerto Rico , or any possession of the United States.

Any research in the social sciences, arts, or humanities.

Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).

In the case of a qualified organization described in subparagraph (C) or (D) of paragraph (6), clause (ii) of subparagraph (A) shall not apply.

Except in the case of a taxpayer which was in existence during a taxable year (other than a short taxable year) in the base period , the minimum basic research amount for any base period shall not be less than 50 percent of the basic research payments for the taxable year for which a determination is being made under this subsection.

The cost-of-living adjustment for any calendar year is the cost-of-living adjustment for such calendar year determined under section 1(f)(3), by substituting “calendar year 1987” for “calendar year 2016” in subparagraph (A)(ii) thereof.

If the base period of any taxpayer does not end in 1983 or 1984, section 1(f)(3)(A)(ii) shall, for purposes of this paragraph, be applied by substituting the calendar year in which such base period ends for 2016. Such substitution shall be in lieu of the substitution under clause (i).

The term “ base period ” means the 3-taxable-year period ending with the taxable year immediately preceding the 1st taxable year of the taxpayer beginning after December 31, 1983 .

For purposes of applying subsection (b)(1) to this subsection, any basic research payments shall be treated as an amount paid in carrying on a trade or business of the taxpayer in the taxable year in which it is paid (without regard to the provisions of subsection (b)(3)(B)).

Under regulations prescribed by the Secretary, rules similar to the rules of subsection (d) of section 52 shall apply.

In the case of partnerships, the credit shall be allocated among partners under regulations prescribed by the Secretary.

If a person acquires the major portion of either a trade or business or a separate unit of a trade or business (hereinafter in this paragraph referred to as the “acquired business”) of another person (hereinafter in this paragraph referred to as the “predecessor”), then the amount of qualified research expenses paid or incurred by the acquiring person during the measurement period shall be increased by the amount determined under clause (ii), and the gross receipts of the acquiring person for such period shall be increased by the amount determined under clause (iii).

The amount determined under this clause is the amount which would be determined under clause (ii) if “the gross receipts of” were substituted for “the qualified research expenses paid or incurred by” each place it appears in clauses (ii) and (iv).

For purposes of this subparagraph, the term “ measurement period ” means, with respect to the taxable year of the acquiring person for which the credit is determined, any period of the acquiring person preceding such taxable year which is taken into account for purposes of determining the credit for such year.

In the case of any short taxable year, qualified research expenses and gross receipts shall be annualized in such circumstances and under such methods as the Secretary may prescribe by regulation.

All persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as related persons for purposes of subparagraph (A)(iii) and as a single person for purposes of subparagraph (A)(iv).

For purposes of subsection (a)(3), amounts paid or incurred for any energy research conducted outside the United States, the Commonwealth of Puerto Rico , or any possession of the United States shall not be taken into account.

Any amount taken into account under subsection (a)(3) shall not be taken into account under paragraph (1) or (2) of subsection (a).

The term “energy research” does not include any research which is not qualified research .

At the election of a qualified small business for any taxable year, section 3111(f) shall apply to the payroll tax credit portion of the credit otherwise determined under subsection (a) for the taxable year and such portion shall not be treated (other than for purposes of section 280C) as a credit determined under subsection (a).

Such term shall not include an organization which is exempt from taxation under section 501.

The amount specified in any election made under this subsection shall not exceed $250,000.

In the case of taxable years beginning after December 31, 2022 , the amount in subclause (I) shall be increased by $250,000.

A person may not make an election under this subsection if such person (or any other person treated as a single taxpayer with such person under paragraph (5)(A)) has made an election under this subsection for 5 or more preceding taxable years.

In the case of a qualified small business which is a partnership or S corporation, the election made under this subsection shall be made at the entity level.

Except as provided in subparagraph (B), all persons or entities treated as a single taxpayer under subsection (f)(1) shall be treated as a single taxpayer for purposes of this subsection.

The date of the enactment of the Energy Tax Incentives Act of 2005 , referred to in subsec. (b)(3)(D)(iv), is the date of enactment of title XIII of Pub. L. 109–58 , which was approved Aug. 8, 2005 .

A prior section 41, added Pub. L. 97–34, title III, § 331(a) , Aug. 13, 1981 , 95 Stat. 289 , § 44G; amended Pub. L. 97–448, title I, § 103(g)(1) , Jan. 12, 1983 , 96 Stat. 2379 ; renumbered § 41 and amended Pub. L. 98–369, div. A, title I, § 14 , title IV, §§ 471(c), 474(l), 491(e)(2), (3), July 18, 1984 , 98 Stat. 505 , 826, 833, 852, 853, related to employee stock ownership credit, prior to repeal by Pub. L. 99–514, title XI, § 1171(a) , Oct. 22, 1986 , 100 Stat. 2513 , applicable to compensation paid or accrued after Dec. 31, 1986 , in taxable years ending after such date, except as otherwise provided, see section 1171(c) of Pub. L. 99–514 , set out as an Effective Date of 1986 Amendment note under section 38 of this title . For transition rules relating to such repeal, see section 1177 of Pub. L. 99–514 , set out as a Transition Rules note under section 38 of this title .

Another prior section 41 was renumbered section 24 of this title .

2022—Subsec. (h)(4)(B)(i). Pub. L. 117–169, § 13902(a) , designated existing provisions as subcl. I, inserted heading, and added subcl. (II).

Subsec. (h)(5)(B)(ii). Pub. L. 117–169, § 13902(c) , substituted “each of the $250,000 amounts” for “the $250,000 amount”.

2018—Subsec. (c)(4). Pub. L. 115–141, § 101(c)(1) , (2), redesignated par. (5) as (4) and struck out former par. (4) which related to election of alternative incremental credit.

Subsec. (c)(4)(A). Pub. L. 115–141, § 401(b)(6) , struck out “(12 percent in the case of taxable years ending before January 1, 2009 )” after “14 percent”.

Subsec. (c)(4)(C). Pub. L. 115–141, § 101(c)(3) , struck out at end “An election under this paragraph may not be made for any taxable year to which an election under paragraph (4) applies.”

Subsec. (c)(5) to (7). Pub. L. 115–141, § 101(c)(2) , redesignated pars. (5) to (7) as (4) to (6), respectively.

2017—Subsec. (d)(1)(A). Pub. L. 115–97, § 13206(d)(1) , substituted “specified research or experimental expenditures under section 174” for “expenses under section 174”.

Subsec. (e)(5)(C)(i). Pub. L. 115–97, § 11002(d)(1)(F) , substituted “for ‘calendar year 2016’ in subparagraph (A)(ii)” for “for ‘calendar year 1992’ in subparagraph (B)”.

Subsec. (e)(5)(C)(ii). Pub. L. 115–97, § 11002(d)(2) , substituted “1(f)(3)(A)(ii)” for “1(f)(3)(B)” and “2016” for “1992”.

2015—Subsec. (h). Pub. L. 114–113, § 121(c)(1) , added subsec. (h).

Pub. L. 114–113, § 121(a)(1) , struck out subsec. (h) which provided the termination date for applicability of this section and the alternative incremental credit and provided the computation for taxable year in which credit terminates.

2014—Subsec. (h)(1). Pub. L. 113–295 substituted “paid or incurred after December 31, 2014 .” for “paid or incurred—

“(A) after June 30, 1995 , and before July 1, 1996 , or

“(B) after December 31, 2013 .”

2013—Subsec. (f)(1)(A)(ii). Pub. L. 112–240, § 301(c)(1) , substituted “shall be determined on a proportionate basis to its share of the aggregate of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, taken into account by such controlled group for purposes of this section” for “shall be its proportionate shares of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, giving rise to the credit”.

Subsec. (f)(1)(B)(ii). Pub. L. 112–240, § 301(c)(2) , substituted “shall be determined on a proportionate basis to its share of the aggregate of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, taken into account by all such persons under common control for purposes of this section” for “shall be its proportionate shares of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, giving rise to the credit”.

Subsec. (f)(3)(A). Pub. L. 112–240, § 301(b)(1) , amended subpar. (A) generally. Prior to amendment, text read as follows: “If, after December 31, 1983 , a taxpayer acquires the major portion of a trade or business of another person (hereinafter in this paragraph referred to as the ‘predecessor’) or the major portion of a separate unit of a trade or business of a predecessor, then, for purposes of applying this section for any taxable year ending after such acquisition, the amount of qualified research expenses paid or incurred by the taxpayer during periods before such acquisition shall be increased by so much of such expenses paid or incurred by the predecessor with respect to the acquired trade or business as is attributable to the portion of such trade or business or separate unit acquired by the taxpayer, and the gross receipts of the taxpayer for such periods shall be increased by so much of the gross receipts of such predecessor with respect to the acquired trade or business as is attributable to such portion.”

Subsec. (f)(3)(B). Pub. L. 112–240, § 301(b)(2) , amended subpar. (B) generally. Prior to amendment, text read as follows: “If, after December 31, 1983 —

“(i) a taxpayer disposes of the major portion of any trade or business or the major portion of a separate unit of a trade or business in a transaction to which subparagraph (A) applies, and

“(ii) the taxpayer furnished the acquiring person such information as is necessary for the application of subparagraph (A),

then, for purposes of applying this section for any taxable year ending after such disposition , the amount of qualified research expenses paid or incurred by the taxpayer during periods before such disposition shall be decreased by so much of such expenses as is attributable to the portion of such trade or business or separate unit disposed of by the taxpayer, and the gross receipts of the taxpayer for such periods shall be decreased by so much of the gross receipts as is attributable to such portion.”

Subsec. (h)(1)(B). Pub. L. 112–240, § 301(a)(1) , substituted “ December 31, 2013 ” for “ December 31, 2011 ”.

2010—Subsec. (h)(1)(B). Pub. L. 111–312 substituted “ December 31, 2011 ” for “ December 31, 2009 ”.

2008—Subsec. (c)(5)(A). Pub. L. 110–343, § 301(c) , substituted “14 percent (12 percent in the case of taxable years ending before January 1, 2009 )” for “12 percent”.

Subsec. (h)(1)(B). Pub. L. 110–343, § 301(a)(1) , substituted “ December 31, 2009 ” for “ December 31, 2007 ”.

Subsec. (h)(2). Pub. L. 110–343, § 301(d) , redesignated par. (3) as (2) related to computation for taxable year in which credit terminates.

Pub. L. 110–343, § 301(b) , added par. (2). Former par. (2) redesignated (3).

Subsec. (h)(3). Pub. L. 110–343, § 301(d) , amended par. (3) generally, redesignating it as par. (2) related to computation for taxable year in which credit terminated and amending heading and text generally. Prior to amendment, text read as follows: “In the case of any taxable year with respect to which this section applies to a number of days which is less than the total number of days in such taxable year, the base amount with respect to such taxable year shall be the amount which bears the same ratio to the base amount for such year (determined without regard to this paragraph) as the number of days in such taxable year to which this section applies bears to the total number of days in such taxable year.”

Pub. L. 110–343, § 301(b) , redesignated par. (2) as (3).

2007—Subsec. (a)(3). Pub. L. 110–172, § 6(c)(1) , inserted “for energy research” before period at end.

Subsec. (f)(1)(A)(ii), (B)(ii). Pub. L. 110–172, § 11(e)(2) , substituted “qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, ” for “qualified research expenses and basic research payments” .

Subsec. (f)(6)(E). Pub. L. 110–172, § 6(c)(2) , added subpar. (E).

2006—Subsec. (c)(4)(A)(i). Pub. L. 109–432, § 104(b)(1)(A) , substituted “3 percent” for “2.65 percent”.

Subsec. (c)(4)(A)(ii). Pub. L. 109–432, § 104(b)(1)(B) , substituted “4 percent” for “3.2 percent”.

Subsec. (c)(4)(A)(iii). Pub. L. 109–432, § 104(b)(1)(C) , substituted “5 percent” for “3.75 percent”.

Subsec. (c)(5) to (7). Pub. L. 109–432, § 104(c)(1) , added par. (5) and redesignated former pars. (5) and (6) as (6) and (7), respectively.

Subsec. (h)(1)(B). Pub. L. 109–432, § 104(a)(1) , substituted “2007” for “2005”.

2005—Subsec. (a)(3). Pub. L. 109–58, § 1351(a)(1) , added par. (3).

Subsec. (b)(3)(C)(ii). Pub. L. 109–135, § 402 (l)(2), struck out “(other than an energy research consortium) ” after “organization” in introductory provisions.

Pub. L. 109–58, § 1351(a)(3) , inserted “(other than an energy research consortium) ” after “organization” in introductory provisions.

Subsec. (b)(3)(D). Pub. L. 109–58, § 1351(b) , added subpar. (D).

Subsec. (f)(6). Pub. L. 109–58, § 1351(a)(2) , added par. (6).

Subsec. (f)(6)(C), (D). Pub. L. 109–135, § 402 (l)(1), added subpars. (C) and (D).

2004—Subsec. (h)(1)(B). Pub. L. 108–311 substituted “ December 31, 2005 ” for “ June 30, 2004 ”.

1999—Subsec. (c)(4)(A)(i). Pub. L. 106–170, § 502(b)(1)(A) , substituted “2.65 percent” for “1.65 percent”.

Subsec. (c)(4)(A)(ii). Pub. L. 106–170, § 502(b)(1)(B) , substituted “3.2 percent” for “2.2 percent”.

Subsec. (c)(4)(A)(iii). Pub. L. 106–170, § 502(b)(1)(C) , substituted “3.75 percent” for “2.75 percent”.

Subsecs. (c)(6), (d)(4)(F). Pub. L. 106–170, § 502(c)(1) , inserted “, the Commonwealth of Puerto Rico , or any possession of the United States” before period at end.

Subsec. (h)(1). Pub. L. 106–170, § 502(a)(1)(B) , struck out concluding provisions which read as follows: “Notwithstanding the preceding sentence, in the case of a taxpayer making an election under subsection (c)(4) for its first taxable year beginning after June 30, 1996 , and before July 1, 1997 , this section shall apply to amounts paid or incurred during the 36-month period beginning with the first month of such year. The 36 months referred to in the preceding sentence shall be reduced by the number of full months after June 1996 (and before the first month of such first taxable year) during which the taxpayer paid or incurred any amount which is taken into account in determining the credit under this section.”

Subsec. (h)(1)(B). Pub. L. 106–170, § 502(a)(1)(A) , substituted “ June 30, 2004 ” for “ June 30, 1999 ”.

1998—Subsec. (h)(1). Pub. L. 105–277 substituted “ June 30, 1999 ” for “ June 30, 1998 ” in subpar. (B) and substituted “36-month” for “24-month” and “36 months” for “24 months” in concluding provisions.

1997—Subsec. (c)(4)(B). Pub. L. 105–34, § 601(b)(1) , amended heading and text of subpar. (B) generally. Prior to amendment, text read as follows: “An election under this paragraph may be made only for the first taxable year of the taxpayer beginning after June 30, 1996 . Such an election shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary.”

Subsec. (h)(1). Pub. L. 105–34, § 601(a) , substituted “ June 30, 1998 ” for “ May 31, 1997 ” in subpar. (B) and “during the 24-month period beginning with the first month of such year. The 24 months referred to in the preceding sentence shall be reduced by the number of full months after June 1996 (and before the first month of such first taxable year) during which the taxpayer paid or incurred any amount which is taken into account in determining the credit under this section.” for “during the first 11 months of such taxable year.” in concluding provisions.

1996—Subsec. (b)(2)(D)(iii). Pub. L. 104–188, § 1201(e)(1) , (4), substituted “work opportunity credit” for “targeted jobs credit” in heading and text.

Subsec. (b)(3)(C). Pub. L. 104–188, § 1204(d) , added subpar. (C).

Subsec. (c)(3)(B)(i). Pub. L. 104–188, § 1204(b) , reenacted heading without change and amended text generally. Prior to amendment, text read as follows: “The fixed-base percentage shall be determined under this subparagraph if there are fewer than 3 taxable years beginning after December 31, 1983 , and before January 1, 1989 , in which the taxpayer had both gross receipts and qualified research expenses. ”

Subsec. (c)(4) to (6). Pub. L. 104–188, § 1204(c) , added par. (4) and redesignated former pars. (4) and (5) as (5) and (6), respectively.

Subsec. (h). Pub. L. 104–188, § 1204(a) , reenacted heading without change and amended text generally. Prior to amendment, text read as follows:

“(1) In general .—This section shall not apply to any amount paid or incurred after June 30, 1995 .

“(2) Computation of base amount .—In the case of any taxable year which begins before July 1, 1995 , and ends after June 30, 1995 , the base amount with respect to such taxable year shall be the amount which bears the same ratio to the base amount for such year (determined without regard to this paragraph) as the number of days in such taxable year before July 1, 1995 , bears to the total number of days in such taxable year.”

1993—Subsec. (c)(3)(B)(ii). Pub. L. 103–66, § 13112(a) , amended heading and text of cl. (ii) generally. Prior to amendment, text read as follows: “In a case to which this subparagraph applies, the fixed-base percentage is 3 percent.”

Subsec. (c)(3)(B)(iii). Pub. L. 103–66, § 13112(b)(1) , substituted “clauses (i) and (ii)” for “clause (i)”.

Subsec. (c)(3)(D). Pub. L. 103–66, § 13112(b)(2) , substituted “subparagraphs (A) and (B)(ii)” for “subparagraph (A)”.

Subsec. (e)(5)(C). Pub. L. 103–66, § 13201(b)(3)(C) , substituted “1992” for “1989” in cls. (i) and (ii).

Subsec. (h). Pub. L. 103–66, § 13111(a)(1) , substituted “ June 30, 1995 ” for “ June 30, 1992 ” in pars. (1) and (2) and “ July 1, 1995 ” for “ July 1, 1992 ” in two places in par. (2).

1991—Subsec. (h). Pub. L. 102–227 substituted “ June 30, 1992 ” for “ December 31, 1991 ” in pars. (1) and (2), and “ July 1, 1992 ” for “ January 1, 1992 ” in two places in par. (2).

1990—Subsec. (e)(5)(C)(i). Pub. L. 101–508, § 11101(d)(1)(C)(i) , inserted before period at end “, by substituting ‘calendar year 1987’ for ‘calendar year 1989’ in subparagraph (B) thereof”.

Subsec. (e)(5)(C)(ii). Pub. L. 101–508, § 11101(d)(1)(C)(ii) , (iii), substituted “1989” for “1987” and inserted at end “Such substitution shall be in lieu of the substitution under clause (i).”

