Wages, Supplies, and Contract Research: What Counts Toward Your R&D Tax Credit
When business owners think about the R&D tax credit, they usually think about meeting the four prongs of the four-part test, because, of course, the activities won’t qualify at all if they don’t pass. A second set of rules is also important, though, regarding which dollars count. Getting the specifics incorrect can be a costly mistake.
These dollars are called qualified research expenses, or QREs. Under IRC §41(b)(1), QREs are defined as the sum of two things: in-house research expenses and contract research expenses. Under §41(b)(2)(A), in-house research expenses break down into three categories: wages paid for qualified services, supplies used in qualified research, and amounts paid for the right to use computers in qualified research, while contract research expenses cover what you pay outside parties to perform qualified research on your behalf.
Wages
For many companies, wages make up the majority of their credit.
What counts as a wage?
§41(b)(2)(D) ties the definition of a wage to IRC §3401(a), or the federal income tax withholding definition. According to the IRS Audit Techniques Guide, that means taxable wages reported on Form W-2, including bonuses. Important details to consider:
• Untaxed amounts, like certain fringe benefits and other amounts not subject to withholding don’t count toward the credit, even when paid to someone participating in the research.
• Under the §41(b)(2)(D)(iii), wages taken into account for the Work Opportunity Tax Credit under IRC §51(a) cannot also be counted toward the R&D credit.
• Self-employed individuals and owner-employees may be able to claim earned income as wages as defined under IRC §401(c)(2).
• The spread on an exercised option can be included in the year of exercise when the employee’s work in the grant year would have been a qualified service, meaning stock option income may qualify.
Three kinds of qualified services
§41(b)(2)(B) lists three kinds of work that make wages eligible, and Treas. Reg. §1.41-2(c) explains each of them:
• Engaging in qualified research. This is direct, hands-on work in the research, such as a scientist running lab experiments, engineers testing a prototype, a developer building an algorithm, or a dairy farmer experimenting with new genetic lines.
• Direct supervision. This means first-line management of the people doing the research, though the regulations specifically exclude higher-level managers that the first-line managers report to, even if the higher-level manager is a qualified research scientist.
• Direct support. This covers hands-on help to the people performing or directly supervising the research, such as a machinist making a part for an experimental model, a lab worker cleaning research equipment, or a clerk compiling and documenting results.
Direct support does have limitations; the same regulation excludes general administrative work regardless of what department they’re in. Examples of this include payroll staff processing researchers’ paychecks, an accountant tracking costs, a janitor cleaning ordinary lab equipment, or officials handling personnel matters.
Allocating time and the 80 percent rule
Many employees do not spend every minute of their work-day on research and instead split their time between conducting research and their “regular” activities. Treas. Reg. §1.41-2(d)(1) requires an allocation of the time spent between the research and regular activities, and unless you can prove that another method is more appropriate, it is calculated by multiplying an employee’s total wages by the share of their time spent on qualified services.
The regulation also includes a rule that states that if at least 80 percent of an employee’s wages are allocable to qualified services, all of that employee’s wages will count. For example, an engineer who spends 85 percent of their year on qualified work will contribute 100 percent of their wages to the claim, while an engineer that spends 60 percent will contribute 60 percent.
One more thing to note from the Audit Techniques Guide: examiners will decide eligibility based on what the actual employee did in regard to the research activities during the tax year and how much time they spent on research activities, not by their job title.
Supplies
§41(b)(2)(C) defines supplies as any tangible property other than land, improvements to land, and property subject to depreciation. More simply put, supplies are the materials your team uses up while performing the research.
What doesn’t count as a supply
The Audit Techniques Guide lists costs that taxpayers may try to claim as supplies that don’t qualify, including:
• Overhead, license fees, and lease costs
• Travel, meals, and entertainment
• Researchers’ phone expenses
• Relocation, rent, and lease expenses
• Professional dues, royalties, and license expenses
• Equipment and other depreciable property, including depreciable parts built into a prototype
Utilities
Utilities usually count as general overhead, though Treas. Reg. §1.41-2(b)(2) makes one exception: when the special character of the research requires extraordinary additional utility costs, the additional amount can count as a supply. For example, electricity for general lab lighting will not count, but the electricity for running high-energy equipment in laser or nuclear research can count to the extent the taxpayer can establish the extra cost.
Computer rental
§41(b)(2)(A)(iii) also allows amounts paid for the right to use computers in qualified research. Under Treas. Reg. §1.41-2(b)(4), the computer must be owned and operated by another party, located off-premises, and the taxpayer cannot be the primary user.
• Someone else owns and operates the computer. A cloud provider’s servers clearly meet this standard. Your own laptop does not.
• The computer is not located on your premises. A pure SaaS model clearly meets this standard. A hybrid setup, where licensed software runs on your own servers, raises a question the current regulations do not answer.
• You are not the primary user. Multitenant cloud infrastructure usually means many customers share the same hardware, so you rarely dominate it. The regulations give no method for documenting that.
