Claiming the Section 41 R&D Credit After the PATH Act ...media.straffordpub.com/products/claiming-the... · 11/29/2017 · •H.R. 2029, Protecting Americans from Tax Hikes Act (“2015

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Claiming the Section 41 R&D Credit After

the PATH Act: Small Business Provisions

WEDNESDAY, NOVEMBER 29, 2017, 1:00-2:50 pm Eastern

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Nov. 29, 2017

Claiming the Section 41 R&D Credit After the PATH Act

Christina Schenzel, Tax Partner

PwC, Atlanta

[email protected]

Angelique Garcia, Manager

Warner Robinson, Kansas City, Mo.

[email protected]





Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

I. Overview of Section 41 Research Credit II. Four-Part Test to Determine QRAs

Christi Schenzel, PwC Tax Partner

PwC

Sec. 41 Research Tax Credit - Overview

• Research credit first enacted in 1981

• Congress’s intent – encourage domestic R&D and keep high-paying engineering positions in the US

• Federal Credit Cash Benefit – typically between 4.5% and 6.5% of eligible costs

o Improves Cash Flow - reduces taxes payable

o Improves Effective Tax Rate – permanent benefit

• Numerous states (approx. 40) provide R&D incentives

• Credit was temporary prior to the PATH Act - broad bi-partisan support; extended numerous times

6

PwC

Sec. 41 Research Tax Credit – Recent Developments

• H.R. 2029, Protecting Americans from Tax Hikes Act (“2015 PATH Act”)

o Signed into law on 12/18/2015, retroactive to 1/1/2015

o Credit made permanent!

o May be used to offset AMT and/or Payroll Tax (in select circumstances)

• Final Treasury Regulations

o Sec. 174 Regulations - clarifies Sec. 174 eligibility

o Favorable Sec. 41 Regulations

Expanded opportunity to elect Alternative Simplified Credit

Favorable Internal Use Software Regulations

• Taxpayer Favorable Case Law – numerous taxpayer victories since 2009 that demonstrate the research credit’s broad applicability

7

PwC

Overview – Section 41 Credits Currently Available

• Regular Research Credit:

o 20% credit - Net credit value of 13% of qualified research expenses exceeding the base amount

o Base Amount - The product of a control group's average prior four years’ gross receipts (“GRs”) and its fixed-base percentage or 50% of current year QREs (whichever is larger)

o Net Cash Benefit - 6.5% of QREs

• Alternative Simplified Credit (ASC):

o 14% credit - Net credit value of 9.1% of QREs exceeding base amount

o Base Amount - 50% of the average prior 3 years QREs

o Approximate Cash Benefit – 4.5% to 5.5% of QREs

8

PwC

Overview – Eligible Costs and Activities

• Three specific types of eligible costs

o Wages

o Supplies

o Third-party contract payments

9

PwC

Wages

Qualified wages are W-2 wages (Box 1):

• Eliminate overhead, 401(k) and other deferred compensation

Includes taxable fringe benefits, as well as:

• Vacation,

• Sick pay,

• Bonuses, and

• Taxable stock options.

10

PwC

Qualified Activities – Three Types

1. Directly Performing Qualified Research (Core R&D)

2. Direct Supervision

3. Direct Support

11

PwC

Other Qualifying Activities

Direct Supervision: First line supervision of “Qualified Research”

• Excludes general and administrative

• Based on activity, not just title

Direct Support: …of Qualified Research & Direct Supervision

12

PwC

Wages – Direct Support

Examples of Direct Support:

• Machinist who builds prototypes

• Secretary who types lab reports

• Lab assistant who cleans test tubes

Examples of Indirect Support (Ineligible)

• Janitor who cleans the R&D facility

• Payroll personnel who prepare salary checks for company researchers

13

PwC

Wages

Substantially All Rule (80% Test):

• If 80% or more of an employee’s time spent performing services is spent on qualified services, 100% of the employee’s wages may be included in the research credit calculation.

• In applying the 80% test, eliminate all sick, vacation and other compensation that does not relate to performing services. FSA 1997-36 (9/17/97)

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PwC

Supplies

Supplies are tangible personal property other than:

• Land or improvements to land, and

• Property of a character subject to the allowance for depreciation

Examples:

• General supplies (e.g., pens, paper, lab notebooks)

• Materials used in building prototypes,

• Extraordinary utilities, and

• Raw materials used in experimental production lots formulated to test the appropriateness of a design

• Software license costs are ineligible – not tangible property, thus generally not a qualifying supply

15

PwC

Prototype Construction Expenses

Why is this a “hot” issue?