Subsec. (h). Pub. L. 101–508, § 11402(a) , substituted “ December 31, 1991 ” for “ December 31, 1990 ” wherever appearing and “ January 1, 1992 ” for “ January 1, 1991 ” wherever appearing.

1989—Subsec. (a)(1)(B). Pub. L. 101–239, § 7110(b)(2)(A) , amended subpar. (B) generally. Prior to amendment, subpar. (B) read as follows: “the base period research expenses, and”.

Subsec. (b)(4). Pub. L. 101–239, § 7110(b)[(c)] , added par. (4).

Subsec. (c). Pub. L. 101–239, § 7110(b)(1) , substituted “Base amount” for “Base period research expenses” in heading and amended text generally, substituting pars. (1) to (5) for former pars. (1) to (3) which defined “base period research expenses” and “base period” and prescribed minimum base period research expenses.

Subsec. (e)(7)(C)(ii). Pub. L. 101–239, § 7110(b)(2)(B) , substituted “base amount” for “base period research expenses”.

Subsec. (f)(1). Pub. L. 101–239, § 7110(b)(2)(C) , substituted “proportionate shares of the qualified research expenses and basic research payments” for “proportionate share of the increase in qualified research expenses” in subpars. (A)(ii) and (B)(ii).

Subsec. (f)(3)(A). Pub. L. 101–239, § 7110(b)(2)(D) , substituted “ December 31, 1983 ” for “ June 30, 1980 ” and inserted before period at end “, and the gross receipts of the taxpayer for such periods shall be increased by so much of the gross receipts of such predecessor with respect to the acquired trade or business as is attributable to such portion”.

Subsec. (f)(3)(B). Pub. L. 101–239, § 7110(b)(2)(E) , substituted “ December 31, 1983 ” for “ June 30, 1980 ” in introductory provisions and inserted before period at end “, and the gross receipts of the taxpayer for such periods shall be decreased by so much of the gross receipts as is attributable to such portion”.

Subsec. (f)(3)(C). Pub. L. 101–239, § 7110(b)(2)(F) , substituted “Certain reimbursements taken into account in determining fixed-base percentage” for “Increase in base period” in heading, “for the taxable years taken into account in computing the fixed-base percentage shall be increased by the lesser of” for “for the base period for such taxable year shall be increased by the lesser of” in introductory provisions, and new cls. (i) and (ii) for former cls. (i) and (ii) which read as follows:

“(i) the amount of the decrease under subparagraph (B) which is allocable to such base period , or

“(ii) the product of the number of years in the base period , multiplied by the amount of the reimbursement described in this subparagraph.”

Subsec. (f)(4). Pub. L. 101–239, § 7110(b)(2)(G) , inserted “and gross receipts” after “qualified research expenses” .

Subsec. (h). Pub. L. 101–239, § 7814(e)(2)(C) , redesignated subsec. (i) as (h) and struck out former subsec. (h) which related to election, time for election, and manner of election by taxpayer to have research credit not apply for a taxable year.

Subsec. (h)(1). Pub. L. 101–239, § 7110(a)(1)(A) , substituted “ December 31, 1990 ” for “ December 31, 1989 ”.

Subsec. (h)(2). Pub. L. 101–239, § 7110(a)(1) , substituted “ January 1, 1991 ” for “ January 1, 1990 ” in two places and substituted “ December 31, 1990 ” for “ December 31, 1989 ”.

Pub. L. 101–239, § 7110(b)(2)(H) , substituted “base amount” for “base period expenses” in heading and “the base amount with respect to such taxable year shall be the amount which bears the same ratio to the base amount for such year (determined without regard to this paragraph)” for “any amount for any base period with respect to such taxable year shall be the amount which bears the same ratio to such amount for such base period” in text.

Subsec. (i). Pub. L. 101–239, § 7814(e)(2)(C) , redesignated subsec. (i) as (h).

1988—Subsec. (g). Pub. L. 100–647, § 1002(h)(1) , inserted at end “If the amount determined under subsection (a) for any taxable year exceeds the limitation of the preceding sentence, such amount may be carried to other taxable years under the rules of section 39; except that the limitation of the preceding sentence shall be taken into account in lieu of the limitation of section 38(c) in applying section 39.”

Subsec. (h). Pub. L. 100–647, § 4008(b)(1) , added subsec. (h). Former subsec. (h) redesignated (i).

Subsec. (i). Pub. L. 100–647, § 4008(b)(1) , redesignated former subsec. (h) as (i).

Pub. L. 100–647, § 4007(a) , substituted “1989” and “1990” for “1988” and “1989”, respectively, wherever appearing in subsec. (h), prior to redesignation as subsec. (i) by Pub. L. 100–647, § 4008(b)(1) .

1986— Pub. L. 99–514, § 231(d)(2) , renumbered section 30 of this title as this section.

Subsec. (a). Pub. L. 99–514, § 231(c)(1) , amended subsec. (a) generally. Prior to amendment, subsec. (a) read as follows: “There shall be allowed as a credit against the tax imposed by this chapter for the taxable year an amount equal to 25 percent of the excess (if any) of—

“(1) the qualified research expenses for the taxable year, over

“(2) the base period research expenses.”

Subsec. (b)(2)(A)(iii). Pub. L. 99–514, § 231(e) , amended cl. (iii) generally. Prior to amendment, cl. (iii) read as follows: “any amount paid or incurred to another person for the right to use personal property in the conduct of qualified research. ”

Subsec. (b)(2)(D)(iii). Pub. L. 99–514, § 1847(b)(1) , substituted “targeted jobs credit” for “new jobs or WIN credit” in heading.

Subsec. (d). Pub. L. 99–514, § 231(b) , inserted “defined” in heading and amended text generally. Prior to amendment, text read as follows: “For purposes of this section the term ‘qualified research’ has the same meaning as the term research or experimental has under section 174, except that such term shall not include—

“(1) qualified research conducted outside the United States,

“(2) qualified research in the social sciences or humanities, and

“(3) qualified research to the extent funded by any grant, contract, or otherwise by another person (or any governmental entity).”

Subsec. (e). Pub. L. 99–514, § 231(c)(2) , amended subsec. (e) generally, substituting “Credit allowable with respect to certain payments to qualified organizations for basic research” for “Credit available with respect to certain basic research by colleges, universities, and certain research organizations” in heading, and restating and expanding provisions of former pars. (1) to (4) into new pars. (1) to (7).

Subsec. (g). Pub. L. 99–514, § 231(d)(3)(C)(ii) , amended subsec. (g) generally, substituting provisions relating to special rule for pass-thru of credit for provisions relating to limitation on amount of credit for research based on amount of tax liability.

Subsec. (h). Pub. L. 99–514, § 231(a)(1) , added subsec. (h).

1984— Pub. L. 98–369, § 471(c) , renumbered section 44F of this title as this section.

Subsec. (b)(2)(D)(iii). Pub. L. 98–369, § 474(i)(1)(A) , substituted “in determining the targeted jobs credit under section 51(a)” for “in computing the credit under section 40 or 44B”.

Subsec. (g)(1)(A). Pub. L. 98–369, § 612(e)(1) , substituted “section 26(b)” for “section 25(b)”.

Pub. L. 98–369, § 474(i)(1)(B) , amended subpar. (A) generally, substituting “shall not exceed the taxpayer’s tax liability for the taxable year (as defined in section 25(b)), reduced by the sum of the credits allowable under subpart A and sections 27, 28, and 29” for “shall not exceed the amount of the tax imposed by this chapter reduced by the sum of the credits allowable under a section of this part having a lower number or letter designation than this section, other than the credits allowable by sections 31, 39, and 43. For purposes of the preceding sentence, the term ‘tax imposed by this chapter’ shall not include any tax treated as not imposed by this chapter under the last sentence of section 53(a)”.

1983—Subsec. (b)(2)(A). Pub. L. 97–448 inserted provision that cl. (iii) would not apply to any amount to the extent that the taxpayer (or any person with whom the taxpayer must aggregate expenditures under subsection (f)(1)) received or accrued any amount from any other person for the right to use substantially identical personal property.

1982—Subsec. (f)(2)(A). Pub. L. 97–354, § 5(a)(3)(A) , substituted “Pass-thru in the case of estates and trusts” for “Pass-through in the case of subchapter S corporations, etc.” in subpar. heading, and substituted provisions relating to the applicability of rules similar to rules of subsec. (d) of section 52 for provisions relating to the applicability of rules similar to rules of subsecs. (d) and (e) of section 52.

Subsec. (g)(1)(B)(iv). Pub. L. 97–354, § 5(a)(3)(B) , substituted “an S corporation” for “an electing small business corporation (within the meaning of section 1371(b))”.

Pub. L. 117–169, title I, § 13902(d) , Aug. 16, 2022 , 136 Stat. 2014 , provided that:

Amendment by section 101(c) of Pub. L. 115–141 effective as if included in the provision of the Protecting Americans from Tax Hikes Act of 2015, div. Q of Pub. L. 114–113 , to which such amendment relates, see section 101(s) of Pub. L. 115–141 , set out as a note under section 24 of this title .

Amendment by section 11002(d)(1)(F), (2) of Pub. L. 115–97 applicable to taxable years beginning after Dec. 31, 2017 , see section 11002(e) of Pub. L. 115–97 , set out as a note under section 1 of this title .

Pub. L. 115–97, title I, § 13206(e) , Dec. 22, 2017 , 131 Stat. 2113 , provided that:

Amendment by section 121(a)(1) of Pub. L. 114–113 applicable to amounts paid or incurred after Dec. 31, 2014 , see section 121(d)(1) of Pub. L. 114–113 , set out as a note under section 38 of this title .

Amendment by section 121(c)(1) of Pub. L. 114–113 applicable to taxable years beginning after Dec. 31, 2015 , see section 121(d)(3) of Pub. L. 114–113 , set out as a note under section 38 of this title .

Pub. L. 113–295, div. A, title I, § 111(c) , Dec. 19, 2014 , 128 Stat. 4014 , provided that:

Pub. L. 112–240, title III, § 301(d) , Jan. 2, 2013 , 126 Stat. 2328 , provided that:

Pub. L. 111–312, title VII, § 731(c) , Dec. 17, 2010 , 124 Stat. 3317 , provided that:

Pub. L. 110–343, div. C, title III, § 301(e) , Oct. 3, 2008 , 122 Stat. 3866 , provided that:

Amendment by section 6(c) of Pub. L. 110–172 effective as if included in the provisions of the Energy Policy Act of 2005 , Pub. L. 109–58 , to which such amendment relates, see section 6(e) of Pub. L. 110–172 , set out as a note under section 30C of this title .

Pub. L. 110–172, § 11(e)(3) , Dec. 29, 2007 , 121 Stat. 2489 , provided that:

Pub. L. 109–432, div. A, title I, § 104(a)(3) , Dec. 20, 2006 , 120 Stat. 2934 , provided that:

Pub. L. 109–432, div. A, title I, § 104(b)(2) , (3), Dec. 20, 2006 , 120 Stat. 2934 , provided that:

Pub. L. 109–432, div. A, title I, § 104(c)(2) –(4), Dec. 20, 2006 , 120 Stat. 2935 , provided that:

Amendment by Pub. L. 109–135 effective as if included in the provision of the Energy Policy Act of 2005 , Pub. L. 109–58 , to which such amendment relates, see section 402(m)(1) of Pub. L. 109–135 , set out as an Effective and Termination Dates of 2005 Amendments note under section 23 of this title .

Pub. L. 109–58, title XIII, § 1351(c) , Aug. 8, 2005 , 119 Stat. 1058 , provided that:

Pub. L. 108–311, title III, § 301(b) , Oct. 4, 2004 , 118 Stat. 1178 , provided that:

Pub. L. 106–170, title V, § 502(a)(3) , Dec. 17, 1999 , 113 Stat. 1919 , provided that:

Pub. L. 106–170, title V, § 502(b)(2) , Dec. 17, 1999 , 113 Stat. 1919 , provided that:

Pub. L. 106–170, title V, § 502(c)(3) , Dec. 17, 1999 , 113 Stat. 1920 , provided that:

Pub. L. 105–277, div. J, title I, § 1001(c) , Oct. 21, 1998 , 112 Stat. 2681–888 , provided that:

Pub. L. 105–34, title VI, § 601(c) , Aug. 5, 1997 , 111 Stat. 862 , provided that:

Amendment by section 1201(e)(1), (4) of Pub. L. 104–188 applicable to individuals who begin work for the employer after Sept. 30, 1996 , see section 1201(g) of Pub. L. 104–188 , set out as a note under section 38 of this title .

Pub. L. 104–188, title I, § 1204(f) , Aug. 20, 1996 , 110 Stat. 1775 , provided that:

Amendment by section 13111(a)(1) of Pub. L. 103–66 applicable to taxable years ending after June 30, 1992 , see section 13111(c) of Pub. L. 103–66 , set out as a note under section 45C of this title .

Pub. L. 103–66, title XIII, § 13112(c) , Aug. 10, 1993 , 107 Stat. 422 , provided that:

Amendment by section 13201(b)(3)(C) of Pub. L. 103–66 applicable to taxable years beginning after Dec. 31, 1992 , see section 13201(c) of Pub. L. 103–66 , set out as a note under section 1 of this title .

Amendment by Pub. L. 102–227 applicable to taxable years ending after Dec. 31, 1991 , see section 102(c) of Pub. L. 102–227 , set out as a note under section 45C of this title .

Amendment by section 11101(d)(1)(C) of Pub. L. 101–508 applicable to taxable years beginning after Dec. 31, 1990 , see section 11101(e) of Pub. L. 101–508 , set out as a note under section 1 of this title .

Amendment by section 11402(a) of Pub. L. 101–508 applicable to taxable years beginning after Dec. 31, 1989 , see section 11402(c) of Pub. L. 101–508 , set out as a note under section 45C of this title .

Pub. L. 101–239, title VII, § 7110(e) , Dec. 19, 1989 , 103 Stat. 2326 , provided that:

Amendment by section 7814(e)(2)(C) of Pub. L. 101–239 effective, except as otherwise provided, as if included in the provision of the Technical and Miscellaneous Revenue Act of 1988 , Pub. L. 100–647 , to which such amendment relates, see section 7817 of Pub. L. 101–239 , set out as a note under section 1 of this title .

Amendment by section 1002(h)(1) of Pub. L. 100–647 effective, except as otherwise provided, as if included in the provision of the Tax Reform Act of 1986 , Pub. L. 99–514 , to which such amendment relates, see section 1019(a) of Pub. L. 100–647 , set out as a note under section 1 of this title .

Pub. L. 100–647, title IV, § 4008(d) , Nov. 10, 1988 , 102 Stat. 3653 , provided that:

Pub. L. 99–514, title II, § 231(g) , Oct. 22, 1986 , 100 Stat. 2180 , provided that:

Amendment by section 1847(b)(1) of Pub. L. 99–514 effective, except as otherwise provided, as if included in the provisions of the Tax Reform Act of 1984 , Pub. L. 98–369, div. A , to which such amendment relates, see section 1881 of Pub. L. 99–514 , set out as a note under section 48 of this title .

Amendment by section 474(i)(1) of Pub. L. 98–369 applicable to taxable years beginning after Dec. 31, 1983 , and to carrybacks from such years, see section 475(a) of Pub. L. 98–369 , set out as a note under section 21 of this title .

Amendment by section 612(e)(1) of Pub. L. 98–369 applicable to interest paid or accrued after Dec. 31, 1984 , on indebtedness incurred after Dec. 31, 1984 , see section 612(g) of Pub. L. 98–369 , set out as an Effective Date note under section 25 of this title .

Pub. L. 97–448, title I, § 102(h)(2) , Jan. 12, 1983 , 96 Stat. 2372 , provided that the amendment made by that section is effective only with respect to amounts paid or incurred after March 31, 1982 .

Amendment by Pub. L. 97–354 applicable to taxable years beginning after Dec. 31, 1982 , see section 6(a) of Pub. L. 97–354 , set out as an Effective Date note under section 1361 of this title .

Pub. L. 97–34, title II, § 221(d) , Aug. 13, 1981 , 95 Stat. 241 , as amended by Pub. L. 99–514, § 2 , title II, § 231(a)(2), Oct. 22, 1986 , 100 Stat. 2095 , 2173, provided that:

For provisions that nothing in amendment by section 401(b)(6) of Pub. L. 115–141 be construed to affect treatment of certain transactions occurring, property acquired, or items of income, loss, deduction, or credit taken into account prior to Mar. 23, 2018 , for purposes of determining liability for tax for periods ending after Mar. 23, 2018 , see section 401(e) of Pub. L. 115–141 , set out as a note under section 23 of this title .

Pub. L. 109–432, div. A, title I, § 123 , Dec. 20, 2006 , 120 Stat. 2944 , provided that:

Pub. L. 106–170, title V, § 502(d) , Dec. 17, 1999 , 113 Stat. 1920 , provided that:

Pub. L. 101–239, title VII, § 7110(a)(2) , Dec. 19, 1989 , 103 Stat. 2323 , which set forth the method of determining the amount treated as qualified research expenses for taxable years beginning before Oct. 1, 1990 , and ending after Sept. 30, 1990 , was repealed by Pub. L. 101–508, title XI, § 11402(b)(1) , Nov. 5, 1990 , 104 Stat. 1388–473 .

[ Pub. L. 104–188, title I, § 1702(d)(1) , Aug. 20, 1996 , 110 Stat. 1870 , provided that:

Pub. L. 100–647, title IV, § 4007(b) , Nov. 10, 1988 , 102 Stat. 3652 , directed Comptroller General of United States to conduct a study of credit provided by 26 U.S.C. 41 and submit a report of the study not later than Dec. 31, 1989 , to Committee on Ways and Means of House of Representatives and Committee on Finance of Senate .

For provisions directing that if any amendments made by subtitle A or subtitle C of title XI [§§  1101–1147 and 1171–1177 ] or title XVIII [§§ 1800–1899A] of Pub. L. 99–514 require an amendment to any plan, such plan amendment shall not be required to be made before the first plan year beginning on or after Jan. 1, 1989 , see section 1140 of Pub. L. 99–514 , as amended, set out as a note under section 401 of this title .

