R&D Tax Credit Calculation: Using the Proper Method to Calculate R&D Wages

If your company relies on the hard sciences or uses technology to create or improve products or processes, you may be engaging in qualified R&D activities and be eligible for the Research & Development Tax Credit. But you have to know how to apply to get most use out of the credit.

One common area where companies incur most of the qualifying R&D credit costs is also the area of most R&D tax credit calculation mistakes: wages.

How not to claim wages for the R&D credit is in IRS Field Attorney Advice 20171601F released in April, which relates how the IRS concluded that one taxpayer used an impermissible method to determine eligible wages related to research expenses.

The Wrong Approach (Don’t Do This)

The taxpayer claimed credit for increasing research activities for at least four years. Employees of the taxpayer performed both qualified and nonqualified services. But in short (see end of post), the controller of the company simply estimated the level of R&D in terms of wages—what percentage of what employees’ salary was devoted to legitimate R&D activities—then took a statistical sample of the projects and multiplied the estimated wages by the estimated R&D project for the year.

The taxpayer did not use the method provided in Regulation 1.41-2(d)(1), which states:

“If an employee has performed both qualified services and nonqualified services, only the amount of wages allocated to the performance of qualified services constitutes an in-house research expenses. In the absence of another allocation method that a taxpayer can demonstrate to be more appropriate, the amount of in-house research expense shall be determined by multiplying the total amount of wages paid to or incurred for the employee during the taxable year by the ratio of the total time actually spent by the employee in the performance of qualified services for the taxpayer to the total time spent by the employee in the performance of all services for the taxpayer during the taxable year.”

The underlying issue in the case related by the IRS: The taxpayer failed to maintain adequate records reflecting the costs of its qualified research activities and couldn’t determine how much time its employees spent performing qualified services with respect to a particular project.

Five Good Moves[1]

It seems the taxpayer described above was “penny-wise and pound-foolish,” as it appears they didn’t hire a qualified professional to help them pay attention to the methods to claim the R&D tax credit. The following are five things our firm would have advised this company to do when substantiating the wages allocable for the R&D credit:

• Don’t go it alone. Get experienced help in claiming the R&D tax credit.
• Don’t have just your controller do the claim work. You need an in-house subject matter expert who was involved in the actual R&D to work with your accounting personnel and R&D consultants.
• Make every effort to maintain documentation to back up claiming the credit. Look for the historical data that will support the claim and qualitatively discusses the nature of the project: timecards, reports, minutes, even promotional brochures. Anything that points to the innovation or the challenges in creating it helps to support the claim for the credit.
• Look for needed improvements in your internal recordkeeping to make it more efficient to claim the R&D credit in future years.
• We have the necessary experience to help you efficiently claim all the R&D tax credit you are entitled to. Contact us at any time to discuss your particular facts and circumstances so that we can help you maximize and substantiate the credits you are entitled to.[2]

The Wrong Approach: One Taxpayer’s Made-Up Two-Step Process

• The taxpayer’s controller identified which employees were believed to have performed qualified services at any time during the taxable year. They estimated the fraction of each employee’s time spent performing qualified services, then multiplied this fraction by the employee’s total wages for the year. The controller then added the amounts calculated for each employee to calculate the initial estimate of total wages incurred for qualified services.
• The taxpayer multiplied this estimate by a fraction, based on a statistical sample. The denominator was the number of projects that the taxpayer believed to involve 50+ hours of work by employees and that might have involved at least one employee who conducted qualified research during some part of the project. The numerator was a subset of the projects in the denominator, with respect to which the taxpayer (after investigating a random sample of the projects) determined that an employee performed qualified research during some part of the project.

The Biggest Reasons the Methodology is Not Appropriate:

The taxpayer only considered whether the project involved qualified research at some point and did not determine what percentage of total project costs were attributable to the performance of qualified services, such as wages. The taxpayer provided no reasonable basis to apply their methodology, and the process looked at no detail of how the employees’ work time actually contributed to the R&D.  Thus, taxpayer’s methodology is not more appropriate than the method provided by Treasury Regulation 1.41-2(d) and was rejected by IRS.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.