• No complete definition of prototype (however, the definition and understanding of this term has improved due to the new Sec. 174 Regulations)

• Prototypes are often placed in service or sold – thus, the costs are incurred to construct “property of a character subject to the allowance for depreciation”

• Usually significant expenses incurred for non-technical employees and contractors

• When does research end? Testing designs/formulations versus quality control testing (workmanship)

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PwC

Contract Research Expenditures

• 65% of amounts paid to anyone (other than an employee) for qualified research or services.

• Taxpayer must retain “Risk and Rights” for the research undertaken on their behalf

o Taxpayer retains some right to the research results, i.e., can use the IP without paying royalties; and

o Requires the taxpayer to bear the financial risk if the research is not successful, i.e., no refunds if unsuccessful

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PwC

Research Credit Calculation Illustrations

• Regular Research Credit:

o 20% credit - Net credit value of 13% of qualified research expenses exceeding the base amount

o Base Amount - The product of a control group's average prior four years’ GRs and its fixed-base percentage or 50% of current year QREs (whichever is larger)

o Net Cash Benefit - 6.5% of QREs

• Alternative Simplified Credit (ASC):

o 14% credit - Net credit value of 9.1% of QREs exceeding base amount)

o Base Amount - 50% of the average prior 3 years QREs

o Approximate Cash Benefit – 4.5% to 5.5% of QREs

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PwC

Calculating QREs

19

PwC

Regular Research Credit - Calculate Fixed-Base %

• General rule (except for start-up companies): Taxpayer’s fixed-base percentage equals its total qualified research expenditures for tax years beginning after December 31, 1983 and before January 1, 1989 (i.e. 1984 – 1988), divided by its total gross receipts for those years

• Statutory maximum fixed-base percentage is 16%

Consistency Doctrine:

• Must determine gross receipts and QREs in the base period under the same legal standards applied in the credit year (e.g., Internal Use Software)

• Consistent treatment ensures that the increase in research spending will be accurately determined by having a consistent basis of comparison

20

PwC

Fixed-Base Percentage Calculation

21

FB % = $75,000,000 / $1,500,000,000 = 5%

PwC

Calculate Base Amount

Determine Base Amount:

o Calculate the average gross receipts for the 4 years preceding the credit year

o Includes all items of income less: returns and allowances; capital gains and losses; extraordinary items; and

o Multiply the fixed-base % by the average annual gross receipts for the 4 years preceding the credit year

NOTE 1: If the base amount is less than 50% of current QREs, then the base amount is 50% of current QREs (minimum base amount)

22

PwC

Base Amount Calculation Illustrated

23

PwC

Regular Research Credit (Sec. 280C Reduced Credit Election)

24

Base Amount = Greater of $30,000,000 or 50% of QREs (50% X $35,000,000 = $17,500,000)

PwC

Sec. 280C Election

• Section 280C (net credit) must be elected on a timely filed, original tax return

• Prevents having to adjust taxable income after a credit change or an audit adjustment

• If elected, compute the net credit at the 13% (rather than 20%) credit rate (not required to add-back credit amount to taxable income)

• If not elected, compute the credit at the 20% gross credit rate and increase taxable income by the amount of the credit

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PwC

Alternative Simplified Credit (ASC)

• 14% credit - to the extent current year qualified research expenses exceed

• 50% of average qualified research expenses for three preceding taxable years

• ASC election must be elected

o On a timely filed return; or

o By filing an amended return where the period of assessment remains open

26

PwC

How is the ASC calculated?

Example:

Years QREs 2013 $100X 2012 $85X}→

2011 $80X}→ average $80X

2010 $75X}→

27

ASC Example

Current-year QREs: $100X Minus: 50% of avg. (3 prior yrs) 40X Incremental QREs $ 60X Credit Rate 14% Gross Credit $8.40X Minus: 280C Cutback (35%) ( 2.94X) Net ASC $5.46X

PwC

Sec. 41 Qualified Research Activities

• Four Part Test

o Technological In Nature – relies on principles of the hard science or computer science

o Permitted Purpose – intended to discover information useful in developing a new or improved business component (improved reliability, quality, or performance of a product or process)

o Technical Uncertainty – uncertainty as to capability, method or appropriateness of design

o Process of Experimentation – systematic trial and error process; failures may qualify!

• Better, Cheaper, Faster development efforts often qualify!

28

PwC

Technological in Nature

What does this requirement mean?

• Must involve science, engineering, or computer science

• Cannot involve pure cosmetic issues

• Cannot involve “research” in economics, finance, mathematics, etc.

• Does not mean that the credit is limited to paying people in “white lab coats”

- Key issue: Was conquering science and engineering issues key to the success of the project?