Pub. L. 98–369, div. A, title IV, § 474(i)(2) , July 18, 1984 , 98 Stat. 832 , provided that:

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• CREDITS AGAINST TAX

The research credit: Documenting qualified services

• C Corporation Income Taxation

Editor: Alexander J. Brosseau, CPA

A recent Tax Court case illustrates the importance of documenting and substantiating employee wages that are being included in the research credit under Sec. 41. In  Moore,  T.C. Memo. 2023-20, the IRS challenged an S corporation’s substantiation of qualified time performed by the company’s president and COO. This item discusses guidance regarding qualified services, observations from  Moore  and other case law, other recent developments, and considerations that taxpayers may need to make when claiming and defending research credits.

Code and regulations

Sec. 41 allows taxpayers to claim a research credit on the incremental amount of qualified research expenditures (QREs) that they pay or incur during a tax year. QREs include inhouse research expenses, such as wages, supplies, and computer rental costs, as well as contract research expenses. In many instances, the largest portion of QREs claimed by a taxpayer relate to wages for individuals performing qualified services. Sec. 41(b)(2)(B) defines qualified services as “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.”

Regs. Sec. 1.41-2(c) further defines engaging in qualified research as “the actual conduct of qualified research (as in the case of a scientist conducting laboratory experiments).” In addition, “direct supervision” is defined as “immediate supervision” but excludes supervision by a higher-level manager to whom first-line managers report, even if the manager is a qualified research scientist. Lastly, “direct support” is defined as either conducting actual qualified research or directly supervising the actual conduct of qualified research.

The regulations provide examples of what does and does not constitute direct support; for example, “general administrative services, or other services only indirectly of benefit to research activities” do not qualify as direct support. It appears that the IRS has been successful in recent cases in contesting taxpayers’ application of direct support. As with other tax issues, taxpayers bear the burden of proof, and in cases where taxpayers are not able to provide proof regarding the direct support or direct supervision of qualified research, the IRS has been prevailing on these issues.

Additionally, Regs. Sec. 1.41-2(d)(2) provides the “substantially all” test, which states that “if substantially all of the services performed by an employee for the taxpayer during the taxable year consist of services meeting the requirements of [Sec.] 41(b)(2)(B)(i) or (ii), then the term ‘qualified services’ means all of the services performed by the employee for the taxpayer during the taxable year.” Under this provision, if at least 80% of an employee’s activity was for qualified research or direct supervision or direct support of qualified research, then all the employee’s wages are eligible as QREs.

Moore and substantiating engagement in qualified research

In  Moore,  the IRS challenged the taxpayer’s substantiation of qualified time regarding the company’s president and COO, identified in the Tax Court’s opinion only as “Mr. Robert.” Court documents showed Robert devoted much of his attention to new product development. This was supported by the fact that Robert was an engineer by trade and left most administrative aspects of his job to other executive leaders. The opinion describes Robert’s participation in four sample projects for which he defined and specified requirements for new and improved products and developed them with the company’s engineers.

Despite Robert’s testimony at trial that the court considered corroborated by others, detailing his roles and responsibilities, the court ultimately disallowed the inclusion of a portion of his wages and time in computing the taxpayer’s QREs, based on two key points: First, the record provided “no estimates of the amount of time Mr. Robert spent on qualified research as distinguished from the broader category of new product development.” For example, the court noted that specifying and developing requirements for a product is not qualified research, yet the amounts were included within the represented time. The court had no means to segregate that time from that of other, potentially qualifying activities. Second, the court reasoned Robert’s time could not be captured under the “supervisory” definition, as Robert was not the engineers’ first-line manager. Additionally, the court ruled that Robert did not provide direct support as that term is defined in the regulations.

Ultimately, the  Moore  case is a reminder to taxpayers that, although time estimates may be used when determining the portion of an employee’s wages to be treated as QREs, those estimates should be carefully tied to specific qualified (and nonqualified) activities. Taxpayers may also need to consider documenting wage QREs for each category of qualified services.

Other case law

Time spent on qualified services:  A foundational case when it comes to the substantiation of time allocations is  Fudim,  T.C. Memo. 1994-235, which revolved around the substantiation of qualified time claimed by Efrem and Margarita Fudim and their daughter, Natalie. Mr. and Mrs. Fudim were heavily involved in the development of new rapid modeling processes using ultraviolet light and light-sensitive liquid polymers to fabricate plastic objects. Court documents showed that both Mr. and Mrs. Fudim had an extensive technical background in the field. With no time-tracking systems used by the company, the Fudims estimated they spent at least 80% of their time engaging in qualified services.

Despite the couple’s lack of formal time tracking or documentation regarding time spent, the court applied the  Cohan  rule ( Cohan,  39 F.2d 540 (2d Cir. 1930)), under which the court agreed with the time allocations claimed by the Fudims. The court based its decision on the corroborating evidence presented at trial, including employee testimony, scientific articles Mr. Fudim had published, and patents he had filed, as well as both spouses’ technical backgrounds. However, the court removed the time of their daughter, for whom no contemporaneous documentation was provided to support the allocation. This case illustrates that companies without time-tracking systems or other timekeeping records can use estimates of time to compute research credits; however, those estimates must be supported through corroborating evidence.

Process of experimentation and “substantially all” test:  In  Little Sandy Coal Co.,  T.C. Memo. 2021-15, aff ’d, 62 F.4th 287 (7th Cir. 2023), the IRS challenged whether the taxpayer’s shipbuilding activities were qualified research activities. The majority of the substantiation the taxpayer provided was oral testimony; the Tax Court found this mostly lacking. For example, the taxpayer provided estimated wage expenses that were not based on specific projects. Although the taxpayer could identify the individuals contributing to the estimated wages, i.e., engineers and managers of the company’s subsidiary, Corn Island Shipyard Inc. (CIS), the oral testimony merely indicated that they contributed to the wage research expenses instead of describing the specific activities that the wages were related to.

Some of the oral testimony was intended to support the taxpayer’s assertion that its ship design activities constituted a process of experimentation as defined in Sec. 41(d)(3)(A), such as the statement by Brian Varner, CIS’s engineering technician: “We have to feel pretty comfortable with a design before we start cutting steel. Any repairs or modifications become very costly very quickly.” Varner’s statement was confirmed by the IRS’s expert’s report, which also concluded that the uncertainty of the appropriate design was basically resolved prior to assembly.

However, the Tax Court held, and the Seventh Circuit ultimately agreed (although disagreeing with some aspects of the Tax Court’s reasoning), that the taxpayer did not substantiate that substantially all of the claimed activities constituted elements of a process of experimentation. Uncertainty with respect to some of the claimed activities, such as determining the appropriate design of a new dry dock model, was not resolved until the design was finally tested and thus not eliminated by experimentation, the Tax Court stated. The Seventh Circuit agreed, stating that in developing the dry dock, the taxpayer “did not document whether hypotheses and alternatives were tested and refined in a scientific manner.”

With respect to the use of estimates, the Seventh Circuit stated, “Only after a taxpayer establishes that qualified research has occurred under Section 41(d) may we estimate, if needed, the amount of qualified research expenses under Section 41(b).”

A takeaway from  Little Sandy Coal  is that oral testimony alone is insufficient to substantiate that substantially all of the activities constitute elements of a process of experimentation for qualified research activities, especially when a taxpayer’s research credit claim relies on estimates.

In  Betz,  T.C. Memo. 2023-84, the Tax Court reached varying conclusions of whether the taxpayer had substantiated qualified research in each of a sampling of projects. The court echoed other cases by stating that the  Cohan  rule will not apply to estimating wages paid or incurred if the taxpayer fails to make a threshold showing that a particular employee performed activities that constituted qualified services with respect to a business component. Further, the Tax Court clarified that the Seventh Circuit in  Little Sandy Coal  addressed the substantiation burden that taxpayers claiming the research credit bear and determined that shortcut estimates of experimentation that rely merely on trial testimony that basically asks courts to “take on faith” their allocations are insufficient without further documentation to support the testimony.

For example, in  Betz,  the taxpayer failed to substantiate technical uncertainty through an employee’s testimony that the final design of components as a whole in a proposal delivered to a customer were “significantly different” than the initial design. Therefore, the majority of the uncertainty had been resolved prior to incurring or paying the subsequent wages.

In contrast, a project related to the design of an oxidizer was concluded to establish that uncertainty existed regarding the design of a gas train component, based on email correspondence that fleshed out the specifications and alternatives related to the uncertainty. However, the Tax Court went on to state that allocating a  de minimis  estimated amount of wages to the email activity, pursuant to the  Cohan  rule, would be futile because the activities were not part of a structured process of experimentation.

A key lesson learned from  Betz  is that trial testimony is not only insufficient to substantiate qualified research activity without further contemporaneous documentation, but it is also insufficient to dispute contrary evidence in contemporaneous documentation, such as a final proposal delivered to customers or clients. The court stated several times that a contract supporting the trial testimony would have sufficed to substantiate the taxpayer’s testimony.

In  Suder,  T.C. Memo. 2014-201, the IRS challenged the taxpayer’s substantiation of qualified research expenditures, particularly wages, to compute the research credit. Allocations of qualified time were estimated by the company’s senior vice president of product operations, Harvey Wende. The IRS challenged Wende’s prepared time allocations, arguing he lacked the tax or accounting educational background to make reliable estimates. The court disagreed, citing Wende’s knowledge on the subject, having worked with a research credit consulting firm previously to claim the company’s research credit. Additionally, the court placed heavy emphasis on Wende’s credible testimony regarding the roles and responsibilities of the qualified individuals.

Suder  demonstrates that time estimates can and should be employed in instances where time-tracking data does not exist, so long as those estimates are made by individuals who have the institutional knowledge and the educational background to reliably make them and other documentary evidence exists in the record. It is also important to note that the court did not challenge Wende’s practice of first leveraging the prior-year R&D percentage as a starting point, then considering whether the employee’s role had changed since the prior year, as well as allocating small percentages of time to employees outside product development (i.e., quality assurance or shipping and handling) to the extent they assisted product development. This point supports the notion that it is the individual’s yearly activities, not their job title, that should be assessed when determining qualification.

In  Shami,  T.C. Memo. 2012-78, the IRS challenged the taxpayer’s substantiation of wage qualified research expenditures for the company’s CEO and a vice president. Similar to the other cases discussed here, the company used estimates of time to compute qualified wage spending. However, unlike in  Suder,  the employee testimony presented in the case was inadequate, as several witnesses contradicted each other when discussing the engagement of the CEO and vice president in qualified research activities. Additionally, neither executive had any sort of training or extensive technical background in science or engineering. Despite these facts, the taxpayer argued the court was bound to apply the  Cohan  rule and estimate the amount of time the executives engaged in qualified research. However, with noncredible and conflicting testimony, along with no other corroborating evidence, the court disagreed, citing the lack of evidence established to make the estimate.

The  Shami  case is an important reminder that, although estimates can be used, there must be some level of contemporaneous documentation and credible corroborating testimony with which the court can make the estimate. Courts are not bound to apply the Cohan rule in instances where sufficient evidence is not produced.

Other recent developments

On Sept. 15, 2023, the IRS issued a news release ( IR-2023-173 ) requesting feedback on a preview of proposed changes to Form 6765,  Credit for Increasing Research Activities,  for the 2024 tax year. The proposed Form 6765 included several new reporting requirements for taxpayers to claim the research credit. One of these proposed requirements is for taxpayers to show, for each business component, the breakout of wage QREs to qualified research, direct support of qualified research, and direct supervision of qualified research. The inclusion of this reporting requirement illustrates the IRS’s continued focus on substantiation of qualified services.

On Sept. 29, 2023, Treasury and the IRS issued their  2023–2024 Priority Guidance Plan , which contains a list of projects that they will prioritize from July 1, 2023, through June 30, 2024. The second priority under the General Tax Issues section of the Priority Guidance Plan is the need for regulations under Sec. 41 that address research credit substantiation. Taxpayers should be aware that research credit substantiation continues to be a priority for Treasury and the IRS and that further guidance may be issued.

Readiness to adapt

Given that the burden of proof is on the taxpayer to substantiate research credit claims, it would be prudent for taxpayers to consider recent events and case law when evaluating their methodology for determining and documenting qualified services. This may include analyzing how employee time and expenditures are captured and tied to the appropriate categories of qualified services and business components and, in particular, what documentation supports that substantially all of the activities are a process of experimentation. This may better position taxpayers to implement any potential changes in reporting requirements and technical guidance that may be on the horizon.

Editor Notes

Alexander J. Brosseau , CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office. For additional information about these items, contact Brosseau at [email protected] . Unless otherwise noted, contributors are associated with Deloitte Tax LLP.

This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte shall not be responsible for any loss sustained by any person who relies on this article.

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R&D Tax Credits: Section 41 Overview and New Refund Claim Requirements

By Kerrie Howes, J.D.

July 20, 2022

The Research and Development (R&D) tax credi t is a powerful federal tax savings opportunity available to those conducting qualified research activities. Many businesses do not consider the credit because of the various misconceptions about what specific activities may qualify. In fact, qualified research activities may include a broader spectrum of activities than most think. Getting a tax refund for work that is already being done might seem like it’s too easy, and while the process of getting the refund has changed, qualifying is more accessible than many might believe. The IRC Section 41 research tax credit is designed to reward taxpayers who create, experiment, improve, and innovate, in whatever form and in whatever business or industry where that process happens. Despite the broad application, there are important eligibility, calculation, expense tracking, and documentation requirements that must be followed. In addition, recently released IRS guidance has added an additional layer of complexity. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.

About IRC Section 41

The Section 41 research tax credit is permanent, thanks to a 2015 legislative change. It’s a generous tax incentive for any type of business that engages in qualified research activities, which must meet the four-part test.

An activity satisfies the test criteria if the following conditions are met;

• Permitted Purpose – The purpose of the research must be towards the creation of a new or improved product, process, technique, invention, software, or formulation (or “business component”) resulting in increased performance, quality, or reliability. Concurrently, research activities undertaken for aesthetic reasons (style taste, cosmetics) are not eligible. It is important to note that success in a project is not necessary to meet this criterion.
• Uncertainty – The research must eliminate uncertainty about the capability, design, or method related to the development of a new/improved product, process, or component. Since regulations do not require that the taxpayer be successful in eliminating the uncertainty, proof of resolution is not required to meet this test. Concurrently, it can be demonstrated uncertainty existed if the information available to the taxpayer did not establish the method for developing an improved business component. Finally, it is important to remember the Patent Safe Harbor rule, which states the issuance of a patent means information that is technological in nature, and the elimination of uncertainty relating to a new business component has occurred.
• Technological in Nature – Essentially this requires that the process of experimentation was founded in, or fundamentally relies on, hard science principles. Examples include those found in engineering, physics, chemistry, biology, or computer science.
• Process of Experimentation – Requires that uncertainty must be eliminated through a process of experimentation which may include an iterative process, trial, and error, use of the scientific method, simulation, modeling, or any approach that involved the analysis of alternatives. The process is not required to be completely academic, but documentation on the alternatives considered, testing methodology, and results, must be performed and documented to satisfy this requirement.

Important Exceptions

It is important to note there are situations when a business passes the 4-part test but may still not be eligible.  This includes research conducted after commercial production has started, adaption or duplication of an existing business component, surveys focused on market research, foreign research, and funded research. Practical examples include market research, efficiency studies, management functions, routine data collection, or standardized quality control testing or inspection.

The most common stumbling blocks encountered by businesses include the exception for foreign research or funded research. The former requires evidence that research took place in the U.S. The latter requires the taxpayer to illustrate that payments made as part of a contract were not dependent on any outcome, and substantial rights to the research must be retained.

Eligible Expenses

There is often confusion about which project expenses qualify as part of an R&D tax credit claim. Typically, a business can claim the expenses related to wages, supplies, and certain third-party research expenses.

Wage Expenses

The wages paid to employees participating in or directly supporting/supervising R&D activities can be claimed. This means employers can capture a portion of the (W-2 Box 1) wages for the time spent on qualifying activities. There are a few important points to keep in mind:

• If 80% or more of an employee’s time is deemed qualified, then substantially all test is met.
• Rigid time tracking is not required as estimates are permitted but must be made on a reasonable basis.
• Reasonableness may be demonstrated in many ways including oral testimony, written summaries from an individual involved in the project, or contemporaneous documentation.

Supply Expenses

The supplies used in qualified research not related to land or other depreciable assets can often be claimed. When demonstrating that supply expenses are not depreciable in nature it may be necessary to show that it is not attached to the land, not owned by the taxpayer, and has a useful life of less than one year.

The opportunity to claim partial supply expenses is also available. This occurs when a portion of the costs, but not the entire expense, meets established requirements, the taxpayer is permitted to remove the portion inJUeligible for the credit. For example, a portion of the supplies associated with a product or machine, such as a casing that has been made before, but the integral components are configured in a new way. The taxpayer would be able to identify the portions which are new and claim it as an eligible supply expense.

Third-Party Expenses

There are certain third-party expenses that can also be claimed. For example, tasks completed by a contractor would qualify if conducted by an employee, and activities directly supporting the research would qualify. Concurrently, the taxpayer will be required to prove the research is not funded (and therefore excluded). It is necessary to show evidence that payment was not contingent on the results or outcomes of activities performed and substantial rights to the research and results have been retained. It is important to note that in most cases a taxpayer will be able to claim 65% of the cost of an eligible expense.

Documentation is key. Taxpayers need to keep track of research expenditures, such as payroll records, vendor invoices, and job costing or general ledgers. It is also important to track research activities, including project lists, documentation, contracts, and notes. A rule of thumb is to keep track of all expenses associated with a project as they happen and remove non-qualifying expenses later. This helps to ensure that everything is properly recorded.

Calculating the Research Tax Credit

There are two different calculations available to compute the R&D tax credit, the regular and alternative simplified methods. The regular method uses historical data to compute a base amount. Under this method, the R&D credit for a given year is then 20 percent of the tax year’s qualified research expenses over that base amount. The alternative simplified calculation uses the prior three years as the basis for comparison to current year expenditures.

Section 41 R&D credits can be carried back one year and forward up to 20 years.

New Section 41 Refund Requirements

Starting in 2022, taxpayers claiming a refund for eligible research expenses have a new process to follow. The IRS is requiring five pieces of essential information, which must be submitted along with the tax return.

The essential information consists of:

• Identifying all the business components for which a claim is being made.
• For each business component, identifying all research activities performed
• Name the individuals who performed each research activity.
• List the information that each person sought to discover.
• Provide total qualified expenses for employee wages, supplies, and any third-party contracts.

When deciding which research activities need to be listed, taxpayers should describe what was done and how, by business component. The four-part test doesn’t need to be described in detail and in fact simply restating the language of the four-part test wouldn’t be enough anyway.

