There may be errors in spelling, grammar, and accuracy in this machine-generated transcript.
Jeremy Wells: Hey there, I'm Jeremy Wells, back for another episode. This time we're going to look at one of the. I won't say it's the most complicated, but. But it's pretty complicated, uh, parts of tax law. And it's something that can be really beneficial for a select set of businesses. It's [00:00:30] the research and development credit, otherwise known as the credit for increasing research activities. This is one that I work with a lot of small service based businesses. So it doesn't come up a lot in my practice, but there have been some cases where we've had businesses qualify for the credit, and that's always a little exciting for me. It's a credit that can be valuable, and I think it's a credit that more businesses actually qualify or could potentially qualify [00:01:00] if they understood the credit more, and if their advisors understood the credit more. So that's what we're going to talk about on this episode. Is the section 41 credit for increasing research activities. Now, as I just said, this comes from ERC. Section 41, the code section itself is rather long, uh, relative to a lot of other code sections, and there's a lot there. However, uh, the regulations around code section 41 are [00:01:30] pretty significant as well. There's about 12 different regulations, uh, sections going along with section 41, with ERC 41. And so in fact, there's even a table of contents for the regulations itself, which is usually a pretty strong indicator that this a lot. And and it can get pretty complicated.
Jeremy Wells: It can get pretty complex. Trying to understand all the little nuances in this episode. Obviously we're not going to be able to go into all of those nuances. However, I do want [00:02:00] to give sort of a high level overview of what to look for. And also think about this from the perspective of a client that might come to you who has heard of the credit, who's interested in the credit, who thinks they might have some work they've done in their business that that could qualify or should qualify. We all know how clients can be. They can be pretty pushy whenever they hear about a deduction or a credit that they don't really know much about, but they've heard about it and they want to see if it qualifies. Uh, if their business qualifies [00:02:30] or if it applies to them. So in general, when it comes to the, uh, R&D credit, I've been fairly dismissive. Like I said, I work with a lot of small service based businesses, and when we get into the actual criteria for qualifying for the credit, it's the criteria are going to knock a lot of those businesses out. So I'm always kind of skeptical whenever my clients come to me and ask about qualifying for this credit. But like I said, there [00:03:00] are some ways that either these types of businesses are doing some work that might qualify. Or if we think about how to restructure things a little bit in terms of some of the projects that they're doing, or in terms of how they're handling some of those projects, then we might be able to try to get them at least to qualify a little bit for the credit.
Jeremy Wells: And at the end of the day, it's always worth it to try a little bit. So that's the topic for today. So let's start off with [00:03:30] what is section 41 of the IRC. What is actually available there? There are actually three different parts to the credit for increasing research activities. There's three different components of this credit. The first one is a credit for qualified research expenses. And we'll talk more about what that means later on. This is where the bulk of our clients, uh, that are going to qualify for the [00:04:00] credit are going to fall under this first component, the qualified research expenses. There are two other components, though. There's also the basic research payment. And then there's the Energy Research Consortium for Energy Research. In general, the energy research is going to be the massive global energy companies, the big petroleum companies, nuclear research, those sorts of things. I'm not working with any [00:04:30] clients in in those industries, and I probably never will. So I'm not worried about that component of the credit. Also, the basic research, uh, payment, uh, component of the credit is for research that really doesn't have a, uh, business goal attached to it. I work with small business owners.
Jeremy Wells: If they don't have a business goal, then they probably are not going to be able to afford to pay me for very long to work with them. So I'm just not going to be interested [00:05:00] in helping them try to chase after a credit. That's not going to actually bring in more revenue for them. So that component of the credit really isn't relevant to to my firm or a lot of the clients that we're working with, really any of those clients. What is relevant is the qualified research expenses component of the credit. And this component is specifically for 20% of the excess of a taxpayer's qualified research expenses over its base amount. Now, that's a lot of [00:05:30] words and a lot of phrases there that we need to break down, which is what we're going to do. But in general, it's 20% of the taxpayer's qualified research expenses over some base amount. That can be somewhat lucrative because we're talking about a credit here. It's not a deduction. We're not reducing taxable income by that 20%. This isn't like section 109. A qualified business income deduction where it's just a a a tax deduction. Here we're talking about a credit. [00:06:00] So if we think about a company that is doing some of this work, this research and development work, then we're talking about 20% over some base amount of those qualified research expenses that could be coming back as a tax credit. And depending on how much they spend, depending on what kind of work they do, it could be a fairly lucrative credit.