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PwC

IRC §174 Activity Requirements

30

IRC Sec. 174

IRC Sec. 41

• In order to be considered for the IRC Sec. 41 tax credits, the activities/costs must be deductible under IRC Sec. 174

• IRC Sec. 41 has a much more narrow definition of R&D than IRC Sec. 174

PwC

Final 174 Treasury Regulations

• Clarify long-contested positions

o Results of research disregarded in determining eligibility

o Defined term “pilot model”

o Established a shrinking-back provision to address situations in which requirements are met with respect to only a component part of a larger product v. the overall product itself

o Clarified depreciable property rule’s application

• Significant opportunities for taxpayers

o Accelerating deductions

o Sec. 41 R&E credits

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PwC

Sec. 174 - Results of Research do not disqualify eligible Sec. 174 deductions

• Results of research irrelevant in Sec. 174 evaluation

• TG Missouri referenced in Preamble

• Materials and labor expenses to resolve design uncertainty are 174 eligible – Examples include:

o Custom machine sold to customer

o Post implementation design refinements

o Pilot models sold, scrapped, and capitalized could be eligible

o Improvement of machine used in taxpayer’s trade or business

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PwC

Sec 174 - Pilot Model Definition

• Expansive definition

o “Any representation or model or product produced to evaluate and resolve product uncertainty regarding product development or improvement”

o Term includes a fully functional representation or model of the product or component

o Example: Prototype aircraft that cost $5 million to build is eligible for Section 174 deduction even if sold or capitalized

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PwC

Process of Experimentation

• Substantially all of the activities must be elements of a process of experimentation for a purpose relating to: (i) a new or improved function, (ii) performance, (iii) reliability or quality.

• Substantially all means 80% or more measured on a cost or other consistently applied reasonable basis

• 20% or less of the activities can relate to cosmetic issues, i.e., issues not related to functionality, performance, reliability or quality

34

PwC

Process of Experimentation

Final Regs: The taxpayer must identify:

• The uncertainty concerning the development or improvement of a business component;

• One or more alternatives intended to eliminate uncertainty; and,

• A process, fundamentally relying on science or engineering, of evaluating alternatives (through, e.g., modeling, simulation, or systematic trial-and-error)

35

PwC

Qualified Research Activities - Case Law

Union Carbide

• On March 10, 2009, Judge Goeke of the United States Tax Court issued a lengthy opinion in Union Carbide Corporation v. Commissioner, T.C. Memo. 2009-50.

• The case concerned Union Carbide Corporation's (UCC) amended claims for research credits regarding manufacturing process improvement projects.

• The Court held that two of five manufacturing plant process projects qualified for the credit and provided very helpful guidance on issues such as the process of experimentation, recordkeeping and substantiation, rejection of the "discovery" test, base period reconstruction, and supplies.

36

PwC


The following themes came out of the UCC case:

• The court eliminated the discovery test

• Judge Goeke confirmed manufacturing process improvements are qualified research

• Additional supplies used in research qualify for the credit

• Estimation for the base years is acceptable under Cohan

• Taxpayer may rely on internal representations and institutional knowledge

37

PwC


TG Missouri Corp

• Production molds are purchased by an automotive parts supplier (taxpayer) from a third-party toolmaker

• Parts supplier incurs design and engineering costs to modify the molds

• Parts supplier sells completed production molds to its customer, an automobile manufacturer

• Parts supplier includes costs paid to the third-party toolmaker as qualified research expenses (supplies)

• Court rejected IRS argument that the expenses were ineligible as Supplies QREs because they related to molds there were ultimately depreciable property in the purchaser’s hands

38

PwC


Trinity Industries

• District court held that substantial portions of the wages, supplies and contract research costs involved in developing and testing several prototype ships that were later sold were qualified research.

• The Court discussed the concepts of "business component," "integration," and the "substantially all" test.

• Business component - The court held that each "first in class" ship was a business component

• Integration - the court recognized, due to considerable flexibility in the configurations of the ships and complex interactions needed to make a ship operate successfully, there can be integration risk in the design of the vessel as a whole.

• “Substantially all” - Two of the six ships examined qualified for the credit and met the "substantially all" test.

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PwC


Trinity Industries (Fifth Cir. 2014)

• In a taxpayer-favorable decision, the Fifth Circuit, applying the so-called consistency rule of Section 41(c)(6), held that base-period expenses for projects similar to claim-year projects for which the taxpayer was determined not to have incurred QREs should be excluded from the taxpayer's research credit calculation.

• The Fifth Circuit remanded the case to the district court to evaluate the testimony of two Trinity employees who compared the base-period expenses related to four projects to disallowed claim-year research expenditures the district court had excluded from the credit because the claim-year costs did not meet the "substantially all" requirement of Section 41(d).

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PwC


• Taxpayer argument: District court erred in applying the consistency requirement of Section 41(c)(6)

- Certain base-period vessel costs should be removed from the base amount computation

◦ Two witnesses testified that 4 of 10 base-period vessels were no more experimental than the claim-year vessels the district court disallowed

• Fifth Circuit agreed and remanded case to district court for factual finding whether to credit witness testimony regarding the base-period vessels

• If the district court accepts the employees' testimony, the base-period expenses will be reduced, thus increasing the taxpayer's credit.

