Calculate Base Amount Determine Base Amount: • 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 • 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) PwC 23
Base Amount Calculation Illustrated PwC 24
Regular Research Credit (Sec. 280C Reduced Credit Election) Base Amount = Greater of $30,000,000 or 50% of QREs (50% X $35,000,000 = $17,500,000) PwC 25
Sec. 280C Election Adjust credit to account for section 280C (eliminates impact of double tax benefit – current expense deduction for refunded taxes): *Increase taxable income by amount of credit OR * If properly elected on a timely-filed original return, compute credit at 13% (rather than 20% rate) PwC 26
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 o elected on a timely filed return; or o amended return where the period of assessment remains open PwC 27
How is the ASC calculated? Example: Years QREs 2013 $100X 2012 $85X} → 2011 $80X} → average $80X 2010 $75X} → ASC Example Current-year QREs: $100X Minus: 50% of avg. (3 prior yrs) 40X Incremental QREs $ 60X Credit Rate 14% Tentative Credit $8.40X Minus: 280C Cutback (35%) ( 2.94X) ASC $5.46X PwC 28
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 (as defined under Sec. 174) o Process of Experimentation – systematic trial and error • Better Cheaper Faster often qualifies! PwC 29
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? PwC 30
IRC § 174 Activity Requirements • In order to be considered for the IRC Sec. 174 IRC Sec. 41 tax credits, the activities/costs must be deductible IRC Sec. 41 under IRC Sec. 174 • IRC Sec. 41 has a much more narrow definition of R&D than IRC Sec. 174 PwC 31
Final 174 Treasury Regulations • Clarify long-contested positions o Results of research disregarded in determining eligibility o Defined term “pilot model” o Established Shrinkback Rule o Clarified depreciable property rule’s application • Significant opportunities for taxpayers o accelerating deductions o Sec. 41 R&E credits Tax Manager Forum FY14 PwC 32
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 all eligible o Improvement of machine used in taxpayers trade or business Tax Manager Forum FY14 PwC 33
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 Tax Manager Forum FY14 PwC 34
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 PwC 35
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) • Treasury Regulations examples include: o Car Hood Design o Cheese Grater Design PwC 36
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. PwC 37
Qualified Research Activities - Case Law 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 Powered by the Best PwC 38
Qualified Research Activities - Case Law 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 ineligible as Supplies QREs because they related to molds there were ultimately depreciable property in the purchasers hands Powered by the Best PwC 39
Qualified Research Activities - Case Law 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. Powered by the Best PwC 40
Qualified Research Activities - Case Law 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). Powered by the Best PwC 42
Qualified Research Activities - Case Law • 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. Powered by the Best PwC 43
Qualified Research Activities - Case Law • 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 Powered by the Best PwC 44
Qualified Research Activities - Case Law - 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 Powered by the Best PwC 45
Qualified Research Activities - Case Law 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: Sr. Mgt strategy meetings and project follow up meetings o Regression Analysis o Beta Testing in customer environments o 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. PwC 46
Qualified Research Activities - Case Law 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.” Powered by the Best PwC 47
Qualified Research Activities - Case Law 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.” Powered by the Best PwC 48
Qualified Research Activities - Case Law 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.” Powered by the Best PwC 49
Qualified Research Activities - Case Law 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. Powered by the Best PwC 50
Qualified Research Activities - Case Law 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. Powered by the Best PwC 51
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 Powered by the Best PwC 52
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.” Powered by the Best PwC 53
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) Powered by the Best PwC 54
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 . Powered by the Best PwC 55
III. NEW IRS REGULATIONS ON INTERNAL USE SOFTWARE INCLUSION IN QRE CALCULATIONS IV. SAMPLING AND ALLOCATION METHODS FOR QRES Bruce Warner, Warner Robinson (913) 522-6420 bruce@warner-robinson.com
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 57
Allocation Techniques and Sampling in R&D Studies 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) 58
Allocation Techniques and Sampling in R&D Studies • 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 59
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 60
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 61
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) 62
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. 63
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 64
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) 65
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 66
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 67
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 68
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) 69
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) 70
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 71
DOCUMENTATION & SUBSTANTIATION OF CREDIT CLAIMS Mike Flesher Swanson Reed Tax Services m.flesher@swansonreed.com 903.217.9633 December 1, 2016 72 m.flesher@swansonreed.com
Basic Rule “If you can’t or won’t document an expense, don’t claim it!” December 1, 2016 73 m.flesher@swansonreed.com
Documentation / Substantiation Involves • A serious attitude about claiming a credit • Determination to be “audit proof” • Time spent maintaining a logical & responsive record keeping system, separate cost centers • Readiness to support a claim on a moment’s notice . . . any time & all the time! December 1, 2016 74 m.flesher@swansonreed.com