Jeremy Wells: And for some of these small businesses, it could be worth exploring as to whether they're eligible for that or not. So [00:06:30] when we talk about qualified research expenses, we need to start with what do we mean by qualified research. And it's research undertaken to discover information that is technological in nature and intended for use in developing a new or improved business component of the taxpayer. When you read through section 41 of the code, it starts off with those three components that I just told you about. And then you start reading through the qualified [00:07:00] research expenses component of the credit, and you realize that the rest of the outline of this code section is just clarifying and defining phrases in the level above what you just read. So you're constantly reading parts of this code section thinking, huh? I wonder what that phrase means? And then having to go further down the outline to understand even more about what it means. Discovering information is one of these phrases [00:07:30] in the definition of qualified research, along with technological in nature and business components. So these are all things that we have to break down even further what they actually mean in terms of understanding what qualifies as research and therefore what might qualify as research expenditures when it comes to qualifying for the credit itself. When we talk about discovering information for purposes of this credit, it means that we're reducing or removing uncertainty [00:08:00] about the development or improvement of a business component.
Jeremy Wells: Uncertainty exists if current information doesn't show the ability or method for developing or improving the business component, or the appropriate design of the business component. So let's slow down. This is this is a lot. Essentially, you have a business that is thinking about some specific aspect of how it operates. That's that's a business component. We'll talk more about that in a minute. But [00:08:30] you have a business that has some process or some procedure going on inside of that business. And the business itself is not sure whether that process or that procedure is optimized or whether there's room for improvement, or whether there's a way to squeeze out a little bit more efficiency or capability out of that process or procedure. And so the business is going to invest [00:09:00] some time, some energy, and most importantly, some actual money into investigating this business component and working to try to find some ways to optimize that business component. One quick caveat here, because we're talking about knowledge based sort of development here. Uh, we're we're developing new processes, new procedures. Maybe if we're talking about a business that [00:09:30] produces physical goods, some some new machinery or equipment that is going to produce that good. We're talking about developments that might, uh, be eligible to have a patent issued If there is a patent involved, then that provides a safe harbor.
Jeremy Wells: That information has been discovered. So that gets us part of the way in this definition of qualified research that takes care of the discovering information part of the definition, [00:10:00] it does not guarantee the credit. This is a misconception and a bit of a misunderstanding that I've seen out there that I've that I've had to explain to clients. Clients will say, but we got a patent for this. The the entire process might still qualify for the credit, but it doesn't guarantee that now everything that's been spent on working toward getting that patent now qualifies for the credit. So it's definitely a safe harbor for [00:10:30] part of the definition of qualified research. But it's not a guarantee of actually getting the credit. It's also not a precondition for the credit. The business doesn't have to register or trademark, or get a patent for some new development that's come out of this work in order to qualify for the credit. It just provides a safe harbor. That part of the definition of qualifying research has been met. Technological in nature means that there [00:11:00] is a process of experimentation, and this is another phrase that we have to read a little bit further on to understand what Congress meant when they wrote up this code section. But there's a process of experimentation that relies on principles of the physical or biological sciences, engineering or computer science. This right here is probably the the strongest limitation on what qualifies for research especially relevant to my [00:11:30] client.
Jeremy Wells: The research has to involve a process of experimentation that relies on the principles of either the physical or biological sciences, Is engineering or computer science. Usually a lot of the research that happens is not falling under one of these fields. It's not biological, it's not physical, it's not engineering, and it's not computer science. We'll talk about some things that definitely do not qualify for [00:12:00] the credit, uh, in a in a few minutes. But a lot of the work that I see businesses doing that the owners think, well, this feels technological because we're doing this work on computers or we're using smart people to do this research, it actually doesn't qualify. Uh, and so it doesn't necessarily have to be work that is done in a lab setting, though. We're not talking about people wearing white lab coats and mixing together, you know, strange chemicals. [00:12:30] That doesn't necessarily have to be true either. And it also doesn't necessarily have to be Silicon Valley startups, but it does have to be computer science. Engineering, physical or biological science is driving the research, the process of experimentation that's happening now. Process of experimentation. What do we mean by that? It evaluates one or more alternatives to develop or improve a business component where the result was uncertain. [00:13:00] That's coming back up again. Remember when we talked about discovering information? One of the parts of that concept was that there was some uncertainty there.
Jeremy Wells: So now we're applying technology to look at some alternatives in the. In addressing this uncertainty. And this uncertainty existed at the start of the research activities. So we've got some uncertainty over this process or procedure or maybe piece [00:13:30] of equipment that is doing some production work in our business, and we're just not sure about the best way to develop this process or piece of equipment. We're going to look at some alternatives, and we're going to test those different alternatives, which means we're going to have some some, some goal. We're trying to optimize this piece of equipment to produce materials faster or reduce the error rate or something like that. We have some explicit goal, [00:14:00] and we're going to try a couple different things to see if they help us meet that goal. We're not coming at this already with an idea of exactly what we want to achieve and exactly how we're going to get there. So if we're only looking at one way of improving this process, and we know what the goal is, we know what the path to get there is. And we're just now it's just a matter of executing on that idea. That's not research. That's not a process of experimentation. [00:14:30] We have to have some uncertainty as to whether any of these alternatives are actually going to produce the outcome. We're hoping they do, or at least that any of these alternatives are going to get us closer to that outcome than we currently are.