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PwC


• Trinity was primarily a documentation case

- The district court was forced to apply an “all-or-nothing” standard due to a lack of records provided by the taxpayer

• Both the district court and appeals court decisions reject current IRS exam positions

- Consistency doctrine — adjustments should be made in current and base years

- Inventory for sale to customers may constitute supplies QREs

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PwC


- Integration R&D opportunities

◦ Further supported by final Section 174 regs

- Witness/oral testimony may be used to help substantiate a research credit claim

◦ IRS examiners often take the position that taxpayers must provide tangible data (e.g., records) to claim a research credit

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PwC


Suder

• Closely held S-Corp (ESI) – developed telecom products/systems for use by mid-size and small businesses

• IRS characterized ESI’s development efforts as routine software development and disqualified ESI’s QREs

• Court evaluated 12 projects for credit eligibility – found 11 of the 12 qualified under Sec. 41.

• Court qualified many activities IRS examiners often disqualify, including: senior management strategy meetings and project follow up meetings, regression analysis and beta testing in customer environments

• Court affirmed use of employee surveys in determining qualifying percentages

• Royalty element of Mr. Suder’s compensation determined unreasonable and not deductible under Sec. 174.

44

PwC


Suder - Section 174 Test (uncertainty and experts)

• Was there evidence that showed uncertainty regarding the capability, method, or appropriate design?

• IRS relied on the testimony of an expert with a Ph.D. in electrical engineering from MIT. He testified as follows:

o Taxpayer created products that merely matched products already available from other vendors

o He identified no technical challenge in those projects that would require resolving uncertainty through experimentation

o He stated that "ESI's strength is building low-cost, easy-to-use telephone systems that match products introduced earlier by industry leaders such as Avaya and Cisco.”

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PwC


Suder - Section 174 Test (uncertainty and experts)

• Court stated: “Dr. Jackson (IRS expert) offers no factual basis in his report for these assertions.” The court found his report “unreliable.”

o He did not compare a single circuit board designed by Avaya or Cisco to a board designed by ESI's hardware engineers

o No comparison of software code written by Avaya or Cisco to code written by ESI's software engineers

o Used term “routine” to describe development without any definition of the word

o IRS expert’s testimony refuted by “credible evidence in the record” i.e. statements from the ESI engineers

o The court found, “The record contains extensive evidence of the uncertainties present in each of the 12 projects.”

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PwC


Suder Process Of Experimentation (software development process)

• IRS argued that “ESI chose among design alternatives by applying engineering know-how, publicly available knowledge, or by committee,” and asserted that this was not a process of experimentation.

• Taxpayer argued and the court accepted, that a companywide development process established the POE standard:

“ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved 1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, 2) testing these alternative in a scientific manner, 3) analyzing the results, 4) refining the initial hypothesis or discarding it for another if necessary, and 5) repeating the same, if necessary.”

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PwC


Suder – Process of Experimentation

• Court did not accept IRS position that the work involved only “engineering know-how.”

• ESI's engineers were from well-respected companies such as Texas Instruments and Raytheon and had a great deal of knowledge.

• They applied this knowledge, and the institutional knowledge of ESI, to the design of new products.

• Neither Section 41 nor the regulations thereunder require taxpayers to "reinvent the wheel.“

• Court cited to integration risk discussion in Trinity Industries.

• Court distinguished ESI’s work from the non-qualified projects in Norwest and United Stationers. ESI developed new software vs. modification of existing software.

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PwC


Suder - POE (80% test and debugging)

• Hardware and software were tested extensively by ESI's product assurance lab

• Alpha tested by ESI's engineering department

• Beta tested by willing beta testers

• ESI's hardware and software engineers reproduced bugs that were found during testing, fixed them in order of priority, and returned the hardware and software to be retested

• Debugging products in production: “The engineers continued fixing bugs in products that were available for sale to the public.”

• Although the court agreed that debugging for products in production is not POE, it found that 80% or more of the activities in the projects constituted elements of a process of experimentation

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PwC

Qualified Research Activities - Case Law Suder - Nexus and substantiation

IRS argued:

• Taxpayer did not substantiate the QREs claimed

• Taxpayer failed to produce sufficient evidence to make reasonable estimates for QREs.

• Taxpayer failed to provide any nexus between the expenses claimed and qualified research

• Mr. Wende (SVP product operations and development) lacked the tax or accounting educational background and experience to make accurate wage QRE percentage allocations

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PwC

Qualified Research Activities - Case Law Suder - Nexus and substantiation

• Wende found to be a “highly credible and reliable witness.”