Naming the people involved and what information they were looking for can be done in a list, table, or narrative form. Again, by business component. If a group of employees sought to discover the same information for a business component, all the employees can be listed as one group or using job titles/positions. If there is more than one person with the same job title or position in this case, taxpayers would need to indicate how many people hold that position.

Providing total expenses can be completed using Form 6765 , Credit for Increasing Research Activities.

One of the biggest takeaways from updated IRS guidance about filing a refund claim is that a formal report isn’t necessary. Taxpayers can largely choose the format they want to best present the required information. When formal reports are used, the taxpayer will need to specify which page(s) the above essential information is on.

During the first year of the new requirements, taxpayers are allowed to correct deficient refund claims. If a refund claim is deficient, the IRS will notify the taxpayer in writing, along with which piece of essential information is missing or otherwise incorrect. From there, the taxpayer will have 45 days to correct the issue, otherwise, the claim will be rejected. After January 2023, deficient refund claims will simply be denied without an opportunity to appeal.

Therefore, it’s imperative now during the transition year for taxpayers to understand how to meet the new refund requirements and provide the necessary documentation to receive the credit.

We’re here to help

The R&D tax credit is a compelling tax savings tool that should not be overlooked. Although some of the regulations have recently changed, businesses should not be discouraged from investigating the credit. If you have questions about the information outlined above or need assistance with an R&D credit claim, JLK Rosenberger can help. For additional information call us at 949-860-9208 or click here to contact us . We look forward to speaking with you soon.

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• Subchapter A

Sec. 41. Credit For Increasing Research Activities

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Sec. 41 Credit for increasing research activities

26 U.S.C. section 41, Credit for increasing research activities. IRC section 41 provides an incremental tax credit to encourage taxpayers to increase their research spending beyond the level that they would spend if there were no tax incentive. The credit is allowed for an increase in “qualified research expenses” over the “base amount.” Three categories of expenses qualify for the credit: wages, supplies, and contract research. Qualified research activities must meet a four-part test: elimination of uncertainty, process of experimentation, technological in nature, and qualified purpose. Section 41 provides a list of activities that don’t qualify for the credit.

• Internal Revenue Code of 1986
• SUBTITLE A -- INCOME TAXES
• Chapter 1 -- Normal Taxes and Surtaxes
• Subchapter A -- Determination of Tax Liability
• Part IV -- Credits against tax
• Subpart D -- Business related credits

(a) General rule. For purposes of section 38 , the research credit determined under this section for the taxable year shall be an amount equal to the sum of--

(1) 20 percent of the excess (if any) of--

(A) the qualified research expenses for the taxable year, over

(B) the base amount,

(2) 20 percent of the basic research payments determined under subsection (e)(1)(A), and

(3) 20 percent of the amounts paid or incurred by the taxpayer in carrying on any trade or business of the taxpayer during the taxable year (including as contributions) to an energy research consortium for energy research.

(b) Qualified research expenses. For purposes of this section--

(1) Qualified research expenses. The term "qualified research expenses" means the sum of the following amounts which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer--

(A) in-house research expenses, and

(B) contract research expenses.

(2) In-house research expenses.

(A) In general. The term "in-house research expenses" means--

(i) any wages paid or incurred to an employee for qualified services performed by such employee,

(ii) any amount paid or incurred for supplies used in the conduct of qualified research, and

(iii) under regulations prescribed by the Secretary, any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.

Clause (iii) shall not apply to any amount to the extent that the taxpayer (or any person with whom the taxpayer must aggregate expenditures under subsection (f)(1)) receives or accrues any amount from any other person for the right to use substantially identical personal property.

(B) Qualified services. The term "qualified services" means services consisting of--

(i) engaging in qualified research, or

(ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.

If substantially all of the services performed by an individual for the taxpayer during the taxable year consists of services meeting the requirements of clause (i) or (ii), the term "qualified services" means all of the services performed by such individual for the taxpayer during the taxable year.

(C) Supplies. The term "supplies" means any tangible property other than--

(i) land or improvements to land, and

(ii) property of a character subject to the allowance for depreciation.

(i) In general. The term "wages" has the meaning given such term by section 3401(a) .

(ii) Self-employed individuals and owner-employees. In the case of an employee (within the meaning of section 401(c)(1) ), the term "wages" includes the earned income (as defined in section 401(c)(2) ) of such employee.

(iii) Exclusion for wages to which work opportunity credit applies. The term "wages" shall not include any amount taken into account in determining the work opportunity credit under section 51(a) .

(3) Contract research expenses.

(A) In general. The term "contract research expenses" means 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.

(B) Prepaid amounts. If any contract research expenses paid or incurred during any taxable year are attributable to qualified research to be conducted after the close of such taxable year, such amount shall be treated as paid or incurred during the period during which the qualified research is conducted.

(C) Amounts paid to certain research consortia.

(i) In general. Subparagraph (A) shall be applied by substituting "75 percent" for "65 percent" with respect to amounts paid or incurred by the taxpayer to a qualified research consortium for qualified research on behalf of the taxpayer and 1 or more unrelated taxpayers. For purposes of the preceding sentence, all persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as related taxpayers.

(ii) Qualified research consortium. The term "qualified research consortium" means any organization which--

(I) is described in section 501(c)(3) or 501(c)(6) and is exempt from tax under section 501(a) ,

(II) is organized and operated primarily to conduct scientific research, and

(III) is not a private foundation.

(D) Amounts paid to eligible small businesses, universities, and Federal laboratories.

(i) In general. In the case of amounts paid by the taxpayer to--

(I) an eligible small business,

(II) an institution of higher education (as defined in section 3304(f) ), or

(III) an organization which is a Federal laboratory,

for qualified research which is energy research, subparagraph (A) shall be applied by substituting "100 percent" for "65 percent".

(ii) Eligible small business. For purposes of this subparagraph, the term "eligible small business" means a small business with respect to which the taxpayer does not own (within the meaning of section 318 ) 50 percent or more of--

(I) in the case of a corporation, the outstanding stock of the corporation (either by vote or value), and

(II) in the case of a small business which is not a corporation, the capital and profits interests of the small business.

(iii) Small business. For purposes of this subparagraph--

(I) In general. The term "small business" means, with respect to any calendar year, any person if the annual average number of employees employed by such person during either of the 2 preceding calendar years was 500 or fewer. For purposes of the preceding sentence, a preceding calendar year may be taken into account only if the person was in existence throughout the year.

(II) Startups, controlled groups, and predecessors. Rules similar to the rules of subparagraphs (B) and (D) of section 220(c)(4) shall apply for purposes of this clause.

(iv) Federal laboratory. For purposes of this subparagraph, the term "Federal laboratory" has the meaning given such term by section 4(6) of the Stevenson-Wydler Technology Innovation Act of 1980 (15 U.S.C. 3703(6)), as in effect on the date of the enactment of the Energy Tax Incentives Act of 2005.

(4) Trade or business requirement disregarded for in-house research expenses of certain startup ventures. In the case of in-house research expenses, a taxpayer shall be treated as meeting the trade or business requirement of paragraph (1) if, at the time such in-house research expenses are paid or incurred, the principal purpose of the taxpayer in making such expenditures is to use the results of the research in the active conduct of a future trade or business--

(A) of the taxpayer, or

(B) of 1 or more other persons who with the taxpayer are treated as a single taxpayer under subsection (f)(1).

(c) Base amount.

(1) In general. The term "base amount" means the product of--

(A) the fixed-base percentage, and

(B) the average annual gross receipts of the taxpayer for the 4 taxable years preceding the taxable year for which the credit is being determined (hereinafter in this subsection referred to as the "credit year").

(2) Minimum base amount. In no event shall the base amount be less than 50 percent of the qualified research expenses for the credit year.

(3) Fixed-base percentage.

(A) In general. Except as otherwise provided in this paragraph, the fixed-base percentage is the percentage which the aggregate qualified research expenses of the taxpayer for taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years.

(B) Start-up companies.

(i) Taxpayers to which subparagraph applies. The fixed-base percentage shall be determined under this subparagraph if--

(I) the first taxable year in which a taxpayer had both gross receipts and qualified research expenses begins after December 31, 1983, or

(II) there are fewer than 3 taxable years beginning after December 31, 1983, and before January 1, 1989, in which the taxpayer had both gross receipts and qualified research expenses.

(ii) Fixed-base percentage. In a case to which this subparagraph applies, the fixed-base percentage is--

(I) 3 percent for each of the taxpayer's 1st 5 taxable years beginning after December 31, 1993, for which the taxpayer has qualified research expenses,

(II) in the case of the taxpayer's 6th such taxable year, 1/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 4th and 5th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

(III) in the case of the taxpayer's 7th such taxable year, 1/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th and 6th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

(IV) in the case of the taxpayer's 8th such taxable year, 1/2 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, and 7th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

(V) in the case of the taxpayer's 9th such taxable year, 2/3 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, and 8th such taxable years is of the aggregate gross receipts of the taxpayer for such years,

(VI) in the case of the taxpayer's 10th such taxable year, 5/6 of the percentage which the aggregate qualified research expenses of the taxpayer for the 5th, 6th, 7th, 8th, and 9th such taxable years is of the aggregate gross receipts of the taxpayer for such years, and

(VII) for taxable years thereafter, the percentage which the aggregate qualified research expenses for any 5 taxable years selected by the taxpayer from among the 5th through the 10th such taxable years is of the aggregate gross receipts of the taxpayer for such selected years.

(iii) Treatment of de minimis amounts of gross receipts and qualified research expenses. The Secretary may prescribe regulations providing that de minimis amounts of gross receipts and qualified research expenses shall be disregarded under clauses (i) and (ii).

(C) Maximum fixed-base percentage. In no event shall the fixed-base percentage exceed 16 percent.

(D) Rounding. The percentages determined under subparagraphs (A) and (B)(ii) shall be rounded to the nearest 1/100th of 1 percent.

(4) Election of alternative simplified credit.

(A) In general. At the election of the taxpayer, the credit determined under subsection (a)(1) shall be equal to 14 percent of so much of the qualified research expenses for the taxable year as exceeds 50 percent of the average qualified research expenses for the 3 taxable years preceding the taxable year for which the credit is being determined.

(B) Special rule in case of no qualified research expenses in any of 3 preceding taxable years.

(i) Taxpayers to which subparagraph applies. The credit under this paragraph shall be determined under this subparagraph if the taxpayer has no qualified research expenses in any one of the 3 taxable years preceding the taxable year for which the credit is being determined.

(ii) Credit rate. The credit determined under this subparagraph shall be equal to 6 percent of the qualified research expenses for the taxable year.

(C) Election. An election under this paragraph shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary.

(5) Consistent treatment of expenses required.

(A) In general. Notwithstanding whether the period for filing a claim for credit or refund has expired for any taxable year taken into account in determining the fixed-base percentage, the qualified research expenses taken into account in computing such percentage shall be determined on a basis consistent with the determination of qualified research expenses for the credit year.

(B) Prevention of distortions. The Secretary may prescribe regulations to prevent distortions in calculating a taxpayer's qualified research expenses or gross receipts caused by a change in accounting methods used by such taxpayer between the current year and a year taken into account in computing such taxpayer's fixed-base percentage.

(6) Gross receipts. For purposes of this subsection, gross receipts for any taxable year shall be reduced by returns and allowances made during the taxable year. In the case of a foreign corporation, there shall be taken into account only gross receipts which are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States.

(d) Qualified research defined. For purposes of this section --

(1) In general. The term "qualified research" means research --

(A) with respect to which expenditures may be treated as specified research or experimental expenditures under section 174 ,

(B) which is undertaken for the purpose of discovering information--

(i) which is technological in nature, and

(ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and

(C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3).

Such term does not include any activity described in paragraph (4).

(2) Tests to be applied separately to each business component. For purposes of this subsection--

(A) In general. Paragraph (1) shall be applied separately with respect to each business component of the taxpayer.

(B) Business component defined. The term "business component" means any product, process, computer software, technique, formula, or invention which is to be--

(i) held for sale, lease, or license, or

(ii) used by the taxpayer in a trade or business of the taxpayer.

(C) Special rule for production processes. Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).

(3) Purposes for which research may qualify for credit. For purposes of paragraph (1)(C)--

(A) In general. Research shall be treated as conducted for a purpose described in this paragraph if it relates to--

(i) a new or improved function,

(ii) performance, or

(iii) reliability or quality.

(B) Certain purposes not qualified. Research shall in no event be treated as conducted for a purpose described in this paragraph if it relates to style, taste, cosmetic, or seasonal design factors.

(4) Activities for which credit not allowed. The term "qualified research" shall not include any of the following:

(A) Research after commercial production. Any research conducted after the beginning of commercial production of the business component.

(B) Adaptation of existing business components. Any research related to the adaptation of an existing business component to a particular customer's requirement or need.

(C) Duplication of existing business component. Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.

(D) Surveys, studies, etc. Any--

(i) efficiency survey,

(ii) activity relating to management function or technique,

(iii) market research, testing, or development (including advertising or promotions),

(iv) routine data collection, or

(v) routine or ordinary testing or inspection for quality control.

(E) Computer software. Except to the extent provided in regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in--

(i) an activity which constitutes qualified research (determined with regard to this subparagraph), or

(ii) a production process with respect to which the requirements of paragraph (1) are met.

(F) Foreign research. Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.

(G) Social sciences, etc. Any research in the social sciences, arts, or humanities.

(H) Funded research. Any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).

(e) Credit allowable with respect to certain payments to qualified organizations for basic research. For purposes of this section--

(1) In general. In the case of any taxpayer who makes basic research payments for any taxable year--

(A) the amount of basic research payments taken into account under subsection (a)(2) shall be equal to the excess of--

(i) such basic research payments, over

(ii) the qualified organization base period amount, and

(B) that portion of such basic research payments which does not exceed the qualified organization base period amount shall be treated as contract research expenses for purposes of subsection (a)(1).

(2) Basic research payments defined. For purposes of this subsection--

(A) In general. The term "basic research payment" means, with respect to any taxable year, any amount paid in cash during such taxable year by a corporation to any qualified organization for basic research but only if--

(i) such payment is pursuant to a written agreement between such corporation and such qualified organization, and

(ii) such basic research is to be performed by such qualified organization.

(B) Exception to requirement that research be performed by the organization. In the case of a qualified organization described in subparagraph (C) or (D) of paragraph (6), clause (ii) of subparagraph (A) shall not apply.

(3) Qualified organization base period amount. For purposes of this subsection, the term "qualified organization base period amount" means an amount equal to the sum of--

(A) the minimum basic research amount, plus

(B) the maintenance-of-effort amount.

(4) Minimum basic research amount. For purposes of this subsection--

(A) In general. The term "minimum basic research amount" means an amount equal to the greater of--

(i) 1 percent of the average of the sum of amounts paid or incurred during the base period for--

(I) any in-house research expenses, and

(II) any contract research expenses, or

(ii) the amounts treated as contract research expenses during the base period by reason of this subsection (as in effect during the base period).

(B) Floor amount. Except in the case of a taxpayer which was in existence during a taxable year (other than a short taxable year) in the base period, the minimum basic research amount for any base period shall not be less than 50 percent of the basic research payments for the taxable year for which a determination is being made under this subsection.

(5) Maintenance-of-effort amount. For purposes of this subsection--

(A) In general. The term "maintenance-of-effort amount" means, with respect to any taxable year, an amount equal to the excess (if any) of--

(i) an amount equal to--

(I) the average of the nondesignated university contributions paid by the taxpayer during the base period, multiplied by

(II) the cost-of-living adjustment for the calendar year in which such taxable year begins, over

(ii) the amount of nondesignated university contributions paid by the taxpayer during such taxable year.

(B) Nondesignated university contributions. For purposes of this paragraph, the term "nondesignated university contribution" means any amount paid by a taxpayer to any qualified organization described in paragraph (6)(A)--

(i) for which a deduction was allowable under section 170 , and

(ii) which was not taken into account--

(I) in computing the amount of the credit under this section (as in effect during the base period) during any taxable year in the base period, or

(II) as a basic research payment for purposes of this section.

(C) Cost-of-living adjustment defined.

(i) In general. The cost-of-living adjustment for any calendar year is the cost-of-living adjustment for such calendar year determined under section 1(f)(3) , by substituting "calendar year 1987" for "calendar year 2016" in subparagraph (A)(ii) thereof.

(ii) Special rule where base period ends in a calendar year other than 1983 or 1984. If the base period of any taxpayer does not end in 1983 or 1984, section 1(f)(3)(A)(ii) shall, for purposes of this paragraph, be applied by substituting the calendar year in which such base period ends for 2016. Such substitution shall be in lieu of the substitution under clause (i).

(6) Qualified organization. For purposes of this subsection, the term "qualified organization" means any of the following organizations:

(A) Educational institutions. Any educational organization which--

(i) is an institution of higher education (within the meaning of section 3304(f) ), and

(ii) is described in section 170(b)(1)(A)(ii) .

(B) Certain scientific research organizations. Any organization not described in subparagraph (A) which--

(i) is described in section 501(c)(3) and is exempt from tax under section 501(a) ,

(ii) is organized and operated primarily to conduct scientific research, and

(iii) is not a private foundation.

(C) Scientific tax-exempt organizations. Any organization which--

(i) is described in--

(I) section 501(c)(3) (other than a private foundation), or

(II) section 501(c)(6) ,

(ii) is exempt from tax under section 501(a) ,

(iii) is organized and operated primarily to promote scientific research by qualified organizations described in subparagraph (A) pursuant to written research agreements, and

(iv) currently expends--

(I) substantially all of its funds, or

(II) substantially all of the basic research payments received by it,

for grants to, or contracts for basic research with, an organization described in subparagraph (A).

(D) Certain grant organizations. Any organization not described in subparagraph (B) or (C) which--

(i) is described in section 501(c)(3) and is exempt from tax under section 501(a) (other than a private foundation),

(ii) is established and maintained by an organization established before July 10, 1981, which meets the requirements of clause (i),

(iii) is organized and operated exclusively for the purpose of making grants to organizations described in subparagraph (A) pursuant to written research agreements for purposes of basic research, and

(iv) makes an election, revocable only with the consent of the Secretary, to be treated as a private foundation for purposes of this title (other than section 4940 , relating to excise tax based on investment income).