Jeremy Wells: Research relating to style, taste, cosmetic or seasonal design factors do not qualify. So we're not just looking to make something look better, or sound better or work [00:15:00] better during different parts of the year. We're actually looking for some sort of business goal here. We need this machine to be more efficient. We need to be more effective. We need this process to be more profitable or more reliable, whatever that is. There's got to be some explicit business goal. It can't just be because we like the way it'll turn out better than what it currently is. So those sorts of things are right out. Also. We're also we're not looking for research that is going to [00:15:30] make a product better liked by the the marketplace. We're not doing customer satisfaction research. We're not doing, uh, product market fit research. That's not the kind of research we're talking about for the R&D credit. Now, a business component is any product process, computer software technique, formula that's held by the taxpayer for sale, lease or license [00:16:00] to be used in the business. In other words, it's some aspect of the business below the level of the entire business itself. It's something that is done within the business or something that's used within the business that is part of the business's functioning. Any plant, process, machinery or technique for commercial production of a business component is itself a separate business component. [00:16:30] Now, this is kind of an interesting point.
Jeremy Wells: If you are talking about a business that produces something that is then going to produce something else. So a lot of times factories will own the equipment and the machinery, and it will be custom to whatever that factory is doing. So even though it's producing other stuff, it is still essentially itself a a component within that business. [00:17:00] So again, working on the processes itself, we can also think about a software startup. Sometimes software companies, they don't have off the shelf solutions to produce the software or the programs that they're trying to work on. So they need to develop something in-house that can then produce the software that they're trying to bring to market. Those are two separate business components. You have the business component of the new software that's being developed in [00:17:30] house that's going to help the business do its work. And then you have what it's actually producing and hoping to take to market at some point. So those would be two separate business components within that software startup. And each business component is going to separately be able potentially to qualify for the credit. So if we're looking at a company that is producing multiple different processes or versions of computer software, then we'd want to be able [00:18:00] to make an argument that their separate business components and look at them separately in terms of qualifying for the credit. This leads to what's called the shrinking back rule. Shrinking back rule says that the taxpayer can consider the next most significant subcomponent of a business component in order to qualify for the credit.
Jeremy Wells: What does this mean? Let's think about an example a company that manufactures Acuras motorcycle engines. [00:18:30] Now an engine itself for a motor vehicle is itself a product, but it also consists of a lot of different working parts within it. And so there are different components inside of that engine. And one example might be something like a carburetor. So a carburetor itself is a separate component. Now an engine can't run without a carburetor. And a carburetor is kind of useless without an engine. But [00:19:00] they are separate components. So even if we'll talk about other aspects of qualifying for the credit in a minute. But even if the engine itself as a whole doesn't qualify for the credit, it's possible that the work done on the carburetor itself would qualify as research in terms of qualifying for the credit, so the taxpayer can always look one level down in terms of the business component and start [00:19:30] looking at subcomponents within it and see if any of those subcomponents would qualify. So again, back to a software startup example. Maybe this software startup had to develop some software, uh, for itself to be able to produce the programs that it's going to put out to market. And maybe one of those programs is eligible for the credit because it counts as qualifying research. But maybe some of the other programs that [00:20:00] that software allows the business to create, those don't qualify.
Jeremy Wells: And the software that the company produced in the first place doesn't qualify either. So just because a a level up component doesn't qualify doesn't mean that those subcomponents a level down doesn't qualify either. It's possible that they qualify independently as well. What are some things that definitely never qualify as research? Uh, [00:20:30] research after the commercial production of a business component. This is a critical thing that we have to look at, uh, when we're talking about qualification for this credit, uh, when we talk about a product or especially software being in beta mode still, and that means it's in a state that is not quite ready for the market yet, then we're still talking about work that is is potentially eligible, uh, to be considered [00:21:00] qualified research. But once that product is out to market and it's readily available for the intended, uh, buyers of that product, then it's no longer eligible, uh, for this qualified research to be done on it. So we have to be very careful when we think about something like a software startup that's getting ready to launch a new product, We want to try to push that out as far as possible and make sure that the product is actually ready for the market, [00:21:30] and what that's going to do is help maximize the qualifying expenses that we could then count toward. What would be eligible for the credit research.
Jeremy Wells: Adapting an existing business component to a particular customer's requirements or needs won't qualify. So we can't look at an existing process. And even if we get a big new client, we have to spend a lot of time and money trying to adapt that process for new client, because it's only for that one client and it's not for [00:22:00] the broader market. We're not going to be able to consider those expenses or that research as qualifying for the credit and duplicating or reproducing an existing business component is not going to qualify as well for for a similar reason. This next one is where I see a lot of especially smaller businesses get tripped up. So research in the social sciences or involving surveys or studies will never qualify again. Just [00:22:30] researching your customer base, researching the market, looking at how the market is going to react to different marketing approaches, or developing products in different ways. None of that is going to qualify. If you if your research consists of trying to understand your customers better, which honestly is work that most, if not all businesses should be doing, that's not going to qualify as [00:23:00] research. It has to be in the physical or biological sciences, computer science or engineering. Those are the fields that qualify social sciences, statistics, economics, just general business. None of that is going to qualify. Research on computer software, primarily for the internal use of the taxpayer is generally not going to qualify unless it meets a three part high threshold of innovation test, and we'll talk about that in a few minutes.