• Wende used a diagram that showed:

o the employees for which ESI claimed wage QREs for 2004-07

o the department or area in which each employee worked

o each employee's percentage allocations for 2004-07

o Wende identified the employees on the diagram, described their roles and responsibilities, and explained how he determined their percentage allocations

• The court determined that Wende “was intimately familiar with ESI's business and its employees.”

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PwC

Qualified Research Activities - Case Law Suder - Judgment sample

• ESI claimed QREs for 76 projects during the years at issue

• The parties selected 12 of the 76 projects for trial

• Parties stipulated that these 12 projects are representative of the 76 projects for purposes of determining whether ESI performed qualified research under Section 41(d).

• Use of judgment sample by the courts is becoming common:

-Union Carbide (5 projects for 106 projects)

-Norwest (8 projects of 67 projects)

-Geosyntech (6 projects for 370 projects)

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PwC

Qualified Research Activities - Case Law Suder - Unreasonable compensation

• The taxpayers did not fully prevail in this case because the Tax Court held that a considerable portion of the S corporation’s owner’s compensation was not reasonable under Section 174(e), which significantly reduced ESI’s claimed research credits

• The unreasonable compensation finding by the court was based on reasoning from several cases involving reasonable compensation determinations in closely held businesses.

• ESI is a Subchapter S corporation that files a Form 1120S return, and Suder owned 90% of its stock

• It does not appear that this analysis could be used to exclude compensation of a highly compensated employee of a publicly traded company who owns at most a very small percentage of the company’s stock

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III. IRS REGULATIONS ON INTERNAL USE SOFTWARE INCLUSION IN QRE CALCULATIONS IV. SAMPLING AND ALLOCATION METHODS FOR QRES

Angelique Garcia, Warner Robinson

(650) 567-5670

[email protected]

Internal Use Software Regs • New final regs issued October 2016 (T.D. 9786) help define internal

use software and provide new tests for qualifying

• Prospective only (tax years post Oct 4, 2016)

• What is Internal Use Software?

– Prior IRS interpretation was pretty broad – if the software wasn’t licensed or

sold, IRS would treat as internal use

– Also subject to tougher tests to qualify – had to show the software was unique

and novel and differed from prior software on the market

– Result – many software projects were disallowed, backlog of cases at Appeals

• New definition of internal use software under Regs:

– Only internal use if it’s back office software used by the taxpayer to

run the business, general/admin type software systems

– If the software is used by clients/third parties/customers who

interact with the software – it’s not internal use

– So web based apps where customers access data/functions online

would not be considered internal use anymore

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What is Internal Use Software under the Final Regs?

– Back office software - software developed by taxpayer primarily for

use in general and administrative functions that facilitate or support

the conduct of the taxpayer’s trade or business

– Examples:

• Financial management functions (i.e., functions that involve the

financial management/recordkeeping)

• HR management functions

• Support service functions that support the taxpayer’s day-to-day

operations (such as data processing)

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What is NOT internal use software?

– Software that is licensed, leased, sold (so commercial software or

apps that are licensed or sold to customers)

– Software used in a production process or in R&D (software used on

production line, testing tools developed for testing formulas in a lab,

etc.)

– Integrated hardware/software products (so embedded software is not

internal use)

– Third party software – software to enable the taxpayer to interact

with third parties or to allow third parties to initiate functions or

review data

– Success or failure is not a criteria – it’s the taxpayer’s intent – intent

at the outset was to develop software for license – if project is

cancelled/fails, still would not be considered IUS

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Examples of Non-Internal Use – Third Party Use of Software – Evaluate whether the intent of taxpayer was to develop the software

for internal use or third party use at the beginning of the development

– Examples in Regs – third party is using the software to perform

functions or review data (so not IUS): Third party (customer) is using

the software to:

• execute banking transactions

• track the progress of a delivery of goods

• search a taxpayer’s inventory for goods

• store and retrieve a third party’s digital files (cloud computing or software

as a service potentially)

• purchase tickets for transportation or entertainment

• receive services over the Internet

– Third Party Use which is still considered internal use software:

• Setting up a web site; IRS considers this as a marketing purpose so it’s still

a back office function

• Contrast – web application where customer is performing a function or

reviewing their data or executing some transaction – would not be

considered a marketing function

• Vendor accessing an inventory management system – still considered IUS

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Dual Function Software • New regs added a ‘dual use’ or dual function test if the software is both

used for internal use and used by third parties (or in part meets another

exception)

• If taxpayer can split the costs into the internal use function and the third

party function(s), then that portion of the software used by third parties

is not considered internal use

– Internal use tests only get applied to that portion which is used by the

taxpayer for back office functions.