(7) Definitions and special rules. For purposes of this subsection--

(A) Basic research. The term "basic research" means any original investigation for the advancement of scientific knowledge not having a specific commercial objective, except that such term shall not include--

(i) basic research conducted outside of the United States, and

(ii) basic research in the social sciences, arts, or humanities.

(B) Base period. The term "base period" means the 3-taxable-year period ending with the taxable year immediately preceding the 1st taxable year of the taxpayer beginning after December 31, 1983.

(C) Exclusion from incremental credit calculation. For purposes of determining the amount of credit allowable under subsection (a)(1) for any taxable year, the amount of the basic research payments taken into account under subsection (a)(2)--

(i) shall not be treated as qualified research expenses under subsection (a)(1)(A), and

(ii) shall not be included in the computation of base amount under subsection (a)(1)(B).

(D) Trade or business qualification. For purposes of applying subsection (b)(1) to this subsection, any basic research payments shall be treated as an amount paid in carrying on a trade or business of the taxpayer in the taxable year in which it is paid (without regard to the provisions of subsection (b)(3)(B)).

(E) Certain corporations not eligible. The term "corporation" shall not include--

(i) an S corporation,

(ii) a personal holding company (as defined in section 542 ), or

(iii) a service organization (as defined in section 414(m)(3) ).

(f) Special rules. For purposes of this section--

(1) Aggregation of expenditures.

(A) Controlled group of corporations. In determining the amount of the credit under this section--

(i) all members of the same controlled group of corporations shall be treated as a single taxpayer, and

(ii) the credit (if any) allowable by this section to each such member shall be determined on a proportionate basis to its share of the aggregate of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, taken into account by such controlled group for purposes of this section.

(B) Common control. Under regulations prescribed by the Secretary, in determining the amount of the credit under this section--

(i) all trades or businesses (whether or not incorporated) which are under common control shall be treated as a single taxpayer, and

(ii) the credit (if any) allowable by this section to each such person shall be determined on a proportionate basis to its share of the aggregate of the qualified research expenses, basic research payments, and amounts paid or incurred to energy research consortiums, taken into account by all such persons under common control for purposes of this section.

The regulations prescribed under this subparagraph shall be based on principles similar to the principles which apply in the case of subparagraph (A).

(2) Allocations.

(A) Pass-thru in the case of estates and trusts. Under regulations prescribed by the Secretary, rules similar to the rules of subsection (d) of section 52 shall apply.

(B) Allocation in the case of partnerships. In the case of partnerships, the credit shall be allocated among partners under regulations prescribed by the Secretary.

(3) Adjustments for certain acquisitions, etc. Under regulations prescribed by the Secretary--

(A) Acquisitions.

(i) In general. If a person acquires the major portion of either a trade or business or a separate unit of a trade or business (hereinafter in this paragraph referred to as the "acquired business") of another person (hereinafter in this paragraph referred to as the "predecessor"), then the amount of qualified research expenses paid or incurred by the acquiring person during the measurement period shall be increased by the amount determined under clause (ii), and the gross receipts of the acquiring person for such period shall be increased by the amount determined under clause (iii).

(ii) Amount determined with respect to qualified research expenses. The amount determined under this clause is--

(I) for purposes of applying this section for the taxable year in which such acquisition is made, the acquisition year amount, and

(II) for purposes of applying this section for any taxable year after the taxable year in which such acquisition is made, the qualified research expenses paid or incurred by the predecessor with respect to the acquired business during the measurement period.

(iii) Amount determined with respect to gross receipts. The amount determined under this clause is the amount which would be determined under clause (ii) if "the gross receipts of" were substituted for "the qualified research expenses paid or incurred by" each place it appears in clauses (ii) and (iv).

(iv) Acquisition year amount. For purposes of clause (ii), the acquisition year amount is the amount equal to the product of--

(I) the qualified research expenses paid or incurred by the predecessor with respect to the acquired business during the measurement period, and

(II) the number of days in the period beginning on the date of the acquisition and ending on the last day of the taxable year in which the acquisition is made,

divided by the number of days in the acquiring person's taxable year.

(v) Special rules for coordinating taxable years. In the case of an acquiring person and a predecessor whose taxable years do not begin on the same date--

(I) each reference to a taxable year in clauses (ii) and (iv) shall refer to the appropriate taxable year of the acquiring person,

(II) the qualified research expenses paid or incurred by the predecessor, and the gross receipts of the predecessor, during each taxable year of the predecessor any portion of which is part of the measurement period shall be allocated equally among the days of such taxable year,

(III) the amount of such qualified research expenses taken into account under clauses (ii) and (iv) with respect to a taxable year of the acquiring person shall be equal to the total of the expenses attributable under subclause (II) to the days occurring during such taxable year, and

(IV) the amount of such gross receipts taken into account under clause (iii) with respect to a taxable year of the acquiring person shall be equal to the total of the gross receipts attributable under subclause (II) to the days occurring during such taxable year.

(vi) Measurement period. For purposes of this subparagraph, the term "measurement period" means, with respect to the taxable year of the acquiring person for which the credit is determined, any period of the acquiring person preceding such taxable year which is taken into account for purposes of determining the credit for such year.

(B) Dispositions. If the predecessor furnished to the acquiring person such information as is necessary for the application of subparagraph (A), then, for purposes of applying this section for any taxable year ending after such disposition, the amount of qualified research expenses paid or incurred by, and the gross receipts of, the predecessor during the measurement period (as defined in subparagraph (A)(vi), determined by substituting "predecessor" for "acquiring person" each place it appears) shall be reduced by--

(i) in the case of the taxable year in which such disposition is made, an amount equal to the product of--

(I) the qualified research expenses paid or incurred by, or gross receipts of, the predecessor with respect to the acquired business during the measurement period (as so defined and so determined), and

(II) the number of days in the period beginning on the date of acquisition (as determined for purposes of subparagraph (A)(iv)(II)) and ending on the last day of the taxable year of the predecessor in which the disposition is made,

divided by the number of days in the taxable year of the predecessor, and

(ii) in the case of any taxable year ending after the taxable year in which such disposition is made, the amount described in clause (i)(I).

(C) Certain reimbursements taken into account in determining fixed-base percentage. If during any of the 3 taxable years following the taxable year in which a disposition to which subparagraph (B) applies occurs, the disposing taxpayer (or a person with whom the taxpayer is required to aggregate expenditures under paragraph (1)) reimburses the acquiring person (or a person required to so aggregate expenditures with such person) for research on behalf of the taxpayer, then the amount of qualified research expenses of the taxpayer for the taxable years taken into account in computing the fixed-base percentage shall be increased by the lesser of--

(i) the amount of the decrease under subparagraph (B) which is allocable to taxable years so taken into account, or

(ii) the product of the number of taxable years so taken into account, multiplied by the amount of the reimbursement described in this subparagraph.

(4) Short taxable years. In the case of any short taxable year, qualified research expenses and gross receipts shall be annualized in such circumstances and under such methods as the Secretary may prescribe by regulation.

(5) Controlled group of corporations. The term "controlled group of corporations" has the same meaning given to such term by section 1563(a) , except that--

(A) "more than 50 percent" shall be substituted for "at least 80 percent" each place it appears in section 1563(a)(1) , and

(B) the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of section 1563 .

(6) Energy research consortium.

(A) In general. The term "energy research consortium" means any organization--

(i) which is--

(I) described in section 501(c)(3) and is exempt from tax under section 501(a) and is organized and operated primarily to conduct energy research, or

(II) organized and operated primarily to conduct energy research in the public interest (within the meaning of section 501(c)(3) ),

(ii) which is not a private foundation,

(iii) to which at least 5 unrelated persons paid or incurred during the calendar year in which the taxable year of the organization begins amounts (including as contributions) to such organization for energy research, and

(iv) to which no single person paid or incurred (including as contributions) during such calendar year an amount equal to more than 50 percent of the total amounts received by such organization during such calendar year for energy research.

(B) Treatment of persons. All persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as related persons for purposes of subparagraph (A)(iii) and as a single person for purposes of subparagraph (A)(iv).

(C) Foreign research. For purposes of subsection (a)(3), amounts paid or incurred for any energy research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States shall not be taken into account.

(D) Denial of double benefit. Any amount taken into account under subsection (a)(3) shall not be taken into account under paragraph (1) or (2) of subsection (a).

(E) Energy research. The term "energy research" does not include any research which is not qualified research.

(g) Special rule for pass-thru of credit. In the case of an individual who--

(1) owns an interest in an unincorporated trade or business,

(2) is a partner in a partnership,

(3) is a beneficiary of an estate or trust, or

(4) is a shareholder in an S corporation,

the amount determined under subsection (a) for any taxable year shall not exceed an amount (separately computed with respect to such person's interest in such trade or business or entity) equal to the amount of tax attributable to that portion of a person's taxable income which is allocable or apportionable to the person's interest in such trade or business or entity. If the amount determined under subsection (a) for any taxable year exceeds the limitation of the preceding sentence, such amount may be carried to other taxable years under the rules of section 39 ; except that the limitation of the preceding sentence shall be taken into account in lieu of the limitation of section 38(c) in applying section 39 .

(h) Treatment of credit for qualified small businesses.

(1) In general. At the election of a qualified small business for any taxable year, section 3111(f) shall apply to the payroll tax credit portion of the credit otherwise determined under subsection (a) for the taxable year and such portion shall not be treated (other than for purposes of section 280C ) as a credit determined under subsection (a).

(2) Payroll tax credit portion. For purposes of this subsection, the payroll tax credit portion of the credit determined under subsection (a) with respect to any qualified small business for any taxable year is the least of--

(A) the amount specified in the election made under this subsection,

(B) the credit determined under subsection (a) for the taxable year (determined before the application of this subsection), or

(C) in the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under section 39 carried from the taxable year (determined before the application of this subsection to the taxable year).

(3) Qualified small business. For purposes of this subsection--

(A) In general. The term "qualified small business" means, with respect to any taxable year--

(i) a corporation or partnership, if--

(I) the gross receipts (as determined under the rules of section 448(c)(3) , without regard to subparagraph (A) thereof) of such entity for the taxable year is less than $5,000,000, and

(II) such entity did not have gross receipts (as so determined) for any taxable year preceding the 5-taxable-year period ending with such taxable year, and

(ii) any person (other than a corporation or partnership) who meets the requirements of subclauses (I) and (II) of clause (i), determined--

(I) by substituting "person" for "entity" each place it appears, and

(II) by only taking into account the aggregate gross receipts received by such person in carrying on all trades or businesses of such person.

(B) Limitation. Such term shall not include an organization which is exempt from taxation under section 501 .

(4) Election.

(A) In general. Any election under this subsection for any taxable year--

(i) shall specify the amount of the credit to which such election applies,

(ii) shall be made on or before the due date (including extensions) of--

(I) in the case of a qualified small business which is a partnership, the return required to be filed under section 6031 ,

(II) in the case of a qualified small business which is an S corporation, the return required to be filed under section 6037 , and

(III) in the case of any other qualified small business, the return of tax for the taxable year, and

(iii) may be revoked only with the consent of the Secretary.

(B) Limitations.

(i) Amount.

(I) In general. The amount specified in any election made under this subsection shall not exceed $250,000.

(II) Increase. In the case of taxable years beginning after December 31, 2022, the amount in subclause (I) shall be increased by $250,000.

(ii) Number of taxable years. A person may not make an election under this subsection if such person (or any other person treated as a single taxpayer with such person under paragraph (5)(A)) has made an election under this subsection for 5 or more preceding taxable years.

(C) Special rule for partnerships and S corporations. In the case of a qualified small business which is a partnership or S corporation, the election made under this subsection shall be made at the entity level.

(5) Aggregation rules.

(A) In general. Except as provided in subparagraph (B), all persons or entities treated as a single taxpayer under subsection (f)(1) shall be treated as a single taxpayer for purposes of this subsection.

(B) Special Rules. For purposes of this subsection and section 3111(f) --

(i) each of the persons treated as a single taxpayer under subparagraph (A) may separately make the election under paragraph (1) for any taxable year, and

(ii) each of the $250,000 amounts under paragraph (4)(B)(i) shall be allocated among all persons treated as a single taxpayer under subparagraph (A) in the same manner as under subparagraph (A)(ii) or (B)(ii) of subsection (f)(1), whichever is applicable.

(6) Regulations. The Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this subsection, including--

(A) regulations to prevent the avoidance of the purposes of the limitations and aggregation rules under this subsection through the use of successor companies or other means,

(B) regulations to minimize compliance and record-keeping burdens under this subsection, and

(C) regulations for recapturing the benefit of credits determined under section 3111(f) in cases where there is a subsequent adjustment to the payroll tax credit portion of the credit determined under subsection (a), including requiring amended income tax returns in the cases where there is such an adjustment.

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R&D Tax Credit – IRC 41 and Section 174

The IRS provides specific instructions for businesses that perform qualified research and development (R&D) activities and wish to use the federal R&D tax credit  to reduce their tax liability. These guidelines are outlined in Internal Revenue Code (IRC) Section 41 and Section 174.

What is IRC Section 41?

IRC Section 41 explains the R&D tax credit in full detail, including qualifying criteria, credit calculation,   documentation  and certain exclusions. Business owners must demonstrate that their R&D activities – i.e., the design, development or improvement of products, processes, techniques, formulas, software or inventions – meet all the requirements in order to claim the credit. Expenses incurred as a result of qualified research activities are further explained in Section 174.

What is an IRC Section 174 expense?

An IRC Section 174 expense is one that’s directly connected to the taxpayer’s trade or business and represents an R&D cost in the experimental or laboratory sense. Examples include:

• Wages paid to employees who were directly involved in R&D activities and the individuals who directly supervised or supported their work
• Supplies and raw materials used in design, fabrication or testing that were not capitalized or depreciated
• Work performed by a third party as part of a contract, in which the business assumed the brunt of the economic risk, regardless of the outcome

It’s important to note that even if an R&D cost passes the Section 174 test, it must still meet IRC Section 41 requirements to be considered a qualified research expense (QRE) .

How ADP can help your business identify and file for eligible tax credits

ADP offers exclusive resources to clients that allows them to take a broader, deeper view of the tax credit opportunities for which they may be eligible. Our experts thoroughly study qualified expenses to help maximize R&D tax credits, while minimizing involvement on behalf of the taxpayer. We also monitor for regulatory changes affecting our services so that clients can focus more on potential cost savings and less on compliance responsibilities.

Learn more about ADP's tax credit services

Frequently asked questions about IRC Sections 41 and 174

How are research and experimental expenditures defined.

Qualified research activities and expenses are defined using the following four-part IRS test, as outlined under Section 41:

• Permitted purpose R&D activities must develop or improve the functionality, performance, reliability or quality of a new or existing business component (product, process, software, technique, formula or invention).
• Elimination of uncertainty The development or improvement of the business component must seek to discover information that would eliminate uncertainties about its appropriate design or the capability or method of its development.
• Process of experimentation Taxpayers are required to identify technological uncertainty and then properly evaluate one or more alternatives to eliminate it.
• Technological in nature Experimentation has to rely on the principles of engineering, physical or biological science, or computer sciences and seek to discover information that is technological in nature.

What is the credit for increasing research activities?

The traditional R&D tax credit for increasing research activities is 20% of qualified expenses that exceed a calculated base amount. Taxpayers also have the option of using the alternative simplified credit (ASC) , which is 14% of the QREs that exceed a base amount.

Did you know?

ADP has a dedicated team of tax credit experts focused on R&D.

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The Research & Development Credit | Section 41

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Jason B. Freeman

Managing member.

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

Taxpayers are always interested in whether certain expenditures qualify as tax deductions.  But many taxpayers often forget that expenditures may alternatively qualify for various tax credits, such as the research and development credit.  And all things being equal, taxpayers should generally prefer tax credits over tax deductions as the former are more valuable monetarily than the latter.

Regrettably, many taxpayers are unaware that they qualify for certain tax credits.  For this reason, thousands of taxpayers each year fail to file the necessary forms with their tax returns, rendering the credits unclaimed.  After a number of years, these credits are gone forever due to the statute of limitations for refund claims .

This article explains one of the more commonly missed tax credits:  the research and development credit under Section 41. [i]   This article also discusses the IRS’s renewed interest in this credit and its new refund claim procedures applicable to taxpayers who seek to claim the credit after January 10, 2022.

The Research & Development Credit

Section 38 houses many permissible tax credits.  Among these is the “qualified research activities credit,” the requirements of which are found in Section 41.  Section 41 is not an easy read.  Rather, it is full of super-technical statutory definitions (often within other statutory definitions) and various formulas and computations.  Indeed, the IRS recently commented on Section 41 as follows:

The research credit (as provided by I.R.C. § 41) is a complex area of law involving the application of a four-part test, numerous exclusions, and significant computation and calculation elements to each research activity claimed by a taxpayer in any given tax year. [ii]

And the Tax Court has further commented on Section 41:  “The research credit is one of the most complicated provisions in the Code.  Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.” [iii]

Credit Amount

Generally, the amount of the qualified research activities credit can be determined through the following formula:

Research Credit Amount = 20 % x [Qualified Research Expenses for Year – Base Amount]

For these purposes, the term “qualified research expenses” means the sum of all amounts paid or incurred during the tax year by the taxpayer in carrying on a trade or business for “in-house research expenses” and “contract research expenses.” [iv]

In-House Research Expenses

“In-house research expenses” is defined by statute to mean all expenses for: (1) wages paid or incurred to an employee for qualified services performed by the employee; (2) any amount paid or incurred for supplies used in the conduct of qualified research; and (3) certain amounts paid or incurred to another person for the right to use computers in the conduct of qualified research. [v]

Qualifying Wages

For purposes of Section 41, the term “wages” has the same meaning as that term is used throughout the Code. [vi]   Generally, wages must be separated between those allocable to qualified services and those allocable to other services. [vii]   However, there is a taxpayer-friendly rule in the regulations—if substantially all of the services performed by the employee for the taxpayer during the tax year consists of qualified services ( i.e. , 80% or more), the taxpayer may claim all of the employee’s wages as qualified services. [viii]

“Qualified services” means engaging in either:  (1) qualified research; or (2) the direct supervision or direct support of research activities which constitute qualified research. [ix]   “Qualified research” is discussed more extensively below.  For purposes of (2), however, “direct supervision” means the immediate supervision ( i.e. , first-line management) of qualified research and not higher-level managers, and “direct support” means services in the support of persons engaging in actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research. [x]

Section 41 defines “supplies” broadly to mean any tangible property other than land or land improvements and property subject to depreciation. [xi]

Contract Research Expenses

“Contract research expenses” is defined to mean 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. [xii]

What is Qualified Research ?