Contract Research and the 65 Percent Rule
When the taxpayer pays someone other than an employee to perform qualified research on their behalf, IRC §41(b)(3)(A) allows for 65 percent of the amount paid to said contractor to be applied to the credit. That can include outside engineering firms, independent developers, and other contractors, as well as third party testing services.
Treas. Reg. §1.41-2(e)(1) extends the rule to services that would count as qualified services if your own employees performed them, but only at 65 percent of the payment to the firm or contracted employee.
Four conditions
Under Treas. Reg. §1.41-2(e)(2), a payment counts as contract research only if the agreement:
1. There must be a contract in place
2. The contract was entered into prior to the research being performed
3. Provides that the research was performed on the taxpayer’s behalf
4. Requires payments regardless of the success of the research
Research is performed on your behalf if you are at economic risk, and have a right to the results of the research. The regulation clarifies that those rights do not have to be exclusive. Although the agreement is not required to be in writing, a signed contract with clear terms is, of course, the most defensible.
Contingent payments
If part of a payment depends on the research succeeding, that part comes out of the credit calculation. The regulation treats it as a payment for a result rather than for the performance of the research. For example, if a company agrees to pay a contractor $200,000 for the research and $100,000 as a bonus for the success of the research, and the research succeeds, the $100,000 would not qualify for the credit. The calculation would be $200,000 x 65%, equaling $130,000 of QREs.
Mixed contracts
If a contract covers both research and other services, only the research portion counts, and the 65 percent limit applies to that portion. For hourly service contracts, businesses must identify the work that qualifies. For fixed-price contracts specifically covering qualified research, the full contract amount may be eligible for the 65 percent calculation, provided the contractual requirements are met. A fixed price contract alone does not establish eligibility.
Prepayments
Under §41(b)(3)(B), if you prepay for research that happens in a future tax year, the expense will count in the year the research in performed.
Location
Research performed outside the United States, Puerto Rico, and U.S. possessions does not count at any rate, no matter the situation.
When the rate goes above 65 percent
The statute raises the percentage in two situations:
• 75 percent for qualified research consortia. Under §41(b)(3)(C), payments to a qualified research consortium for research on behalf of the taxpayer and one or more unrelated taxpayers can be captured at 75 percent. The consortium must be a tax-exempt 501(c)(3) or 501(c)(6) organization, organized and operated primarily to conduct scientific research.
• 100 percent for certain energy research. Under §41(b)(3)(D), payments for qualified energy research to an eligible small business, an institution of higher education, or a federal lab count in full. An eligible small business generally has 500 or fewer employees and the taxpayer may not own 50 percent or more of it.
Basic research payments to universities and certain scientific research organizations follow a separate set of rules under §419(e) and generate their own credit component, and should be examined carefully.
Building the Record for Each Category
Each QRE category requires its own documentation, and while nothing overly scientific may be required, some best practices include:
• Wages: Track time by project or business component, and keep payroll registers and W-2 data for employees.
• Supplies: Record purchases for research and development separately from materials utilized in your normal production work. Keep records of software and cloud computing software utilized in research as well.
• Contract research: Keep signed agreements and statements of work dated before the work stated, and confirm what payment terms are, who retains rights to the work, and where the work was performed, along with the invoices from the contracts.
Frequently Asked Questions
Do employee benefits count as qualified research expenses?
Generally no. §41 uses the definition of wages from §3401(a), meaning taxable wages are subject to withholding. Certain fringe benefits and other untaxed amounts don’t count.
Does an owner’s time count toward the credit?
It can. An owner who receives W-2 wages is treated like any other employee. For self-employed individuals and owner-employees, §41(b)(2)(D)(ii) treats earned income as wages, but either way the time must be spent on qualified services.
Are independent contractors counted as wages or contract research?
Generally, contract research. Wages under §41 only come from employees, so payments to independent contractors generally count at 65 percent as contract research expenses under IRC §41(b)(3)(A), if the agreement meets the conditions in Treas. Reg. §1.41-2(e). The agreement must be in place before the work starts, the work must be done on your behalf, and you must pay even if the research fails.
What if our contractor also gets to use the research results?
That can still work. If you have a right to the results, those rights don’t need to be exclusive.
How RK Partners Handles QREs
The four-part test gets most of the attention, but an R&D tax credit claim relies heavily on carefully reviewed numbers. Each QRE category has its own set of rules, and RK Partners’ has extensive experience in correctly identifying each activity and qualifying expenses and applying allocation rules correctly to build a defensible tax credit claim for your business.
If you want a second to take a second look at how your R&D tax credit is calculated, or you’re building a study for the first time, we’re happy to talk to you about that.
Your Project Failed. What Does That Mean For Your R&D Tax Credit?
A failed project may still qualify for the R&D tax credit. The Treasury regulations state that the ultimate success or failure does not automatically qualify or disqualify whether its development costs count as research expenditures. Before you write off a shelved prototype, a scrapped software build, or a formulation that was never launched, find out whether the work behind it qualifies.