• Safe Harbor – Regs added a safe harbor – if the software is dual function

but taxpayer can’t break out the costs into these 2 buckets. If taxpayer at

least can show that third party use would be at least 10% of the total use

of the software, then safe harbor rule would apply:

– Safe harbor – allows taxpayer to claim 25% of the total R&D costs that went

into the software development

– Again note if the taxpayer can reasonably break out the costs into the 2

buckets, then no need to use the safe harbor rule

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Three part test for IUS

• If it’s internal use software (IUS), there is a three part additional test to qualify:

– Innovation Test

– Significant Economic Risk

– Not commercially available

• New Regs made innovation test more straightforward and less subjective:

– Instead of tougher ‘unique or novel’ standard, the innovation test is using the

legislative history definition – does the software result in a reduction of costs or

improvement in speed or other substantial improvement

• Significant Economic Risk – due to technical risk, uncertainty of recovery of project funds

(so relates to whether there was technical risk)

• Final IUS regs imply a higher threshold of uncertainty vs. the technical uncertainty

standard of the 4 part test. The modifier ‘substantial’ uncertainty according to the

IRS should denote uncertainty about the capability or methodology. IRS will

consider ‘design’ uncertainty but may be tougher on taxpayers who argue the

project involved only issues on what was the appropriate design of the software.

• No bright line test for how much uncertainty is considered substantial.

• Commercial Availability Test – the system can’t be commercially available off the shelf.

Client has to do new software development (modules or apps that are not just purchased

software)

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Final Regs - Process of Experimentation Requirement for Software Projects

• New Regs on internal use software decided to opine on all software –

provides examples illustrating what IRS believes is or is not R&D

• Experimentation Test: Iterating, testing, evaluating alternatives to

eliminate a technical uncertainty – this happens all the time in software

development – but question is what types of software experimentation will

meet IRS standards?

• New regs provides examples:

– Evaluating several vendor software packages and picking one - is not R&D/no

experimentation (Ex. 5 and 6)

– Designing a new algorithm to handle load balancing = experimentation (Ex. 7)

– Implementing a new ERP system involving routine mapping, data transfer,

using existing templates - is not R&D (Ex. 9)

– Same facts (ERP system) but developing an interface involving a new data

caching software layer is R&D – is R&D but need to shrink back to that qualified

activity and still need to carve out the routine ERP implementation work (Ex.

10)

• Key Point – the IRS may focus more on the experimentation test for all

software claimed as R&D (not just internal use)

62

Qualified Activity Examples - Software

• Development of new software product(s)/modules

• Enhancements/improvements to existing software products/modules

• Product updates and new releases with enhanced or new features,

functionality, performance, scalability or security

• Rearchitecture efforts related to new platforms, technologies

• Creation of a new or unique architecture

• Using new or even existing technology in a unique way

• Projects to develop functionality unique and new to the industry

• Development of new middleware or use of commercial middleware in a

unique way

• Data mining, data warehousing, or other efforts to improve data storage

and retrieval;

• Development and testing of new algorithms

• Qualified software development cycle includes requirements & design,

development, testing, and refining. Usually includes testing through BETA

testing

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Allocation Techniques and Sampling in R&D Studies

Allocation – How to Allocate R&D Costs?

• Start with - what do the client’s records look like?

– Taxpayer may have costs by project, or only costs by department or

cost center

– The company may or may not have a time tracking system

• IRS would prefer to see R&D costs by project but a cost center

approach may be used if there is a nexus between those costs and

a ‘business component’

– Regs require that the R&D costs relate to a new or improved ‘business

component’

– This may mean a specific project, but could mean a higher level initiative,

process, product, method, technique, invention, formula, software

– Ex: To develop Product A, client has teams working on items b,c,d – but

product A is the item offered for sale = bus component

– Ex 2: Three related software modules make up the client’s CRM software

suite – this CRM suite offered for sale/license can be the bus component

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Allocating to Business Components – Cost Center Approach

• No prohibition against using a department or cost center method – See Briefing Paper on Taxpayer Approaches to Capturing Costs for the Research

Credit IRS Pub. dated 5/24/2005

• First determine which departments have qualified activities

• Next which products or business components does that department

develop?

• Have client (i.e., Dept Manager) allocate his/her department costs (i.e.,

wages of employees) to one or more business components for that year

– This can be done via a survey or via interviews or combination

– The department may already track spend across products for other purposes

(which can be leveraged)

• IRS hot button issue is when taxpayer does not make any attempt to

allocate the department’s costs to business component(s)

– IRS position is supported in part by Bayer case (very difficult time with this

issue and judge sided with IRS on one motion)

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• If the client doesn’t track hours, can have them complete a time

survey to do this allocation – allocate employees to the

appropriate business component

– Line of cases allowing use of reasonable estimates (Cohan

rule/case, Fudim, McFerrin, Union Carbide, Suder)

– Estimates need to come from the employees/managers with

first hand knowledge of the activities

– Back up estimates with other supporting documentation:

• Have manager review calendars, project timelines, launch dates,

employee evaluations/reviews

• Allocation should be done first before considering sampling (Bayer

case)