As shown above, the term “qualified research” is ubiquitous throughout Section 41 and its various statutory definitions.  Thus, the heart of Section 41—and a taxpayer’s eligibility for the tax credit—often hinges on whether the activity at issue constitutes a qualified research activity.

Generally, to constitute qualified research, the activity must meet all of the following requirements:  (1) the expenditures associated with the activity must be Section 174 expenditures; (2) the activity must be undertaken for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and (3) substantially all of the activities must constitute elements of a process of experimentation for purposes of Section 41(d)(3). [xiii]   Under Section 41(d)(3), research qualifies if it is conducted for a purpose that relates to a new or improved function, performance, or reliability or quality, unless it also relates to style, taste, cosmetic, or seasonal design factors.

The Section 174 Test

  The first requirement to constitute “qualified research” is that the expenditures from the activity must represent Section 174 expenditures.  Under the Section 174 regulations, Section 174 expenditures are “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” [xiv]   Generally, this definition hinges on uncertainty—the expenditures for the activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a new product. [xv]   In turn, uncertainty is present if the information available to the taxpayer does not establish the capability or method in developing or improving the product or the appropriate design of the product. [xvi]   Examples in the Regulations provide some additional color on Section 174 expenditures and the uncertainty component.

Example .  Company is engaged in the manufacture and sale of custom machines.  Company contracts to design and produce a machine to meet a customer’s specifications.  Because Company has never designed a machine with these specifications, Company is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine.  Company incurs a total of $31,000 on the project.  Of the $31,000, Company incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design.  Company also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine.  This $11,000 of costs represents research and development costs in the experimental or laboratory sense.

After uncertainty is eliminated, Company incurs $20,000 to produce the machine for sale to the customer based on the appropriate design.  The model produced and used to evaluate and resolve uncertainty is a pilot model.  Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under Section 174.  However, Section 174 does not apply to the $20,000 that Company incurred to produce the machine for sale to the customer based on the appropriate design. [xvii]

Example :  Company is a wine producer.  Company is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes.  In order to test the effectiveness of the new method of crushing wine grapes, Company incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process.  The $2,000 of costs represents research and development costs in the experimental or laboratory sense.  Therefore, the $2,000 incurred qualifies as research or experimental expenditures under Section 174 because it is a cost incident to the development or improvement of a component of a process. [xviii]

The Technological Information Test

To be “qualified research,” an activity must be undertaken for the purpose of discovering information that is technological in nature.  Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. [xix]

The Business Component Test

The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer.  For these purposes, a business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its trade or business.” [xx]

The Process of Experimentation Test

To be “qualified research,” the activity must also meet the process of experimentation test.  For these purposes, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. [xxi]   Generally, federal courts and the IRS break the process of experimentation test down further into three separate elements:  (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element. [xxii]   Each of these elements is tested for each separate business component.

To meet the “substantially all” element, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose. [xxiii]

To meet the “process of experimentation” element, the taxpayer must engage in “a process designed to evaluate one or more alternatives to achieve a result” where the taxpayer is uncertain at the beginning of its research activities regarding the capability or method of achieving the result or an appropriate design. [xxiv]   The Section 41 regulations further provide:

A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer sciences and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).  A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. [xxv]

To meet the “qualified purpose” element, the research process must relate to a new or improved function, performance, reliability or qualify of the business component. [xxvi]   Research activities for style, taste, cosmetic, or seasonal design factors do not qualify.  And qualified research specifically does not include the following activities:

• Research after Commercial Production . Any research conducted after the beginning of commercial production of a business component.
• Adaptation of Existing Business Components . Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
• Duplication of Existing Business Component . Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys, Studies, etc. . Any of the following:  (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control.
• Computer Software . Unless otherwise exempted by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in:  (i) an activity which constitutes qualified research, or (ii) a production process with respect to which the requirements of (i) are met.
• Foreign Research . Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
• Social Sciences, Etc. Any research in the social sciences, arts, or humanities.
• Funded Research . Any research to the extent funded by any grant, contract, or otherwise by another person (or government entity). [xxvii]

Examples under the Section 41 regulations are helpful in determining whether an activity meets the qualified purpose element:

Example :  Company is engaged in the business of developing and manufacturing blue vehicles.  Company wants to change the color of its blue vehicles to green.  Company obtains from various suppliers several different shades of green paint.  Company paints several sample vehicles, and surveys its customers to determine which shade of green the Company’s customers prefer.   In this case, the Company’s activities to change the color of its blue vehicles to green are not qualified research because substantially all of Company’s activities are not undertaken for a qualified purpose.  All of Company’s research activities are related to style, taste, cosmetic, or seasonal design factors. [xxviii]

Example :  Same example as above, except that Company chooses one of the green paints.  Company obtains samples of the green paint from a supplier and determines that Company must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints that Company has used.  Company obtains detailed data on the green paint from Company’s paint supplier.  Company also consults with the manufacturer of Company’s paint spraying machines.  The manufacturer informs Company that Company must acquire a new nozzle that operates with the green paint Company wants to use.  Company tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines.  Under these new facts, Company’s activities to modify its painting process are a separate business component, and Company’s activities to modify its painting process to change the color of its blue vehicles to green are not qualified research.  Company did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machine eliminated Company’s uncertainty regarding the modification of its painting process.  Company’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control. [xxix]

Base Amount

If a taxpayer has qualified research and otherwise meets the requirements of Section 41, the taxpayer must then compute the “base amount”.  For these purposes, the “base amount” is defined as the product of (i) the “fixed-base percentage,” and (ii) the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being claimed ( i.e. , the “credit year.”). [xxx]

Section 41(c)(3)(A) generally defines the “fixed-base percentage” as the percentage of aggregate qualified research expenses of the taxpayer for the taxable year beginning after December 31, 1983, and before January 1, 1989, to the aggregate gross receipts of the taxpayer for such tax years.  If the taxpayer had both gross receipts and qualified research expenses after December 31, 1983, the fixed-based percentage is set by statute, starting with 3% for each of the taxpayer’s first five taxable years beginning after December 31, 1993. [xxxi]

Due in part to the complexity of the “base amount” computations, the Code also permits taxpayers to elect an “alternative simplified method.” [xxxii]   Under this method, the credit is equal to 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined.

Claiming the R&D Credit

The Section 41 credit has historically been claimed on IRS Form 6765, Credit for Increasing Research Activities .  More recently, however, the IRS has indicated that it intends to make it more difficult for taxpayers to claim the credit, particularly for claims made after January 10, 2022.  The IRS’s justification for imposing these new requirements is due to its difficulty in ascertaining whether the taxpayer qualifies and a regulation that provides that taxpayers must generally provide sufficient facts to apprise of the IRS of any refund or claim for credit.

Specifically, by regulation, the IRS is not required to issue a refund or credit unless it receives a claim that sets forth in detail each ground upon which the refund or credit is claimed and facts sufficient to apprise the IRS of the exact basis of the refund or credit. [xxxiii]   On October 15, 2021, the IRS issued a Field Attorney Advice (“ FAA ”) that provided additional requirements taxpayers must meet under this regulation to make a valid claim for credit or refund under Section 41. [xxxiv]   If the taxpayer fails to meet the requirements, the IRS has indicated that it will deny the refund or credit claim in its entirety as invalid.

Under the FAA, the taxpayer’s refund claim for a research activity credit is valid if, at a minimum, the taxpayer:

• Identifies all the business components to which the Section 41 research credit claim relates for that year;
• For each business component, the taxpayer identifies all research activities performed; identifies all individuals who performed each research activity; and identifies all the information each individual sought to discover;
• Provides the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (which may be done through using Form 6765);
• Must provide a declaration signed under penalties of perjury verifying that the facts provided in the claim are accurate.

The FAA indicates that if the taxpayer fails to meet these requirements, the IRS will reject the claim as deficient. [xxxv]

Every year, taxpayers who qualify for the Section 41 credit fail to claim it.  This is somewhat understandable, particularly in light of the difficulties taxpayers face in determining whether they meet each of Section 41’s various statutory and regulatory requirements.  However, business owners who engage in new processes and products should consult with a tax professional to determine whether they are leaving money on the table each year in not claiming the tax credit.

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[i] All section references are to the Internal Revenue Code of 1986, as amended (the “ Code ”).

[ii] IRS FAA 20214101F.

[iii] Suder v. Comm’r , T.C. Memo. 2014-201.

[iv] See I.R.C. § 41(b)(1).

[v] I.R.C. § 41(b)(2).

[vi] I.R.C. § 41(b)(2)(D).

[vii] Treas. Reg. § 1.41-2(d)(1).

[viii] Id. at (d)(2).

[ix] I.R.C. § 41(b)(2)(B).

[x] Id. at (c)(3).

[xi] I.R.C. § 41(b)(2)(C).

[xii] I.R.C. § 41(b)(3).

[xiii] I.R.C. § 41(d).

[xiv] Treas. Reg. § 1.174-2(a)(1).

[xvii] Treas. Reg. § 1.174-2(a)(11), Ex. 4.

[xviii] Id. , Ex. 10.

[xix] Treas. Reg. § 1.41-4(a)(4); see also Max v. Comm’r , T.C. Memo. 2021-37 (quoting legislative history).

[xx] Sec. 41(d)(2)(B).

[xxi] Treas. Reg. § 1.41-4(a)(5).

[xxii] Union Carbide Corp. & Subs. v. Comm’r , T.C. Memo. 2009-50.

[xxiii] Treas. Reg. § 1.41-4(a)(6).

[xxiv] Treas. Reg. § 1.41-4(a)(5).

[xxvii] I.R.C. § 41(d)(4).

[xxviii] Treas. Reg. § 1.41-4(a)(8), Ex. 1.

[xxix] Id. , Ex. 2.

[xxx] I.R.C. § 41(c)(1).

[xxxi] I.R.C. § 41(c)(3).

[xxxii] I.R.C. § 41(c)(4).

[xxxiii] See Treas. Reg. § 301.6402-2(b)(1).

[xxxiv] See FAA 20214101F.

[xxxv] The AICPA has provided comments and concerns to the IRS regarding its implementation of the change in requirements for a valid refund claim for the R&D credit.

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The Research and Development Credit – Section 41

Taxpayers are always interested in whether certain expenditures qualify as tax deductions. But many taxpayers often forget that expenditures may alternatively qualify for various tax credits. And all things being equal, taxpayers should generally prefer tax credits over tax deductions as the former are more valuable monetarily than the latter.

Regrettably, many taxpayers are unaware that they qualify for certain tax credits. For this reason, thousands of taxpayers each year fail to file the necessary forms with their tax returns, rendering the credits unclaimed. After a number of years, these credits are gone forever due to the statute of limitations for refund claims.

This article explains one of the more commonly missed tax credits: the research and development credit under Section 41. [i] This article also discusses the IRS’s renewed interest in this credit and its new refund claim procedures applicable to taxpayers who seek to claim the credit after January 10, 2022.

The Research & Development Credit .

Section 38 houses many permissible tax credits. Among these is the “qualified research activities credit,” the requirements of which are found in Section 41. Section 41 is not an easy read. Rather, it is full of super-technical statutory definitions (often within other statutory definitions) and various formulas and computations. Indeed, the IRS recently commented on Section 41 as follows:

The research credit (as provided by I.R.C. § 41) is a complex area of law involving the application of a four-part test, numerous exclusions, and significant computation and calculation elements to each research activity claimed by a taxpayer in any given tax year. [ii]

And the Tax Court has further commented on Section 41: “The research credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.” [iii]

Credit Amount .

Generally, the amount of the qualified research activities credit can be determined through the following formula:

Research Credit Amount = 20 % x [Qualified Research Expenses for Year – Base Amount]

For these purposes, the term “qualified research expenses” means the sum of all amounts paid or incurred during the tax year by the taxpayer in carrying on a trade or business for “in-house research expenses” and “contract research expenses.” [iv]

In-House Research Expenses .

“In-house research expenses” is defined by statute to mean all expenses for: (1) wages paid or incurred to an employee for qualified services performed by the employee; (2) any amount paid or incurred for supplies used in the conduct of qualified research; and (3) certain amounts paid or incurred to another person for the right to use computers in the conduct of qualified research. [v]

Qualifying Wages .

For purposes of Section 41, the term “wages” has the same meaning as that term is used throughout the Code. [vi] Generally, wages must be separated between those allocable to qualified services and those allocable to other services. [vii] However, there is a taxpayer-friendly rule in the regulations—if substantially all of the services performed by the employee for the taxpayer during the tax year consists of qualified services ( i.e. , 80% or more), the taxpayer may claim all of the employee’s wages as qualified services. [viii]

“Qualified services” means engaging in either: (1) qualified research; or (2) the direct supervision or direct support of research activities which constitute qualified research. [ix] “Qualified research” is discussed more extensively below. For purposes of (2), however, “direct supervision” means the immediate supervision ( i.e. , first-line management) of qualified research and not higher-level managers, and “direct support” means services in the support of persons engaging in actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research. [x]

Section 41 defines “supplies” broadly to mean any tangible property other than land or land improvements and property subject to depreciation. [xi]

Contract Research Expenses .

“Contract research expenses” is defined to mean 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. [xii]

What is Qualified Research ?

As shown above, the term “qualified research” is ubiquitous throughout Section 41 and its various statutory definitions. Thus, the heart of Section 41—and a taxpayer’s eligibility for the tax credit—often hinges on whether the activity at issue constitutes a qualified research activity.

Generally, to constitute qualified research, the activity must meet all of the following requirements: (1) the expenditures associated with the activity must be Section 174 expenditures; (2) the activity must be undertaken for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and (3) substantially all of the activities must constitute elements of a process of experimentation for purposes of Section 41(d)(3). [xiii] Under Section 41(d)(3), research qualifies if it is conducted for a purpose that relates to a new or improved function, performance, or reliability or quality, unless it also relates to style, taste, cosmetic, or seasonal design factors.

The Section 174 Test .

The first requirement to constitute “qualified research” is that the expenditures from the activity must represent Section 174 expenditures. Under the Section 174 regulations, Section 174 expenditures are “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” [xiv] Generally, this definition hinges on uncertainty—the expenditures for the activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a new product. [xv] In turn, uncertainty is present if the information available to the taxpayer does not establish the capability or method in developing or improving the product or the appropriate design of the product. [xvi] Examples in the Regulations provide some additional color on Section 174 expenditures and the uncertainty component.

Example . Company is engaged in the manufacture and sale of custom machines. Company contracts to design and produce a machine to meet a customer’s specifications. Because Company has never designed a machine with these specifications, Company is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine. Company incurs a total of $31,000 on the project. Of the $31,000, Company incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design. Company also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine. This $11,000 of costs represents research and development costs in the experimental or laboratory sense.

After uncertainty is eliminated, Company incurs $20,000 to produce the machine for sale to the customer based on the appropriate design. The model produced and used to evaluate and resolve uncertainty is a pilot model. Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under Section 174. However, Section 174 does not apply to the $20,000 that Company incurred to produce the machine for sale to the customer based on the appropriate design. [xvii]

Example : Company is a wine producer. Company is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes. In order to test the effectiveness of the new method of crushing wine grapes, Company incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process. The $2,000 of costs represents research and development costs in the experimental or laboratory sense. Therefore, the $2,000 incurred qualifies as research or experimental expenditures under Section 174 because it is a cost incident to the development or improvement of a component of a process. [xviii]

The Technological Information Test .

To be “qualified research,” an activity must be undertaken for the purpose of discovering information that is technological in nature. Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. [xix]

The Business Component Test .

The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer. For these purposes, a business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its trade or business.” [xx]

The Process of Experimentation Test .

To be “qualified research,” the activity must also meet the process of experimentation test. For these purposes, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. [xxi] Generally, federal courts and the IRS break the process of experimentation test down further into three separate elements: (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element. [xxii] Each of these elements is tested for each separate business component.

To meet the “substantially all” element, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose. [xxiii]

To meet the “process of experimentation” element, the taxpayer must engage in “a process designed to evaluate one or more alternatives to achieve a result” where the taxpayer is uncertain at the beginning of its research activities regarding the capability or method of achieving the result or an appropriate design. [xxiv] The Section 41 regulations further provide:

A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer sciences and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. [xxv]

To meet the “qualified purpose” element, the research process must relate to a new or improved function, performance, reliability or qualify of the business component. [xxvi] Research activities for style, taste, cosmetic, or seasonal design factors do not qualify. And qualified research specifically does not include the following activities:

• Research after Commercial Production . Any research conducted after the beginning of commercial production of a business component.
• Adaptation of Existing Business Components . Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
• Duplication of Existing Business Component . Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys, Studies, etc. . Any of the following: (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control.
• Computer Software . Unless otherwise exempted by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in: (i) an activity which constitutes qualified research, or (ii) a production process with respect to which the requirements of (i) are met.
• Foreign Research . Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
• Social Sciences, Etc. Any research in the social sciences, arts, or humanities.
• Funded Research . Any research to the extent funded by any grant, contract, or otherwise by another person (or government entity). [xxvii]

Examples under the Section 41 regulations are helpful in determining whether an activity meets the qualified purpose element:

Example : Company is engaged in the business of developing and manufacturing blue vehicles. Company wants to change the color of its blue vehicles to green. Company obtains from various suppliers several different shades of green paint. Company paints several sample vehicles, and surveys its customers to determine which shade of green the Company’s customers prefer. In this case, the Company’s activities to change the color of its blue vehicles to green are not qualified research because substantially all of Company’s activities are not undertaken for a qualified purpose. All of Company’s research activities are related to style, taste, cosmetic, or seasonal design factors. [xxviii]

Example : Same example as above, except that Company chooses one of the green paints. Company obtains samples of the green paint from a supplier and determines that Company must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints that Company has used. Company obtains detailed data on the green paint from Company’s paint supplier. Company also consults with the manufacturer of Company’s paint spraying machines. The manufacturer informs Company that Company must acquire a new nozzle that operates with the green paint Company wants to use. Company tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines. Under these new facts, Company’s activities to modify its painting process are a separate business component, and Company’s activities to modify its painting process to change the color of its blue vehicles to green are not qualified research. Company did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machine eliminated Company’s uncertainty regarding the modification of its painting process. Company’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control. [xxix]

Base Amount .