Jeremy Wells: Research conducted [00:23:30] outside the US is never going to qualify. We're only talking about research conducted inside the US and research funded by another person or government entity. So the business itself has to be footing the bill for the research that's done. Now, that high threshold of innovation test for internal software has to be met in order for it to qualify for research for purposes of the credit. And and it's a very high bar. This is one that I've [00:24:00] looked at quite a bit for my own clients because, you know, we we live in the age of where, uh, you know, you can use a combination of various tools to create something that looks like a software product. Uh, you can use I, for example, you can use spreadsheets, databases, you can use app scripts and different kinds of automations. And if you configure these in such a way, you [00:24:30] could produce some software without really having to do a lot of the direct coding and programing yourself. So I'll have clients that come to me and they've worked really hard, spent a lot of time on developing some of this. Maybe they built an app, maybe they've built a web service, maybe they've built an extension. They want to sell that. Um, but we have to look very carefully at whether this is something that if they're primarily [00:25:00] intending to use it internally, and even if that means they're they're going to better serve their clients, they're still just using it internally.
Jeremy Wells: They're not looking to put this as a standalone product out into the marketplace. They're just using it internally. They're going to be the ones using this software. They're going to be taking data from the client, putting it into it, letting the software crunch the numbers or crunch the data and then produce some sort of recommendation or result for the client. If it's internal [00:25:30] software, then it has to meet this high threshold of innovation. Test has to be innovative. It would reduce. It would result in a reduction in cost or improvement in speed or other measurable improvement that substantial and economically significant. This is very difficult to test. How am I going to be able to test how much of a reduction in cost, or an improvement in speed, that has resulted in your solo marketing consulting [00:26:00] company as a result of you producing this internal software, this new database software, for example, A it? I'm not saying that that wouldn't happen. I'm just saying it's going to be very difficult to quantify in such a way that we would want to calculate a credit and then file a return, claiming that credit, based on the information that you've been able to provide as a, as a taxpayer, as a client. There also has to be a significant economic risk, the taxpayer commit substantial [00:26:30] resources to the development.
Jeremy Wells: And there's a substantial uncertainty because of technical risk that such resources would be recovered within a reasonable period. Again, most small business owners are either not in a situation where they can spend a lot of money on this kind of work or that uncertainty factor. They have identified a need in their own business or in their client's need, and they've determined what they think is a pretty reasonable path [00:27:00] toward addressing that need. They're not necessarily considering multiple alternatives. They're not testing those alternatives against each other. And so that's not really meeting the definition of a process of experimentation. And if it's not a process of experimentation, then it's not a technological development and it's not qualifying research. Here we're taking that a step further and saying, not only are we not doing that, but is the owner of the business or is the business itself really putting a [00:27:30] lot of economic resources, a lot of money? Are they spending a lot of money and hoping that there's going to be some return on investment? What doesn't count here, and I tend to agree with a lot of my clients when they tell me how unfair this is, but there's really nothing I can do about it. Is that sweat equity, or the time spent by the business owner, or the uncompensated work by their partners, or even their staff? None of [00:28:00] that counts toward this significant economic risk. We're talking about actual money spent.
Jeremy Wells: So it's got to be compensation paid. Supplies bought. Expenditures paid. It can't be a lot of time and energy. None of that counts. None of that is reported on a profit and loss statement or on a tax return. None of that counts toward qualifying research. And then it also has to be not commercially available, meaning that there can't be an off the shelf product [00:28:30] that can do essentially what the taxpayer is trying to do here. They just wanted to build it in house. Now they can take an off the shelf product and significantly modify it to work for themselves better internally. However, the significance of those modifications has to be pretty substantial. It can't just be that they took an existing spreadsheet or database software, and they made some slight modifications to it, and now it does something [00:29:00] that really any database or software or spreadsheet software could handle for them. Absent those modifications, it needs to be Be substantial. Now in terms of the expenses, how we're actually going to start qualifying or how we're actually going to start calculating this credit. If we have qualified research that has happened. Then we're going to look at how much was actually spent on that qualified research. There's a [00:29:30] couple of ways that that can happen. The first is in-house research expenses. So this is what we tend to think of. The company has in-house employees staff that it's paying to do this kind of research work.