• Key takeaway – allocations – lack of a time tracking system at your

client doesn’t mean they can’t claim the R&D credit

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Use of Sampling Techniques in R&D Studies

• Two uses of sampling: – Sampling to calculate qualified costs including extrapolating sample

costs to other projects/departments to arrive at total QREs for the

year

– Sampling to determine which projects to document; client can

calculate total QREs but needs to determine an approach to

documenting qualified projects

• Two types of sampling: – Statistical sample

– Judgment sample

• Two key IRS documents – authority for using sampling: • Rev. Proc. 2011-42 – statistical sampling

• 2012 Field Directive – use of sampling in research credit cases –

pertains more to judgment sampling in R&D cases

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Use of Sampling Techniques in R&D Studies • Stat Sampling under Rev. Proc. 2011-42

– Following the IRS guidance in this Rev. Proc. allows taxpayers to use a

stat sample when conducting the R&D study

– Applicable to calculating R&D costs and extrapolating those costs to

determine the total QREs and R&D credit amount

• Steps Needed:

– Pick the sample unit:

– Could be the employee, the project, the wage amount, job title, etc.

– Could even have more than one sample unit if more than one strata (see

below)

– Create Strata:

– Group similar items together; can stratify based on wage bands, project

types, project size, job titles, criteria for qualifying (internal use in one

strata, non-internal in second strata, supply costs separate from wage

costs)

– Results of each strata are typically applied to that strata only

– Certainty strata – strata of largest projects which will be examined in full

– Random strata – use random number generator program to randomly pick

several smaller projects from random strata population

– Extrapolate these results to rest of random population

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Use of Sampling Techniques in R&D Studies

• Define sample size for each strata: – Goal is to pick enough items to achieve a 95% confidence level

(95% confident that the sample results reflect the rest of the

population)

– The lower the number of items selected, the lower the confidence

level and higher the margin of error

• Apply results to population (Note if relative precision

exceeds 10%, taxpayer has to give back some of the sampling error)

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Use of Judgment Sample

IRS Field Directive on use of sampling in R&D cases

– This paper states if the number of projects is very high, a true stat sample may

still not be administrable; how to narrow down number of projects to review?

– Or if number of projects is too small and precision would not be sufficient,

then use a judgment sample

– Taxpayer can also use these techniques in doing the R&D study

– Generally used for which projects to fully document; not commonly used for

extrapolating dollars and arriving at total qualified costs (QREs)

• Steps Needed:

– Goal is to document projects to achieve the greatest coverage of QREs claimed

– Can (and likely should) use strata – stratify based on like projects or like units

– Gather documentation, do interviews, prepare memos on largest projects in

each strata

– Example:

• Total population – 50 projects

• Create 3 strata; pick top 5 largest projects in each of the three strata to document;

assume this provides 85% coverage of all QREs

• Last 15% of QREs? Could randomly pick projects using random number generator

• IRS audit would likely also focus on largest projects, so you have documented 85% of

your biggest projects; some risk that IRS would pick some projects out of the other

15%, but those are only 15% of your QREs. Have taxpayer retain other documentation

on these smaller projects.

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V. Documentation and Substantiation

Christi Schenzel, PwC Tax Partner

PwC

Documentation and Substantiation

• IRS expects taxpayer to maintains sufficient books and records to substantiate QRE claimed

• Tier I IDR Expectations

• QRE by business component

• Cost center detail

• Wage QRE computed using Box 1 W-2s at the individual employee level

• Expense QRE documentation

• Documentation may include:

• Financial books and records

• Project / time tracking data, if applicable

• SME testimony

• Wage and expense surveys

• Contemporaneous documentation

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PwC


• Quantitative Documentation

• Credit calculation workpapers

• Wage, supplies and contract research QRE detail

• Project / time tracking detail, if applicable

• Qualitative Documentation

• Costing methodology

• Company overview

• Departmental / site activity documentation

• Business component / project documentation

• Contemporaneous documentation

• Patents

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PwC


• IRS Focus Areas

• Supervisory and/or highly compensated employees

• QRE from direct support areas

• Prototype costs and experimental trial runs

• Contract research

• Process of experimentation

• Software

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PwC


New IRS Directive (September 2017)

• Safe harbors for taxpayers that report GAAP ASC 730 R&D costs on audited financial statements

• 95% of taxable wages for individual contributors and first level supervisors

• 10% safe harbor for upper level managers

• Supplies QRE amounts expensed under ASC 730

• Computer rentals and leases for performance of qualified research

• No safe harbor for contract research

• Eligibility

• Effective date – original returns timely filed (including extensions) on or after the date of the Directive

• Requires certification statement and reconciliation of reported ASC 730 expenses to QRE

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VI. SMALL BUSINESS STRATEGIES AND APPLYING CREDITS AGAINST AMT OR PAYROLL TAX LIABILITY