If a taxpayer has qualified research and otherwise meets the requirements of Section 41, the taxpayer must then compute the “base amount”. For these purposes, the “base amount” is defined as the product of (i) the “fixed-base percentage,” and (ii) the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being claimed ( i.e. , the “credit year.”). [xxx]

Section 41(c)(3)(A) generally defines the “fixed-base percentage” as the percentage of aggregate qualified research expenses of the taxpayer for the taxable year beginning after December 31, 1983, and before January 1, 1989, to the aggregate gross receipts of the taxpayer for such tax years. If the taxpayer had both gross receipts and qualified research expenses after December 31, 1983, the fixed-based percentage is set by statute, starting with 3% for each of the taxpayer’s first five taxable years beginning after December 31, 1993. [xxxi]

Due in part to the complexity of the “base amount” computations, the Code also permits taxpayers to elect an “alternative simplified method.” [xxxii] Under this method, the credit is equal to 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined.

Claiming the R&D Credit .

The Section 41 credit has historically been claimed on IRS Form 6765, Credit for Increasing Research Activities . More recently, however, the IRS has indicated that it intends to make it more difficult for taxpayers to claim the credit, particularly for claims made after January 10, 2022. The IRS’s justification for imposing these new requirements is due to its difficulty in ascertaining whether the taxpayer qualifies and a regulation that provides that taxpayers must generally provide sufficient facts to apprise of the IRS of any refund or claim for credit.

Specifically, by regulation, the IRS is not required to issue a refund or credit unless it receives a claim that sets forth in detail each ground upon which the refund or credit is claimed and facts sufficient to apprise the IRS of the exact basis of the refund or credit. [xxxiii] On October 15, 2021, the IRS issued a Field Attorney Advice (“ FAA ”) that provided additional requirements taxpayers must meet under this regulation to make a valid claim for credit or refund under Section 41. [xxxiv] If the taxpayer fails to meet the requirements, the IRS has indicated that it will deny the refund or credit claim in its entirety as invalid.

Under the FAA, the taxpayer’s refund claim for a research activity credit is valid if, at a minimum, the taxpayer:

• Identifies all the business components to which the Section 41 research credit claim relates for that year;
• For each business component, the taxpayer identifies all research activities performed; identifies all individuals who performed each research activity; and identifies all the information each individual sought to discover;
• Provides the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (which may be done through using Form 6765);
• Must provide a declaration signed under penalties of perjury verifying that the facts provided in the claim are accurate.

The FAA indicates that if the taxpayer fails to meet these requirements, the IRS will reject the claim as deficient. [xxxv]

Conclusion .

Every year, taxpayers who qualify for the Section 41 credit fail to claim it. This is somewhat understandable, particularly in light of the difficulties taxpayers face in determining whether they meet each of Section 41’s various statutory and regulatory requirements. However, business owners who engage in new processes and products should consult with a tax professional to determine whether they are leaving money on the table each year in not claiming the tax credit.

[i] All section references are to the Internal Revenue Code of 1986, as amended (the “ Code ”).

[ii] IRS FAA 20214101F.

[iii] Suder v. Comm’r , T.C. Memo. 2014-201.

[iv] See I.R.C. § 41(b)(1).

[v] I.R.C. § 41(b)(2).

[vi] I.R.C. § 41(b)(2)(D).

[vii] Treas. Reg. § 1.41-2(d)(1).

[viii] Id. at (d)(2).

[ix] I.R.C. § 41(b)(2)(B).

[x] Id. at (c)(3).

[xi] I.R.C. § 41(b)(2)(C).

[xii] I.R.C. § 41(b)(3).

[xiii] I.R.C. § 41(d).

[xiv] Treas. Reg. § 1.174-2(a)(1).

[xvii] Treas. Reg. § 1.174-2(a)(11), Ex. 4.

[xviii] Id. , Ex. 10.

[xix] Treas. Reg. § 1.41-4(a)(4); see also Max v. Comm’r , T.C. Memo. 2021-37 (quoting legislative history).

[xx] Sec. 41(d)(2)(B).

[xxi] Treas. Reg. § 1.41-4(a)(5).

[xxii] Union Carbide Corp. & Subs. v. Comm’r , T.C. Memo. 2009-50.

[xxiii] Treas. Reg. § 1.41-4(a)(6).

[xxiv] Treas. Reg. § 1.41-4(a)(5).

[xxvii] I.R.C. § 41(d)(4).

[xxviii] Treas. Reg. § 1.41-4(a)(8), Ex. 1.

[xxix] Id. , Ex. 2.

[xxx] I.R.C. § 41(c)(1).

[xxxi] I.R.C. § 41(c)(3).

[xxxii] I.R.C. § 41(c)(4).

[xxxiii] See Treas. Reg. § 301.6402-2(b)(1).

[xxxiv] See FAA 20214101F.

[xxxv] The AICPA has provided comments and concerns to the IRS regarding its implementation of the change in requirements for a valid refund claim for the R&D credit.

[ View source .]

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• What is the R&D Tax Credit?
• What qualifies for a Research and Development Tax Credit?
• How can your business benefit from the R&D tax credit?
• How can my business claim an R&D Tax Credit?
• Common misconceptions why businesses assume they don’t qualify for the R&D Tax Credit
• What states qualify for the R&D Tax Credit?
• How to determine your R&D Tax Credit eligibility?
• Research and Development Tax Credit Limitations
• R&D Tax Credit Examples
• Research and Development Tax Credit Calculation – How to calculate your R&D Tax Credit
• What documentation is required to claim an R&D Tax Credit?
• How has the R&D Tax Credit Changed in Recent Years?
• How has tax reform changed the R&D Tax Credit in recent years?
• What are the R&D Tax Credit Costs?
• When Did R&D Tax Credits Start?
• R&D Tax Credit Carryforward
• How do Tax Credits Work?
• When can you Claim R&D Tax Credit?
• What is IRS Form 6765?
• How can an R&D Tax Credit Offset Payroll Taxes?
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What is Section 41?

How does IRC Section 41 relate to the R&D tax credit?

IRC Section 41 is the source for most of the facets of the R&D tax credit. IRC Sec 41 lays out the calculation methodology, definitions, and limitations relating the the research and development tax credit.

What are the different codes under Section 41?

IRC Section 41 has subsections from (a) through (h). Some of the relevant sections are outlined below:

What is Section 41 d?

IRC Section 41(d) contains an all important definitive test for qualifying R&D activity. This test is defined as: activity undertaken for purposes of discovering information that is technological in nature, intended to develop a new or improve an existing business component, which involves a process of experimentation.

What is Section 41 c?

Section 41(c) defines the Base Amount for calculating a Research & Development tax credit. The Base Amount equals the product of a Fixed Base Percentage and the average gross receipts of the 4 years preceding the tax year for which the credit is being calculated. Subsection (c) also lays out the minimum base amount, and maximum fixed base percentage (16%) allowed in R&D credit calculations.

Importantly, subsection (c) also sets out the calculation methodology for the Alternative Simplified Credit.

What is Section 41 g?

Section 41(g) states that an individual with interest in a pass-through entity shall only use credits to offset income tax associated with income from the same entity.

Section 41 Tax Code Regulations and Limitations?

There are several limitations defined in IRC 41 tax credit code. Among the most relevant are the maximum fixed base percentage of 16% found in 41(c), the minimum base amount, and the 41(g) limitation on pass through entity income and credits.

What is a Section 41 credit?

It is a tax credit set out by Section 41 of the tax code, which allows taxpayers to recoup roughly 10% of their R&D spend as a dollar-for-dollar tax credit. The credit is an incentive to reward U.S. business for creating and keeping technical jobs in the U.S.

What expenses qualify for research and development tax credit?

Wages, supplies, and contractor expenses can qualify. Additionally, computer rental costs and internal software development expenses can qualify. Capital equipment and assets that are depreciated, as well as travel expenses, cannot be included in R&D expenses.

How do you claim credit for increasing research activities?

The credit should be claimed through a specialist. The nuances, limitations, and mechanics of the credit require legal, industry, financial, and accounting know-how. In addition, the IRS and state taxing authorities require the R&D credit process to be documented and substantiated in specific ways that research and development specialists are familiar with.

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The research and development credit – section 41.

Taxpayers are  always  interested in whether certain expenditures qualify as tax deductions.  But many taxpayers often forget that expenditures may alternatively qualify for various tax credits.  And all things being equal, taxpayers should generally prefer tax credits over tax deductions as the former are more valuable monetarily than the latter.

Regrettably, many taxpayers are unaware that they qualify for certain tax credits.  For this reason, thousands of taxpayers each year fail to file the necessary forms with their tax returns, rendering the credits unclaimed.  After a number of years, these credits are gone forever due to the statute of limitations for refund claims.

This article explains one of the more commonly missed tax credits:  the research and development credit under Section 41. [i]   This article also discusses the IRS’s renewed interest in this credit and its new refund claim procedures applicable to taxpayers who seek to claim the credit after January 10, 2022.

The Research & Development Credit . 

Section 38 houses many permissible tax credits.  Among these is the “qualified research activities credit,” the requirements of which are found in Section 41.  Section 41 is not an easy read.  Rather, it is full of super-technical statutory definitions (often within other statutory definitions) and various formulas and computations.  Indeed, the IRS recently commented on Section 41 as follows:

The research credit (as provided by I.R.C. § 41) is a complex area of law involving the application of a four-part test, numerous exclusions, and significant computation and calculation elements to each research activity claimed by a taxpayer in any given tax year. [ii]

And the Tax Court has further commented on Section 41:  “The research credit is one of the most complicated provisions in the Code.  Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.” [iii]

Credit Amount .    

Generally, the  amount  of the qualified research activities credit can be determined through the following formula:

Research Credit Amount = 20 % x [Qualified Research Expenses for Year – Base Amount]

For these purposes, the term “qualified research expenses” means the sum of all amounts paid or incurred during the tax year by the taxpayer in carrying on a trade or business for “in-house research expenses” and “contract research expenses.” [iv]

In-House Research Expenses . 

“In-house research expenses” is defined by statute to mean all expenses for: (1) wages paid or incurred to an employee for qualified services performed by the employee; (2) any amount paid or incurred for supplies used in the conduct of qualified research; and (3) certain amounts paid or incurred to another person for the right to use computers in the conduct of qualified research. [v]

Qualifying Wages . 

For purposes of Section 41, the term “wages” has the same meaning as that term is used throughout the Code. [vi]   Generally, wages must be separated between those allocable to qualified services and those allocable to other services. [vii]   However, there is a taxpayer-friendly rule in the regulations—if substantially all of the services performed by the employee for the taxpayer during the tax year consists of qualified services ( i.e. , 80% or more), the taxpayer may claim all of the employee’s wages as qualified services. [viii]

“Qualified services” means engaging in either:  (1) qualified research; or (2) the direct supervision or direct support of research activities which constitute qualified research. [ix]   “Qualified research” is discussed more extensively below.  For purposes of (2), however, “direct supervision” means the immediate supervision ( i.e. , first-line management) of qualified research and not higher-level managers, and “direct support” means services in the support of persons engaging in actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research. [x]

Supplies . 

Section 41 defines “supplies” broadly to mean any tangible property other than land or land improvements and property subject to depreciation. [xi]

Contract Research Expenses . 

“Contract research expenses” is defined to mean 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research. [xii]

What is Qualified Research ?

As shown above, the term “qualified research” is ubiquitous throughout Section 41 and its various statutory definitions. Thus, the heart of Section 41—and a taxpayer’s eligibility for the tax credit—often hinges on whether the activity at issue constitutes a qualified research activity.

Generally, to constitute qualified research, the activity must meet all of the following requirements:  (1) the expenditures associated with the activity must be Section 174 expenditures; (2) the activity must be undertaken for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and (3) substantially all of the activities must constitute elements of a process of experimentation for purposes of Section 41(d)(3). [xiii]   Under Section 41(d)(3), research qualifies if it is conducted for a purpose that relates to a new or improved function, performance, or reliability or quality,  unless  it also relates to style, taste, cosmetic, or seasonal design factors.

The Section 174 Test . 

The first requirement to constitute “qualified research” is that the expenditures from the activity must represent Section 174 expenditures.  Under the Section 174 regulations, Section 174 expenditures are “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” [xiv]   Generally, this definition hinges on uncertainty—the expenditures for the activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a new product. [xv]   In turn, uncertainty is present if the information available to the taxpayer does not establish the capability or method in developing or improving the product or the appropriate design of the product. [xvi]   Examples in the Regulations provide some additional color on Section 174 expenditures and the uncertainty component.

Example .  Company is engaged in the manufacture and sale of custom machines.  Company contracts to design and produce a machine to meet a customer’s specifications.  Because Company has never designed a machine with these specifications, Company is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine.  Company incurs a total of $31,000 on the project.  Of the $31,000, Company incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design.  Company also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine.  This $11,000 of costs represents research and development costs in the experimental or laboratory sense.

After uncertainty is eliminated, Company incurs $20,000 to produce the machine for sale to the customer based on the appropriate design.  The model produced and used to evaluate and resolve uncertainty is a pilot model.  Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under Section 174.  However, Section 174 does not apply to the $20,000 that Company incurred to produce the machine for sale to the customer based on the appropriate design. [xvii]

Example :  Company is a wine producer.  Company is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes.  In order to test the effectiveness of the new method of crushing wine grapes, Company incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process.  The $2,000 of costs represents research and development costs in the experimental or laboratory sense.  Therefore, the $2,000 incurred qualifies as research or experimental expenditures under Section 174 because it is a cost incident to the development or improvement of a component of a process. [xviii]

The Technological Information Test .

To be “qualified research,” an activity must be undertaken for the purpose of discovering information that is technological in nature.  Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. [xix]

             The Business Component Test . 

The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer.  For these purposes, a business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its trade or business.” [xx]

The Process of Experimentation Test .

To be “qualified research,” the activity must also meet the process of experimentation test.  For these purposes, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. [xxi]   Generally, federal courts and the IRS break the process of experimentation test down further into three separate elements:  (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element. [xxii]   Each of these elements is tested for each separate business component.

To meet the “substantially all” element, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose. [xxiii]

To meet the “process of experimentation” element, the taxpayer must engage in “a process designed to evaluate one or more alternatives to achieve a result” where the taxpayer is uncertain at the beginning of its research activities regarding the capability or method of achieving the result or an appropriate design. [xxiv]   The Section 41 regulations further provide:

A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer sciences and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).  A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. [xxv]

To meet the “qualified purpose” element, the research process must relate to a new or improved function, performance, reliability or qualify of the business component. [xxvi]   Research activities for style, taste, cosmetic, or seasonal design factors do not qualify.  And qualified research specifically does not include the following activities:

• Research after Commercial Production . Any research conducted after the beginning of commercial production of a business component.
• Adaptation of Existing Business Components . Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
• Duplication of Existing Business Component . Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys, Studies, etc. . Any of the following:  (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control.
• Computer Software . Unless otherwise exempted by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in:  (i) an activity which constitutes qualified research, or (ii) a production process with respect to which the requirements of (i) are met.
• Foreign Research . Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
• Social Sciences, Etc.  Any research in the social sciences, arts, or humanities.
• Funded Research . Any research to the extent funded by any grant, contract, or otherwise by another person (or government entity). [xxvii]

Examples under the Section 41 regulations are helpful in determining whether an activity meets the qualified purpose element:

Example :  Company is engaged in the business of developing and manufacturing blue vehicles.  Company wants to change the color of its blue vehicles to green.  Company obtains from various suppliers several different shades of green paint.  Company paints several sample vehicles, and surveys its customers to determine which shade of green the Company’s customers prefer.   In this case, the Company’s activities to change the color of its blue vehicles to green are not qualified research because substantially all of Company’s activities are not undertaken for a qualified purpose.  All of Company’s research activities are related to style, taste, cosmetic, or seasonal design factors. [xxviii]

Example :  Same example as above, except that Company chooses one of the green paints.  Company obtains samples of the green paint from a supplier and determines that Company must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints that Company has used.  Company obtains detailed data on the green paint from Company’s paint supplier.  Company also consults with the manufacturer of Company’s paint spraying machines.  The manufacturer informs Company that Company must acquire a new nozzle that operates with the green paint Company wants to use.  Company tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines.  Under these new facts, Company’s activities to modify its painting process are a separate business component, and Company’s activities to modify its painting process to change the color of its blue vehicles to green are not qualified research.  Company did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machine eliminated Company’s uncertainty regarding the modification of its painting process.  Company’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control. [xxix]

Base Amount . 

If a taxpayer has qualified research and otherwise meets the requirements of Section 41, the taxpayer must then compute the “base amount”.  For these purposes, the “base amount” is defined as the product of (i) the “fixed-base percentage,” and (ii) the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being claimed ( i.e. , the “credit year.”). [xxx]

Section 41(c)(3)(A) generally defines the “fixed-base percentage” as the percentage of aggregate qualified research expenses of the taxpayer for the taxable year beginning after December 31, 1983, and before January 1, 1989, to the aggregate gross receipts of the taxpayer for such tax years.  If the taxpayer had both gross receipts and qualified research expenses after December 31, 1983, the fixed-based percentage is set by statute, starting with 3% for each of the taxpayer’s first five taxable years beginning after December 31, 1993. [xxxi]

Due in part to the complexity of the “base amount” computations, the Code also permits taxpayers to elect an “alternative simplified method.” [xxxii]   Under this method, the credit is equal to 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined.

Claiming the R&D Credit .

The Section 41 credit has historically been claimed on IRS Form 6765,  Credit for Increasing Research Activities .  More recently, however, the IRS has indicated that it intends to make it more difficult for taxpayers to claim the credit, particularly for claims made after January 10, 2022.  The IRS’s justification for imposing these new requirements is due to its difficulty in ascertaining whether the taxpayer qualifies and a regulation that provides that taxpayers must generally provide sufficient facts to apprise of the IRS of any refund or claim for credit.

Specifically, by regulation, the IRS is not required to issue a refund or credit unless it receives a claim that sets forth in detail each ground upon which the refund or credit is claimed and facts sufficient to apprise the IRS of the exact basis of the refund or credit. [xxxiii]   On October 15, 2021, the IRS issued a Field Attorney Advice (“ FAA ”) that provided additional requirements taxpayers must meet under this regulation to make a valid claim for credit or refund under Section 41. [xxxiv]   If the taxpayer fails to meet the requirements, the IRS has indicated that it will deny the refund or credit claim in its entirety as invalid.