Jeremy Wells: It might also have some supplies some equipment that it's paying for. There's also contract research expenses. Those are a bit more limited. But we'll talk about how in a minute. As far as in-house research expenses, primarily we're looking at wages [00:30:00] that are paid for the qualifying services of staff. There might also be some supplies and personal property that we're buying. So if we're looking at a manufacturing business, for example, they'll need to buy some raw material that's going to be used in those test manufacturing processes. Maybe they have to build some machinery in-house, uh, to try to figure out a better configuration [00:30:30] for their manufacturing process. All of that would be, uh, potentially part of the supplies and personal property. But the key here is that it has to be non depreciable. So as soon as we talk about a capital asset that then would have to be depreciated. That's not an expenditure that would qualify here for the credit. Once it becomes something that has to be depreciated. Now we've got to put that on the balance sheet like any other depreciable asset. It's no longer going to be part of the expenditures that we can [00:31:00] use to calculate the credit. And then if there is, uh, a, an amount paid for the use of computers for qualified research. This is something that it might be, uh, a little bit more difficult to think of today because 50, 60 years ago, if you wanted to do significant computing, you had to go to a local university or some sort of research facility that had the computing power that you needed [00:31:30] in order to be able to do that research.
Jeremy Wells: Now we have phones that fit in our pockets, that have more computing power than what those entire research labs did more than a few decades ago, so there's less of that. However, we do need access to cloud servers. And so this is what we're talking about here. So if your, uh, software startup or if your, uh, business client is using a significant amount of cloud computing, [00:32:00] then those costs would also qualify here. Uh, as as an in-house research expense. So even though they're using an external resource such as that used to be computer lab, now it might be cloud computing server, we're still going to consider that an in-house research expense. The wages that we pay to staff for qualified services is for the work that is directly related to the research. This [00:32:30] might mean that we have to bifurcate the salaries paid to employees and companies. If the work that they're doing is not 100% focused on the research and development work. So, for example, we've got some employees and their main job description is in one set of services to the company. The company wants to start a new revenue stream. They want to put a new product out to market. [00:33:00] And so they take some of their existing staff and they reallocate a portion of their time or their work toward that new project, such that now they're not focusing 100% on their prior job, but they're still doing some of that work.
Jeremy Wells: Now we have to look at usually on a time basis. So how many hours per week are they allocating toward their normal job? How many hours per week are they allocating toward this new project? And we might have to [00:33:30] use that as a way of bifurcating the wages that are applicable toward the qualified research, in terms of calculating the credit in general for the frontline workers who are going to be focusing specifically on the new research project. Their wages are going to qualify as part of the qualified in-house research expenses. However, when we go up a level [00:34:00] in terms of the administrative hierarchy for the business. We have to start looking, especially at the managers and in particular the executives, and thinking critically about how their wages might be bifurcated between their normal jobs and what they're putting into the actual research effort. Direct supervision of the workers who are focused on the research project will also qualify as focused on the research qualified [00:34:30] on the research project. So if you have a manager and that manager's entire team is focused on working on the research project, then that manager's wages will typically qualify as qualified expenses as well. Same goes for direct support. If you have a receptionist or a secretary or clerk, or even cleaning staff.
Jeremy Wells: If those cleaning staff are assigned to a research lab, for example, or if they're assigned to a computer lab where the work being done in that computer lab [00:35:00] is focused on the research project. Then, though, the wages for that support staff would also qualify, where we get into a little bit of trouble, from what I've seen with companies that are trying to qualify for the credit, is where they start going up levels higher than the direct supervisors and trying to claim a significant portion of those wages as qualifying, especially when we get to the level of an executive. I have seen clients and taxpayers [00:35:30] try to claim that in a company of 10 to 50 employees, that 100% of the CEO's wages should be eligible for the credit or that see the chief operating officer, the chief financial officer. For these executives, it's going to be very difficult to convince anyone that their spending really any significant amount of time directly involved in the research project. Now, it might [00:36:00] be that the CEO is actually a technical expert in the field of whatever this research project is focused on. And so they really are contributing a lot of time and dedicating a lot of time to that process. However, even then, you still have to look at are they just not doing the work that any CEO would have to do? Have they completely given up their control over the business? Have they completely stopped doing any sort of executive level work? I [00:36:30] hope not, I hope they would still be doing the oversight of the entire company, that we would expect a CEO, COO or other C-suite member, uh, of of doing.
Jeremy Wells: So in that case, we need to look at bifurcating, uh, for executives at least bifurcating, if not entirely writing off their, There their wages and their salaries as just not related to [00:37:00] the actual research project itself. If we do say that a portion of their wages are applicable to the research project, we need to be very clear on how we came up with that. When it comes to support staff and supervision, we are looking at a threshold in the law. There is a threshold of 80% involvement with the research activities makes those wages 100% qualifying. So if you've got a a manager, [00:37:30] a first level manager or a clerk or receptionist, some sort of support staff that is spending at least 80%, four out of five working days a week directly involved in that research project, then we're going to go ahead and say that their wages qualify in full. Anything less than 80%, we need to be clear on what that division is. Is it 50, 50, 70, 30? Something else? Um, as far as how we're going to delineate between [00:38:00] just their normal working wages versus the wages that are applicable for the purposes of the credit. Then we have contract research expenses. And this is where a lot of the clients that I work with who want the R&D credit, or maybe even qualify for the R&D credit, this is where they tend to fall, because most small businesses don't really have the resources or the personnel to be able to dedicate [00:38:30] a significant portion of their work toward the R&D effort.