Angelique Garcia, Warner Robinson (650) 567-5670 [email protected]

Protecting Americans from Tax Hikes (PATH) Act of 2015

• December 15, 2015

• House amendment # 2 to a Senate amendment to H.R. 2029, Military Construction & Veterans’ Affairs and Related Agencies Appropriate Act of 2016

• 233 pages

– § 143: Bonus depreciation for grafting nut & fruit bearing trees

– § 166: Extension 7-year recovery period for motorsports entertainment complexes

– § 335: Modification of the definition of hard cider

– § 407: Termination of employment of Internal Revenue Service employees for taking official actions for political purposes

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R&D Credit in the PATH Act

Title I - Extenders

Subtitle A – Permanent Extensions

Part 3 – Incentives for Growth, Jobs, Investment, and Innovation

Sec. 121: Extension and modification of research credit

• § 121 Subsections

(a) Made Permanent

(b) Credit Allowed Against Alternative Minimum Tax in Case of Eligible Small Business

(c) Treatment of Research Credit for Certain Startup Companies

(d) Effective Dates

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PATH Act - § 121 Subsection (a)

• The R&D Credit was first codified in the Economic Recovery Act of 1981

• Written to be temporary, but continuously renewed 16 times except for one-year lapse in 1995

• The PATH Act strikes the temporary provisions of § 41, making the R&D credit permanent

• Easier to include in financial planning

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PATH Act - § 121 Subsection (b)

Alternative Minimum Tax (AMT)

• Purpose: ensure high-income individuals pay more tax than they otherwise might

–Corporations

– Individuals earning roughly $180k+ per year

• Reimposes tax on tax-exempt income and denies certain credits & deductions

• Form 6251

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R&D Credit as AMT Offset

• “Credit allowed against alternative minimum tax in case of eligible small business (ESB)”

• ESB – average of less than $50MM in gross receipts over prior three tax years

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R&D Credit as AMT Offset • C-Corps

–Can qualify as ESBs –Benefit directly

• Shareholders, Partners of S-Corps or

Partnerships –Each must separately be below the gross

receipts threshold to offset personal AMT –Benefit indirectly – R&D credit lowers

entity taxable income, resulting in a higher pass-through benefit

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PATH Act - § 121 Subsection (c)

R&D Credit as Payroll Tax Relief • “Treatment of Research Credit for Certain

Startup Companies” • “Certain Startup Companies” = Qualified

Small Businesses (QSB) –Gross receipts in credit year less than $5MM –No gross receipts prior to the five-year

period ending in the year of the current claim

–So if claiming for 2017, first year must be 2013 or later

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R&D Credit as Payroll Tax Relief

• Federal Insurance Contributions Act (FICA)

–Social Security (OASDI) – 6.2% of gross wages

–Medicare (HI) – 1.45% of gross wages

• Limitations

–$250k limit per year

–Not refundable – credit cannot exceed tax

–Unused credits may be carried forward to the next quarter

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R&D Credit as Payroll Tax Relief • Form 6765 Sec D – timely filed return

(including extensions) –Line 41: “Check this box if you are a

qualified small business electing the payroll tax credit.”

–Line 42: “Enter the portion of line 36 elected as payroll tax credit (do not enter more than $250,000).”

• Credits begin to be claimed against payroll

taxes owed in the first quarter after the tax year for which the 6765 was filed

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R&D Credit as Payroll Tax Relief

• Form 941 (filed every quarter)

–Line 11: “Qualified small business payroll tax credit for increasing research activities”

–Line 12: “Total taxes after adjustments and credits”

• Form 8974 - NEW

–Asks a few basic questions about the return

–Determines the credit that can be used each quarter

–Attached to Form 941 that quarter

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PATH Act - § 121 Subsection (d)

Effective Dates

• Changes imposed are effective after December 31, 2015

• Tax year 2016 and beyond – remember, this is PERMANENT!

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How to Plan

• Determine eligibility based on 4-part test

• Get an estimate of the size of benefit

• Discuss procedures with your PEO if claiming payroll credit

• Work with an expert to document and substantiate qualified projects and costs

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A Note on 2016

• Payroll tax credit election must be made on timely filed return (including extensions) – except for 2016

• If a return was filed for tax year 2016 (beginning after 12/31/15) without the election, taxpayers may file an amended return with the election by December 31, 2017

• If considering this option, speak with your tax professional ASAP!

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Summary

• More companies qualify for the R&D Credit than you might think

• The PATH Act significantly strengthened the R&D Credit for both larger, more established companies and young startups

• The time to plan is now!

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Documents

Claiming the Section 41 R&D Credit After the PATH Act ...media.straffordpub.com/products/claiming-the... · 11/29/2017 · •H.R. 2029, Protecting Americans from Tax Hikes Act (“2015