Under the FAA, the taxpayer’s refund claim for a research activity credit is valid if, at a minimum, the taxpayer:

• Identifies all the business components to which the Section 41 research credit claim relates for that year;
• For each business component, the taxpayer identifies all research activities performed; identifies all individuals who performed each research activity; and identifies all the information each individual sought to discover;
• Provides the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (which may be done through using Form 6765);
• Must provide a declaration signed under penalties of perjury verifying that the facts provided in the claim are accurate.

The FAA indicates that if the taxpayer fails to meet these requirements, the IRS will reject the claim as deficient. [xxxv]

Conclusion . 

Every year, taxpayers who qualify for the Section 41 credit fail to claim it.  This is somewhat understandable, particularly in light of the difficulties taxpayers face in determining whether they meet each of Section 41’s various statutory and regulatory requirements.  However, business owners who engage in new processes and products should consult with a tax professional to determine whether they are leaving money on the table each year in not claiming the tax credit.

[i]  All section references are to the Internal Revenue Code of 1986, as amended (the “ Code ”).

[ii]  IRS FAA 20214101F.

[iii]   Suder v. Comm’r , T.C. Memo. 2014-201.

[iv]   See  I.R.C. § 41(b)(1).

[v]  I.R.C. § 41(b)(2).

[vi]  I.R.C. § 41(b)(2)(D).

[vii]  Treas. Reg. § 1.41-2(d)(1).

[viii]   Id.  at (d)(2).

[ix]  I.R.C. § 41(b)(2)(B).

[x]   Id.  at (c)(3).

[xi]  I.R.C. § 41(b)(2)(C).

[xii]  I.R.C. § 41(b)(3).

[xiii]  I.R.C. § 41(d).

[xiv]  Treas. Reg. § 1.174-2(a)(1).

[xvi]   Id.

[xvii]  Treas. Reg. § 1.174-2(a)(11), Ex. 4.

[xviii]   Id. , Ex. 10.

[xix]  Treas. Reg. § 1.41-4(a)(4);  see also Max v. Comm’r , T.C. Memo. 2021-37 (quoting legislative history).

[xx]  Sec. 41(d)(2)(B).

[xxi]  Treas. Reg. § 1.41-4(a)(5).

[xxii]   Union Carbide Corp. & Subs. v. Comm’r , T.C. Memo. 2009-50.

[xxiii]  Treas. Reg. § 1.41-4(a)(6).

[xxiv]  Treas. Reg. § 1.41-4(a)(5).

[xxv]   Id.

[xxvi]   Id.

[xxvii]  I.R.C. § 41(d)(4).

[xxviii]  Treas. Reg. § 1.41-4(a)(8), Ex. 1.

[xxix]   Id. , Ex. 2.

[xxx]  I.R.C. § 41(c)(1).

[xxxi]  I.R.C. § 41(c)(3).

[xxxii]  I.R.C. § 41(c)(4).

[xxxiii]   See  Treas. Reg. § 301.6402-2(b)(1).

[xxxiv]   See  FAA 20214101F.

[xxxv]  The  AICPA  has provided comments and concerns to the IRS regarding its implementation of the change in requirements for a valid refund claim for the R&D credit.

Have a question? Contact Matthew Roberts , Freeman Law.

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Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Qualified Research Activities

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Publication Date - June, 2005

* Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.

NOTE: This guide is current through the publication date.  Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

Chapter 4 | Table of Contents | Chapter 6

5. QUALIFIED RESEARCH ACTIVITIES

A. in general.

In order for an activity to qualify for the research credit, the taxpayer must show that it meets all the requirements as described in section 41(d). Under section 41(d), the term "qualified research" means research:

• With respect to which expenditures may be treated as expenses under section 174, (also known as the section 174 test);
• Which is undertaken for the purpose of discovering information which is technological in nature, (also known as the discovering technological information test);
• The application of which is intended to be useful in the development of a new or improved business component of the taxpayer (also known as the business component test); and
• Substantially all of the activities of which constitutes elements of a process of experimentation for a qualified purpose (also known as the process of experimentation test).

To be considered “qualified research”, the taxpayer must be able to establish that the research activity being performed meets ALL four of the above tests. 11 These tests must be applied separately to each business component of the taxpayer.  Activities listed in section 41(d)(4) are not qualified research.  Infra.

(1). The Section 174 Test

In order to meet the section 174 test, the expenditure must (1) be incurred in connection with the taxpayer’s trade or business, and (2) represent a research and development cost in the experimental or laboratory sense.

Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.  Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.

Whether expenditures qualify as research or experimental expenditures depends on the nature of the activity to which the expenditures relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.

Section 174 treatment is allowed only to the extent that the amount is reasonable under the circumstances.  Expenditures for land and depreciable property are not allowed under section 174, although in certain cases, depreciation may be treated as a section 174 expense.  (Depreciation is not a QRE under section 41).  Exploration expenditures do not qualify as section 174 expenses.  Furthermore, the provisions of section 174 are not applicable to any expenditure paid or incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore, oil, gas, or other mineral.  Refer to the regulations under section 174 for further explanation on specific expense disallowances.

Treasury Regulation section 1.174-2(a)(3) disallows section 174 treatment for certain activities, including:

• The ordinary testing or inspection of materials or products for quality control;
• Efficiency surveys;
• Management studies;
• Consumer surveys;
• Advertising or promotions;
• The acquisition of another’s patent, model, production or process; or
• Research in connection with literary, historical, or similar projects.

Since section 41 is more restrictive than section 174, expenses allowable under section 174 will still have to meet the other requirements of section 41(b) and (d) to be a QRE.  For example, patent procurement expenses generally qualify under section 174 but would not qualify under section 41.

(2). The Discovering Technological Information Test

Final regulations, issued in January 2004 (TD 9104),  12 mirror the 2001 proposed regulations with respect to the discovering technological information test.  There is no “discovery” requirement under section 41 separate and apart from that already required under Treasury Regulation section 1.174-2(a)(1) (i.e., was the research undertaken to eliminate uncertainty concerning the development or improvement of a business component).  The final regulations, like the proposed regulations, abandon the requirement that the research activities be undertaken to obtain knowledge that exceeds, expands or refines the common knowledge of skilled professionals in a particular field of science or engineering.

Research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component.  Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.

In order to satisfy the technological in nature requirement for qualified research, the process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.  A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.

The final regulations state that the issuance of a patent by the Patent and Trademark Office under 35 USC sections 51 is conclusive evidence that a taxpayer has discovered information that is technological in nature that is intended to eliminate uncertainty concerning the development or improvement of a business component.  This is known as the “patent safe-harbor”.  Be aware that the issuance of a patent is not conclusive evidence of qualified research, as the taxpayer still has to meet all the other activity requirements of section 41(d).  Examiners should note that the securing of a patent usually occurs some time after the actual research year(s).

(3). The Business Component Test

The taxpayer must intend to apply the information being discovered to develop a new or improved business component of the taxpayer.  A business component is any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer.  Often times, taxpayers group all research in one broad category and do not identify the specific business component to which the business relates.  A taxpayer must be able to tie the research it is claiming for the credit to the relevant business component.  The ‘substantially all’ test is applied at the business component level.

(4). The Process of Experimentation Test

The final research credit regulations provide rules on the “process of experimentation test”, which requires that qualified research be research “substantially all of the activities of which constitute elements of a process of experimentation”.

The final regulations clarify the requirement that a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.  Examiners are encouraged to read the preamble to these regulations to get a better understanding of the changes made.  A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer's capability or method of achieving the desired result, so long as the appropriate design of the desired result is uncertain as of the beginning of the taxpayer's research activities.  Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the business component, or the appropriate design of the business component.

The final regulations articulate the core elements of a process of experimentation.  In addition to requiring that the research be undertaken for the purpose of discovering information that is technological in nature, the taxpayer must:

• Identify the uncertainty regarding the development or improvement of a business component that is the object of the taxpayer’s research activities;
• Identify one or more alternatives intended to eliminate that uncertainty; and
• Identify and conduct a process of evaluating the alternatives.

The key difference regarding “uncertainty” in sections 41 and 174 is that, under section 41, uncertainly must relate to a qualified purpose, and must be resolved through a 3-element process of experimentation, fundamentally relying on the principles of the hard sciences, engineering, or computer science.  The regulations clarify that merely demonstrating that uncertainty has been eliminated is insufficient to satisfy the process of experimentation test.  Focus upon developing facts necessary to determine whether the taxpayer’s activities meet these requirements and the core elements.

The preamble to the final regulations states that because of the clarifications made, the readily discernible and applicable provision in the 2001 proposed regulations is no longer necessary, because those activities do not constitute a process of experimentation under the final regulations.  Accordingly, examiners who properly applied the “readily discernible and applicable” rule as a basis for disallowing the research credit have made proper adjustments.  In pending and future examinations, however, the readily discernible and applicable standard should not be applied to a taxpayer’s activities.

In order for activities to constitute qualified research under section 41(d)(1), 80 percent or more of taxpayer’s research activities, measured on a cost or other consistently applied reasonable basis (and without regard to Treasury Regulation section 1.41-2(d)(2)), must constitute elements of a process of experimentation for a qualified purpose.  The regulations provide that, if this substantially all requirement is met, then the balance of the research activities may qualify, if the remaining balance meets the requirements of section 41(d)(1)(A) (with respect to which expenditures may be treated as expenses under section 174), and if they are not excluded activities under section 41(d)(4) (such as research after commercial production, adaptation or duplication of an existing business component, etc.).

Although the final regulations are effective for taxable years ending after December 31, 2003, the Service will not challenge return positions that are consistent with the final regulations.  As these final regulations merely clarify the proposed regulations upon which taxpayers are already relying, the Service’s administrative approach will follow these final rules for all open years.

The process of experimentation must be conducted for a “qualified purpose”, i.e., it must relate to a new or improved function, performance, reliability, or quality of the business component.  The process of experimentation is not for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors.  I.R.C. § 41(d)(3)(B).  Accordingly, be alert to claimed QREs for research related to non-functional aspects of the business component.

b. Shrink Back

The requirements of section 41(d) are to be applied first at the level of the discrete business component, i.e., the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in its trade or business.

If the requirements for credit eligibility are met at that first level, then some, or all, of the taxpayer's research activities are eligible for the credit.  If all aspects of such requirements are not met at that level, the test applies at the most significant subset of elements of the product, process, computer software, technique, formula, or invention to be held for sale, lease, or license.  This “shrinking back” is to continue until either a subset of elements of the business component that satisfies the requirements is reached, or the most basic element of the business component is reached and such element fails to satisfy the test.

The burden is on the taxpayer to establish that all of the section 41(d)(1) requirements have been met.  The examiner should issue an IDR requesting a list of each qualifying project or activity, along with a complete description of that activity or project as a starting point in the evaluation, including the business component to which each research activity relates.  As with the evaluation of wages, interviews should be considered to supplement and corroborate information obtained from the review of existing records.

c. Exclusions

There are certain research activities that are specifically excluded from qualified research under section 41(d)(4).  It is critical to look at the underlying facts to see if the exclusions apply.  Taxpayer labels are not controlling.  The following activities are not qualified research:

1. Exclusion for Research after Commercial Production

Section 41(d) (4) states that qualified research does not include any research conducted after the beginning of commercial production.  A business component is considered ready for commercial production when it is developed to the point where it is ready for use or meets the basic functional and economic requirements of the taxpayer.  In some cases, there may be “product release” documents where all responsible managers sign off that the new product and or new production method is now released for production, which may be helpful in the application of this exclusion.

The following activities are deemed to occur after the commencement of commercial production:

• Preproduction planning for a finished business component,
• Tooling up for production,
• Trial production runs,
• Troubleshooting involving detecting faults in production equipment or processes,
• Accumulating data relating to production processes, and
• Debugging flaws in a business component.

This per se list includes “debugging” activities, but not “correction of flaws”.  Treasury Regulation section 1.41 4(c)(10), Examples 1 and 2, illustrate the application of the exclusion for research after commercial production.

2. Exclusion for Adaptation

This exclusion applies if the taxpayer's activities relate to adapting an existing business component to a particular customer's requirement or need.  This exclusion does not apply merely because a business component is intended for a specific customer.  A contractor’s adaptation of an existing business component to a taxpayer’s particular requirement or need is not qualified research.

Treasury Regulation section 1.41 4(c)(10), Examples 3 7, illustrates the application of the adaptation exclusion.

3. Exclusion for Duplication

This exclusion applies if the taxpayer reproduced an existing business component, in whole or in part, from a physical examination of the business component, plans, blueprints, detailed specifications, or publicly available information with respect to such component.  This exclusion does not apply merely because the taxpayer evaluates another's business component in the course of developing its own business component. 

Treasury Regulation section 1.41 4(c)(10), Example 8, illustrates the application of the duplication exclusion. 

4. Exclusion for Surveys, Studies, Research Relating to Management Functions

The following activities are excluded under this provision:

• Management functions or techniques, including such items as preparation of  financial data and analysis, development of employee training programs and management organization plans, and management based changes in production processes (such as rearranging work stations on an assembly line);
• Market research, testing, or development (including advertising or promotions);
• Routine data collections; or
• Routine or ordinary testing or inspections for quality control. 

Treasury Regulation section 41 4(c)(10), Example 9, illustrates the application of this exclusion.

Note that it is the activity which governs, not the intended end result.  For example, the development of a new production process, which met all the tests for qualified research, would not be excluded simply because the activity was preceded by a management efficiency survey.

5. Exclusion for Internal-Use Software

This exclusion is beyond the scope of this ATG. 

6. Exclusion for Foreign Research

Qualified research does not include any research conducted outside the United States, Puerto Rico, or any possession of the United States. 13   This exclusion applies to in-house, as well as contract research.  The foreign research disallowance applies even if the research is done by American researchers, or performed for an American taxpayer.

7. Exclusion for Research in the Social Sciences, etc.

Qualified research does not include research in the social sciences (including economics, business management, and behavioral sciences, arts, or humanities).

Treasury Regulation section 1.41 4(c)(10), Example 10, illustrates the application of this exclusion.  Note that the process, not the end result, governs.  The development of new formulation of artists’ paint would not be excluded simply because it benefited the arts, while research into Van Gogh’s life would be excluded under this rule.

8. Exclusion for Funded Research 

The exclusion for "funded research" under section 41(d)(4)(H) provides that the credit shall not be available for qualified research to the extent funded by a contract, grant, or otherwise by another person (or governmental entity).

All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons are to be considered in determining the extent to which the research is funded.  As a result, the examiner should request a complete copy of all contracts (including modifications), agreements, letters of understanding or similar documents where funding is an issue. These contracts and similar documents will need to be reviewed to determine whether, and to what, extent the research is to be considered funded.  A “fixed-price” contract, where the customer agrees to pay a set price for a deliverable, and a “cost-plus” contract, where the customer agrees to pay the actual costs incurred by the contractor in acquiring/constructing the deliverable plus an additional amount for profit, are examples of the different contracts you may encounter.  Counsel can be helpful in securing and interpreting these agreements.  In the case of documents that are “classified” by a government agency, contact the Classified Contract Technical Advisor or a Research Credit Technical Advisor for further assistance.

In order to determine if the contractor’s research expenditures are “funded”, you must resolve the following issues:

• Is payment for the contractor’s research activities “contingent upon the success of the research” under Treasury Regulation section 1.41-4A(d)(1)? 
• Does the contractor retain “substantial rights” in the results of the research activities within the meaning of Treasury Regulation section 1.41-4A(d)(2)?

If the answer to either question is no, then the research is treated as funded.  Amounts payable under any agreements that are contingent on the success of the research (thus considered to be paid for the product or result of the research) are treated as funded research.  If a contractor retains substantial rights in the results of the research, and if payment to him is contingent on the success of the research, then the contract is not funded and the contractor is eligible to claim the credit.

 Note that, if the contractor performing research for another person does not retain substantial rights in the research, and if the research payments are contingent on the contractor’s success, neither the contractor nor the person paying for the research is eligible to claim the credit.

 If a taxpayer performing qualified research for another person retains substantial rights in the research under the agreement providing for the research, the research is funded to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research.  A taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research.

Frequently, taxpayers make some sort of funding allocation between “qualified research” and “non-qualified research” expenditures incurred in certain types of contracts, e.g., cost-share or cost overrun situations.  In so doing, taxpayers often overlook the “pro rata allocation” requirements of Treasury Regulation section 1.41-4A(d)(3)(ii).

The general rule is that funding is to be allocated 100 percent to otherwise qualified research expenses (as provided by Treasury Regulation section 1.41-4A(d)(3)(i)) unless the taxpayer can meet the pro rata allocation requirements of Treasury Regulation section 1.41-4A(d)(3)(ii).

Pursuant to Treasury Regulation section 1.41-4A(d)(3)(ii), the taxpayer may allocate funding pro rata to nonqualified, and otherwise qualified research expenses, rather than allocating it 100 percent to otherwise qualified research expenses, if the taxpayer can establish to the satisfaction of the Service:

• the total amount of research expenses,
• that the total amount of research expenses exceed the funding, and
• that the otherwise qualified research expenses (that is, the expenses that would be qualified research expenses if there were no funding) exceed 65 percent of the funding.

In no event, however, shall less than 65 percent of the funding be applied against the otherwise qualified research expenses.  Material adjustments may be warranted if the specific requirements of Treasury Regulation section 1.41-4A(d)(3)(ii) have not been met.

Funding is determinable only in the subsequent taxable year.  Treasury Regulation section 1.41-4A(d)(5) states that if, at the time the taxpayer files its return for a taxable year, it is impossible to determine to what extent particular research performed by the taxpayer during the year may be funded, then the taxpayer shall treat the research as completely funded for purposes of completing that return.  When the amount of funding is finally determined, the taxpayer should amend the return and any interim returns to reflect the proper amount of funding.

11   In the case of certain software developed for internal use, taxpayers must meet the requirements of an additional three-part “high threshold of innovation” test.  See Prop. Treas. Reg. § 1.41-4(c)(6)(vi). See also the ANPRM relating to the section 41(d)(4)(E) internal use software exclusion.

12   Final Regulations for the Definition of Qualified Research under section 41(d) (doc, 90kb), also in HTML (htm, 137kb) and Adobe (pdf, 65kb), T.D. 9104.

13 Section 41(d)(4)(F) was modified by P.L. 106-170 section 502(c)(1) which added the Commonwealth of Puerto Rico and any possession of the United States for amounts paid or incurred after June 30, 1999.  Prior to amendment, section 41(d)(4)(F) applied only to the United States.

Chapter 4  | Table of Contents  | Chapter 6

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