Jeremy Wells: Either that or everyone is working on it, um, including the founder. And so it's the founder and a handful of people, and they're all working on it. Uh, in which case, uh, we'll look at that. And even then, uh, back to the prior point, I would still look at bifurcating. Maybe the founder is spending Percent, maybe 60%. Probably more than half, but less than all of their time working on the research project. In [00:39:00] the case of a really small business, though, a lot of times they're going to contract this out for a couple different reasons. One, again, they just lack the the personnel and the and the, the, uh, the actual capacity to do that kind of work in-house. And then second, they might actually lack the expertise. They might have the idea and a notion of how to get the idea up and running. They might even have the marketing connections, the business connections, the financial connections to get the business up and running. But they might lack the technical expertise [00:39:30] in-house to bring that product to a point to where it's ready for the market. And so they need to contract out a significant portion of the expense of doing the research and development.
Jeremy Wells: So in this case, we have to look at what kind of work is being done by the contractors and what kind of contractors this business is using, because there are limitations on the amount of the expense that qualify. In general, [00:40:00] contracted expenses for qualifying research are limited to 65% of the amounts paid to those contractors. So in general, if your business pays a contract service to do the qualifying research for you, only 65% of those payments are going to qualify for purposes of calculating the credit. If you use a qualified research consortium, [00:40:30] which has to be a 501, C 3 or 500 1C6 tax exempt entity, that's primarily organized for the purposes of doing this kind of research work. Then that goes up to 75% if it is an eligible small All business and I'll talk about what that means in a second. If it's an eligible small business, a university or a federal laboratory, then it's 100%. So what is an eligible small [00:41:00] business here? It means a and this is a unique definition to section 41. This is not a definition that we would go to other parts of the code and use something from those other sections, because we have that phrase small business used throughout the code in different ways here. For purposes of section 41, a small business means that it has fewer than 500 employees in either of the two years prior, and it's [00:41:30] not owned 50% or more by the taxpayer.
Jeremy Wells: So it has to be somewhat independent. There can be some co-ownership there, but it has to be less than 50%, and it has to be fewer than 500 employees in the two prior years. That makes an it an eligible small business that's actually, you know, not that difficult of a scale to hurdle for, uh, being able to call it an eligible small business and therefore 100% of those payments, uh, qualifying [00:42:00] now the qualified research uh consortium, those are 75%, though, and those are generally going to be tax exempt entities. So we need to be clear when we are looking at these contract, uh, research expenses, whether we're talking about a qualified research consortium, which we take 75% of, or whether this is an eligible small business, a university or a federal laboratory, and now 100% of [00:42:30] the expenditures, uh, paid are eligible. So that's an important distinction to make when you have a client that is tracking their research expenditures through their bookkeeping, and all of those expenditures get lumped together, Gather, uh, either in terms of just contractor expense or maybe even if they break that out so that they're independent contractors working on normal business operations is separate from the contractors that are doing the research work. We might [00:43:00] still need to go into the general ledger and break out those payments into the different categories. Which of those payments are going to contractors that qualify at the 65% rate? Are there any here that are qualified research consortia and therefore qualify for a 75% inclusion, or do we have any eligible small businesses, universities or federal laboratories that qualify for the full 100% calculating [00:43:30] the credit once we have those qualifying research expenses totaled up, actually calculating the credit on one hand, it can be straightforward.
Jeremy Wells: On the other hand, it can be very complicated if you read through section 41 and you try to understand what is actually included in terms of calculating the 20% credit. It is not very easy to understand in general, because the way [00:44:00] the code section reads is it's 20% of the excess of a taxpayer's qualified research expenses over its base amount. You then get a what I find to be just a really convoluted way of calculating what that base amount is. In general, it's multiplying the taxpayer's annual gross receipts for the preceding four years by its fixed base percentage. And this is where it gets even more confusing, because [00:44:30] the fixed base percentage is the aggregate qualifying research expenditures and aggregate gross receipts, the the the percentage of that between 1984 1988. Why that time period? I'm not exactly sure. It's not relevant for virtually all the clients I work with. However, the next part of calculating this, which is if that part of the definition doesn't fit your client, then [00:45:00] you go to this part of the definition for a startup, which technically is going to be any business that we would work with here for a startup, it's 3% for each of the first five years.
Jeremy Wells: And then there's a formula for after those first five years. I think it's pretty safe to say that if if you're reading through that, and none of that seems to really apply to your client, which is the way it works for most of my clients. Uh, [00:45:30] then we look at the fact that the minimum base amount is 50% of qualifying research expenditures for the credit year, that The amount calculation is is not easy to understand, but we have a minimum which is 50% of the qualified research expenditures. So if you think there's a chance that your client qualified, research expenditures are [00:46:00] going to be in such a way that their base amount is going to exceed 50%, then by all means do the math for me. Most of them, if not all of my clients, are all just going to qualify at that minimum of 50%. So think about what we're saying is 20% of the excess of a taxpayer's qualified research expenses over the base amount, and the base amount is a minimum of 50%. So we're saying the excess over 50%, [00:46:30] which is just going to be the other 50%. In general, we're looking at 50% of qualified research expenses and then we're taking 20% of that. Now, the way this is reported is on form 6765.
