The Research and Development (R&D) Tax Credit is comprised of three main categories of cost that can qualify for the credit. The three categories, formally known as “Qualified Research Expenses (QREs),” include wages, supplies, and contractors.
Qualified Labor is the portion of the company’s total labor expense (summed up on Form W3) that was dedicated to conducting qualified research. To determine your Total Qualified Labor expense, follow these steps:
- List all of your employees that received a W2 from the company last year.
- Next to their name, list the title or job description.
- Next, list their Gross Federal Taxable Wage from Box 2 on their W2 form.
- Now the hard part: determine what percentage of time was spent on the job last year either doing qualified research or DIRECTLY supporting or supervising the person who conducted the qualified research. This percentage determined for each employee is their “Allocation Percentage.” Every employee is different based on their job description.
- Multiply each employee’s W2 wage times their Allocation Percentage. This is known as their “Contribution to the Credit.”
- Sum up all of your employees’ Contributions. This is the company’s Total Qualified Labor expense.
Keep in mind, that although employee W2 values are easy to identify and defend, their allocation percentages are more difficult. When receiving the Research Credit, the taxpayer has the burden of proof to verify the Credit amount is accurate and defensible.
It is important to note that the total sum of the QREs is considered the “cost” of when an employee partakes in Qualified Research Activities. Example of Qualified Research Activities include:
- Participating in qualified research (ie. the chemist)
- Directly supervising the qualified research (ie. the chemist’s boss who’s working on with the chemist on the experiment. Note that the chemist’s boss’s boss doesn’t count.)
- Directly supporting qualified research (ie. the chemist’s assistant washing the beakers)
- Administrative or general support doesn’t count (ie. although the chemist’s admin assistant works for the chemist, their work is not directly correlated to the qualified research)
Now that you have a foundational understanding of how QREs are determined, let’s dig a little deeper. In this blog post, we will specifically focus on wages, also known as Labor QREs. Keep in mind that labor QREs don’t include all of the company’s wages or necessarily all of a specific employee’s wages, but rather the percentage of each employee’s time on the job performing what the IRS calls “qualified services.”
According to chapter 5 of the IRS ATG, these wages specifically include “all taxable wages as reported on Form W-2, including bonuses and stock option redemptions.” It does not include amounts that are not subject to withholding, such as certain fringe benefits or non-taxed income, even if paid for research services performed by an employee.
A taxpayer can claim the research credit for the amount spent or incurred for supplies used in conducting their research.
According to the IRS ATG, a qualified supply is “any tangible property that was directly used for the research.” It is important to note that supplies do not include the land (building) used to house the research or administrative costs. For example, you cannot claim the warehouse that your engineers work in, just the supplies used to conduct the experiment.
Other examples of costs that are not considered qualified supplies:
- Travel, meals, or entertainment
- Telephone expenses of researchers
- Relocation or rental/lease expense
- Professional dues or royalty/license expenses substantial
To calculate your Total Qualified Supplies Expense, follow the procedure outlined above for your QREs-Labor. However, instead of listing all of your employees, start by listing all of your vendors who provided materials used in your business. Then, when evaluating their total cost for the year (i.e. their total compensation on Form 1099 you provided them), determine what percentage of that total cost (their Allocation Percentage) was spent on supplies used in the development of your qualified research.
QUALIFIED CONTRACT RESEARCH EXPENSES
Contractor QREs are calculated much like Supplies QREs. However, by definition, a Contractor is a vendor that provided service, whereas a Supplier is a vendor that provided materials. With this clarification, calculate your Total Qualified Contractor Expense the same way you calculated your QRE-Supplies above.
There’s one additional step for Contractors, though. A contract research expense equates to 65% of the wages paid to a contractor (independent contractors and vendors) who partake in the taxpayer’s qualified research or services. Keep in mind that the contract work must be done in the United States, as it cannot be outsourced off-shore, despite contrary belief.
In an audit, the IRS will most likely request to review all contracts or agreements with your contractors that provided qualified services, along with the dollar amount claimed as contract research expenses.
The IRS has a three-part test that helps determine if the payment is for the performance of qualified research. Below are the determining factors:
- The agreement between both parties must be entered before the qualified research takes place.
- Research should be performed on behalf of the taxpayer.
- The taxpayer must take responsibility for the expenses incurred for the research even if the research is not successful.
You should now have a good understanding of how to determine your total qualified research expenses. You’ll need these numbers to complete Form 6765 to claim your credit. For the magical formula on how to compute your total QREs, click on the below button for the infographic:
If you’re struggling with determining Allocation Percentages for your wages, supplies, and contractors, you should first determine your Qualified Research Activities (QRAs). Once you can identify all of your QRAs, it will be easier for you to determine all of your QREs.