As With All Income Taxes • “Stay in an audit frame of mind!” • “I can possibly be required to explain anything I report!” • Audits are typically “come as you are.” December 1, 2016 75 m.flesher@swansonreed.com
Impartial Documentation • Externally-produced documents are always more credible than internal ones • Invoices, gov’t forms, etc., are not subject to manipulation, as are internal spreadsheets December 1, 2016 76 m.flesher@swansonreed.com
Presenting Data • Sort by the fiscal operating period, whether that be calendar year or fiscal year • Filing systems should cut-off in like manner December 1, 2016 77 m.flesher@swansonreed.com
Four Areas to Document • Is the object of the R&D claim really R&D? • Labor costs • Supplies-durable equipment • Contracted services December 1, 2016 78 m.flesher@swansonreed.com
Is the Object of the Claim Really R&D? • Speak to the four-part test, this is literally the test to pass • Written, technical justifications work best & ideally should be submitted with the return to preempt IRS concerns in advance • Patents (automatic pass), results of trial runs, websites, brochures, designs, schematics, diagrams, blue prints, minutes from meetings December 1, 2016 79 m.flesher@swansonreed.com
Labor Costs • Calendar year filers: w2’s • Fiscal year filers: payroll registers synchronized to the fiscal year, test for tie- back to the w2’s on the front & back ends of the fiscal year December 1, 2016 80 m.flesher@swansonreed.com
Labor Costs Allocation to R&D • Some employees work 100% on R&D, others don’t, and therein lies the challenge • Design a consistent methodology for explaining the %’s assigned to employees who not fully dedicated to R&D December 1, 2016 81 m.flesher@swansonreed.com
Labor Costs Assigning %’s Less Than 100% • Memorandums discussed with the employee • Time schedules • Software that tracks hours, calculating per cent-to-total hours & multiplying a ratio times the gross salary December 1, 2016 83 m.flesher@swansonreed.com
Labor Costs High Risk • Assigning the same % to every employee because employees are unique individuals, implies laziness on the taxpayer’s part • Assigning anything greater than 25% to the salary of a CEO or Plant Manager December 1, 2016 84 m.flesher@swansonreed.com
Supplies & Durable Equipment • Supplies: safest to claim, consumed entirely on the R&D projects, invoices are the best documentation • Durable equipment: claimable but with additional risk December 1, 2016 85 m.flesher@swansonreed.com
Supplies & Durable Equipment Durable Equipment Precautions • Identify the portion of use on R&D, hours meter, memorandum • Ideally scrapped or sold after the R&D, don’t fall suspect to refurbishing your company with new equipment & charging it to R&D • Computers are the traditional “red flag” December 1, 2016 86 m.flesher@swansonreed.com
Supplies & Durable Equipment Durable Equipment Documentation • Purchased outright: invoice or bill of sale within the fiscal year • Purchased on credit: the principal portion of an amortization schedule for the fiscal year being reported • Reverse the claimed expenses against ordinary business expenses December 1, 2016 87 m.flesher@swansonreed.com
Contracted Services • Typically, invoices or 1099’s • For collusion with universities, contracts & scope of work December 1, 2016 88 m.flesher@swansonreed.com
Summary • If you can’t/don’t document or substantiate an expense, don’t claim it • Maintain a responsive & logical filing system, so documentation can be retrieved on a moment’s notice, select the right employee for this job • Consistent & methodical processes draw the least attention December 1, 2016 89 m.flesher@swansonreed.com
SMALL BUSINESS STRATEGIES & APPLYING CREDITS AGAINST AMT OR PAYROLL TAX LIABILITY Mike Flesher Swanson Reed Tax Services m.flesher@swansonreed.com 903.217.9633 December 1, 2016 90 m.flesher@swansonreed.com
Examining the Law • Much has been written about the law, not all of which can be found in the law • As much as possible, we will limit our discussion to what the law says December 1, 2016 91 m.flesher@swansonreed.com
“Relief from AMT & Payroll Tax Liabilities” aka Protecting Americans from Tax Hikes (PATH) Act of 2015 • House amendment # 2 to a Senate amendment to H.R. 2029, Military Construction & Veterans’ Affairs and Related Agencies Appropriate Act of 2016 • 233- page document December 1, 2016 92 m.flesher@swansonreed.com
Broad Scope of Coverage • § 143: Bonus depreciation for grafting nut & fruit bearing trees • § 165: Classification of certain race horses as 3-year property • § 172: Increase in the limit of excise taxes on rum from Puerto Rico & the Virgin Islands • § 183: Credit for 2-wheeled plug-in electric vehicles December 1, 2016 93 m.flesher@swansonreed.com
Broad Scope of Coverage • § 308: Early retirement distributions for the U.S. Capitol police & others • § 335: Modification of the definition of hard cider • § 402: Prohibition of IRS employees from using personal email accounts for official business & claiming deductions December 1, 2016 94 m.flesher@swansonreed.com
Limit of Our Focus Title I Extenders Subtitle A-Permanent Extensions Part 3-Incentive for Growth, Jobs, Investment, and Innovation § 121: Extension & modification of research credit Pages 20-28 in my version December 1, 2016 95 m.flesher@swansonreed.com
§ 121 Divided Into 4 Subsections (a)Permanency of the law (b) Alternative Minimum Tax (AMT) (c) Payroll taxes . . . amends § 41 (d) Effective date December 1, 2016 96 m.flesher@swansonreed.com
The Short Sub-paragraphs § 121 (a) and (d) • § 121 sub-paragraph (a): simply says that the temporary provisions of § 41 are stricken • § 121 sub-paragraph (d): simply says that the changes imposed are effective after December 31, 2015, i.e., tax year 2016 & beyond December 1, 2016 97 m.flesher@swansonreed.com
Permanency of the R&D Credit Provision • Since its inception with the Economic Recovery Act of 1981, the R&D credit authorization was renewed 16 times, with one exception in 1995. • The PATH Act makes claiming the R&D credit a permanent feature for which financial planning can be laid December 1, 2016 98 m.flesher@swansonreed.com
Relief from Alternative Minimum Tax (AMT) § 121 (b) December 1, 2016 99 m.flesher@swansonreed.com
Something for older, more established companies December 1, 2016 100 m.flesher@swansonreed.com
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