Jeremy Wells: And that form is the credit for increasing research expenses. Section A is the qualification for the regular [00:47:00] credit, which is what we've just gone over. We're essentially going to take the qualified research expenses. We're going to look at the base amount. The minimum there is 50%. We're going to look at the excess of those expenses over that base amount, which will be probably 50% again. And then we're going to take 20% of that. And that's essentially going to be the credit. So if you think about [00:47:30] mathematically what that works out to be, it's roughly 10%, 10% of the qualifying research expenditures is what works out to be the the credit in general. There's also an alternative simplified credit. I don't get into this with my clients as much, because that that credit tends to be the most straightforward. And the and the, the best, uh, route for most of my clients to take. However, there's an alternative [00:48:00] simplified credit taxpayer can elect to use the alternative simplified method, uh, which is 14% of those excess qualified research expenditures, over 50% of the average qualified research expenditures for the past three tax years, or 6% if there were no qualified research expenditures in one or more of those prior years. For most businesses, when they're just getting started, it's going to be zero [00:48:30] for at least one of the prior three years. And so therefore we're only looking at 6%. Now you might get to a point to where they have research expenditures for all the last three years, and then we're looking at taking 14% of the excess over 50%.
Jeremy Wells: So now we've gone down from what is usually 10% under the standard calculation to now 7% for the alternative simplified credit. [00:49:00] I have tried to find a way that this would make sense for most of my clients, and I've never come up with one that did. Um, that's not to say that it wouldn't make sense in some cases, but for most of my clients, in fact, virtually all of them, it's always worked out to where the standard calculation is what works best for them. There is also a an election to apply the credit against [00:49:30] payroll tax. This can be a good option for, especially for startups that are short on cash. If you think about it, the research credit, especially for a C corporation, would offset tax liability, but only if there is a tax liability. If we're looking at a true startup, it might be years before that business truly has a A tax liability. And so that credit is going [00:50:00] to carry over. But it's not going to benefit either the business or its shareholders, for it could be years before they see any benefit. The same thing might be true for a pass through entity. If they are having losses that are going to pass through, and they might get some offset from the losses, but the credit, there would be no income for that credit to offset.
Jeremy Wells: In those cases, we might look at [00:50:30] applying the credit against payroll tax. And what this does is it shows up as a credit on the. 941 against payroll tax in the following tax year, which is the tax year that we actually are calculating the credit and filing the return. This is under IRC 41 H1. And it's an offset of the employer's portion of Social Security tax. So the 6.2% payroll tax that the employer pays. [00:51:00] This can help with cash flow issues for example, because it's going to make, uh, the the bulk of the employer's portion of payroll tax. Uh, it's going to offset that for the tax year in which we're filing the return, not the not the year we file the return for, but the year that we're actually calculating the credit and filing the return that that year, we can offset some of that payroll tax burden by applying the, uh, [00:51:30] the R&D credit against that payroll tax burden. And so this can create a little bit of a benefit in real time for businesses that are eligible for the credit here. It's important to note that there is an interaction between I.r.c. 41, the R&D credit and ERC 174. Erc 174 requires an amortization of research expenditures. [00:52:00] This has been controversial, uh, over the last couple of years. And this is an item that was included in the Tax Cuts and Jobs Act of 2017 that came into play a couple years ago.
Jeremy Wells: Now, companies are required to amortize their research expenditures over five years for domestic research and experimental expenditures. And anything paid to researchers outside the US is amortized [00:52:30] over 15 years. The. Typically, there's a lot of overlap between the expenditures that qualify for both the section 41 credit and the section 174, uh, expense or amortization. The credit, any amount taken for that credit is going to reduce the amount of expenses that would then be subject to amortization and eligible to be expensed [00:53:00] under 174. So it's important to think about the interaction there. Now, the taxpayer could elect not to take the credit and amortize all of those expenses over time, or the taxpayer could elect to take the credit. And then that would reduce the amount of expenses, uh, eligible to be amortized and expensed. But it's important to think about how those two might interact with each other. There's [00:53:30] a special rule for partnerships and joint ventures that's important to keep in mind. If you have a client that is a partnership for for federal tax purposes, then we have to look at if all the partners are entitled to, uh, the, the full credit. So if they're all entitled to make independent use of the results of the research, or even if some of the partners are, then we have to calculate the credit [00:54:00] based on the allocable share of expenditures for those partners. Let's look at an example real quick.
Jeremy Wells: Let's say A, B and C three different partners. They form a partnership with equal interests to develop and produce a widget. Each of them can independently use the results of the research. This is written into the operating agreement for the partnership, so each of them can then take the results of the research and they can go back [00:54:30] to their own businesses and they can do whatever they want with that research. Let's say that only A and B, though, are actually in the widget industry. C is not. C is coming in maybe as a silent partner, just fronting money financial resources for the effort or C is in a completely different industry when it comes to calculating the credit. A and B can calculate that credit based on 60% of the partnership's qualified [00:55:00] research expenditures. However, the other, uh, excuse me, the 66%, the the one third from each A and B, however, the one third for C does not count. C is not in the business of creating widgets, and therefore the allocable share of those expenditures to see do not qualify for calculating the credit. As far as qualified research expenditures, [00:55:30] it's something important to keep in mind and it's something that we might not think about. But you know, we're not talking about partnerships of three individuals typically here. We're probably talking about partnerships of multiple businesses that are involved in some joint effort to do some research on some shared, uh, process or piece of equipment that maybe they all use.
Jeremy Wells: So maybe they come together for purposes of just doing some research specific [00:56:00] to a piece of equipment that they use in their businesses. If any of those partners is not directly involved in the industry, that is going to use this research, as long as they all have equal access to independently used the results of the research, then we have to allocate those qualified research expenditures just to the partners that are directly involved in that industry. This is [00:56:30] probably not going to be common with a lot of our clients, but if we do work with corporate clients that are involved in these kinds of partnerships or joint ventures, it might be something important to look for. I want to close with a couple of common myths that I see pop up around the R&D credit. The first myth that I hear out there is that service businesses automatically don't qualify. And when I first got started, I thought that sounded [00:57:00] right. They're not doing, uh, lab research work. And they're also not tech startups out in Silicon Valley. So, uh, you know, in general, they're probably not going to qualify. And to a degree that that usually true. A lot of the work that the owners of these small service based businesses that I work with, they think they're doing work that would qualify for the credit. And in general, it's just not they're just improving their own internal processes.
Jeremy Wells: Um, they're not really testing different options. [00:57:30] However, uh, don't give them too short a shrift. If your clients come to you and they're interested in the R&D credit, because not only is it possible that the work they're doing, uh, would qualify, however, it might be possible to advise them in such a way, uh, to help them qualify for it, at least in part. So, for example, if you've got a client that's coming to you and they're working on developing some sort of product or process that's internal to the business, [00:58:00] it might be worth it to work with them to think about how they could outsource some of the research work to, uh, a contract research, uh, service, maybe to develop some new software that they could use in-house, maybe work together to develop a new software product, for example, that could then eventually be taken to market. The key there is that we've got to make sure that it's truly qualifying research, that they're looking at multiple options, that there is some uncertainty about how [00:58:30] that project is going to unfold. And in those cases, if they're putting significant economic resources toward it, if they're actually spending some money on solving this problem, it might be possible to help even a service based business qualify for the credit. And that leads to another myth that I often see a lot is that payroll is required. It's not necessarily required like I talked about. It is possible to apply expenses paid [00:59:00] to contract researchers.
Jeremy Wells: Now there is going to be some limitation. In general, you're going to be limited to 65% of the expenditures paid to those contractors is actually going to qualify. So if we think about the math of calculating the credit, it's 20% of generally the 50% of qualifying research expenditures. So now we're down to just 10%, and then we're only going to take 65% of what's paid to contractors as going to be qualifying research expenditures. [00:59:30] So now we're down to 6.5%. So if all of the qualifying research expenditures are paid to contractors, then we're only going to be able to get about 6.5% of those expenditures in terms of the credit. But that might be better than nothing. Um, it might be better than thinking that it has to be payroll and therefore nothing qualifies. And it might also be more advantageous to pay contractors and be able to take 65% of what's paid to [01:00:00] contractors than to worry about taking existing staff and trying to allocate some of their work toward the research project, and then get into the complicated work of bifurcating Between what of their work was just normal operating work versus what was applied to the project. So this has been a very high level overview. There's still a lot of nuance, still a lot of detail. That's that's, uh, you know, hasn't been addressed. And I, I don't want [01:00:30] to necessarily say that you could have listened to this talk, and now you're ready to help your clients, uh, qualify for the R&D credit.
Jeremy Wells: There are a there are a few firms out there, uh, that specifically focus on tax credits and specifically on R&D credits. And they will work with tax advisors as well as, uh, companies to help them see if they qualify for the credit. And if so, what of their expenses are actual qualifying research expenditures? I [01:01:00] strongly recommend working, uh, with one of those firms, finding a good, reputable one to work with or to recommend, uh, and refer your clients to. But in general, it's important that you understand the the basis and the basics of section 41, and be thinking about how you might advise your clients, especially your small business owning clients, on how they can qualify, or at least how they can look into qualifying for these credits. And if nothing else, [01:01:30] you'll just be able to field those questions that they bring to you as far as thinking that they qualify for the credits. Again, in general, a lot of them are not going to, um, but you need to have some confidence about how you answer those questions and explain to them why they do or don't qualify for the credit. So again, this has been a very high level overview of section 41 and the R&D credit. But hopefully it's enough to get you thinking about some ways that maybe your clients could potentially qualify for it. Uh, and if so, to start [01:02:00] leading them down that path.