analysis of r&d tax code sections

(law school paper)

RESEARCH MEMORANDUM
To:         Ms. Stokes
              Expert Systems, Inc
From:     Travis A. Wise
Re:         Applicability of �174 and �41 to ES research

1. Can the cost of CAD/CAM software be deducted under �174(a)? No.
Qualifying research and experimental (R&E) costs can be expensed as they are incurred under �174(a), rather than capitalized. R&E costs qualify for this treatment if they meet all of the following requirements, each of which I will evaluate below:

  1. Incurred in connection with the trade or business of the taxpayer (�174(a)).
  2. Represent research and development costs in the experimental or laboratory sense to eliminate uncertainty as to taxpayer's development or improvement of a product (26 CFR 1.174-2(a)(1)).
  3. The expense must be reasonable (�174(e)). This requirement is satisfied if the "amount would ordinarily be paid for like activities by like enterprises under like circumstances" (26 CFR 1.174-2(a)(6)).
  4. Not expenses for depreciable property (�174(c)).
ES is in an existing and ongoing business of designing, manufacturing and selling integrated circuits, which includes chips. R&E costs for design of new chips would therefore be "in connection with" ES' trade or business, even if ES is not yet selling the chips, because ES is designing the chips for the purpose of selling them. Snow v. Commissioner, 416 U.S. 500 (1974).
The CAD/CAM software was purchased to aid in the design of these chips. Because the chips are new, and therefore not previously designed, uncertainty exists at the outset as to the appropriate design of the product. The CAD/CAM software will establish the appropriate design of the product, thus eliminating the uncertainty.
Whether or not the $350,000 cost of the software is reasonable under �174(e) or not would depend whether companies similar to ES would pay a similar price for the software for use in similar purposes. This could be shown by actual purchases by other companies, and whether the company selling the software sells it off-the-shelf for that price regardless of who the purchaser is, as opposed to software which was created solely for ES.
Despite meeting these three requirements, software is a depreciable asset under �167(f), which provides for a 36 month depreciation period, and therefore is excluded from �174(a) by �174(c), which excludes depreciable assets from treatment under �174(a). The inability to use �174 treatment for a purchase of software with a useful life of one year or more is confirmed in Rev. Proc. 69-21, �4, which has been interpreted by the IRS to deny deduction and require capitalization of purchasing software (IRS General Counsel Memorandum 34681; TAM 9449003). However, the depreciation allowances would be allowed as expenditures under �174(a) to the extent that the software is used in R&E (26 CFR 1.174-2(b)(1)).
Therefore, the cost of the CAD/CAM software would not be deductible under �174(a) as an expense in the year purchased, but would be depreciable under �167(f) over a three-year period.
2. Will costs incurred to develop a chip similar to a competitor's constitute R&E under �174? Yes.
�174 defines R&E as present research and development costs in the experimental or laboratory sense for the purpose of eliminating uncertainty as to the taxpayer's development or improvement of a product (26 CFR 174-2(a)(1)). This requirement is satisfied if "the information available to the taxpayer does not establish that capability or method for developing or improving the product or the appropriate design of the product" (26 CFR 1.174-2(a)(1)).
The chip which ES is designing will have the same functionality as a competitor's chip. The information regarding the design is known to the competitor, and therefore not uncertain to the world. However, as long as the information regarding the design is uncertain as to ES, which it is, the costs will qualify for treatment under �174. If ES intends to treat the expenses under �174, it should adequately document what information it has regarding chip design, and the research undertaken to design the chip, in the event that there is an audit in the future.
The $300,000 borrowed to fund software design to improve the functionality of its circuits would also qualify for �174 treatment because the money was expended to "improve" taxpayer's product (26 USC 1.174-2(a)(1) and Rev. Proc. 69-21, 1969-2 C.B 303). While the purchase of software cannot be expensed because it is depreciable property under �167(f), creation of software for internal use is not depreciable property, and therefore is not excluded from �174 treatment. The fact that the $300,000 was borrowed does not change the treatment because �174 applies to "expenditures" without regard to the source of the funding.
3. Applicability of �41 to first-time expenditures.
In order to claim the �41 tax credit for increasing research expenditures, we must determine first if the research is qualified, and second if the expense is qualified.
For the research to be qualified, it must meet each of these tests (�41(d)):
  1. Qualify as R&E under �174
  2. Discovery test: Be undertaken to discover new information (i.e. not already known to a competitor) which is technological in nature, which is intended to be useful in the development of a new or improved business component.
  3. Used a process of experimentation for at least 80% of the research to evaluate more than one alternative to achieving a result, where uncertainty exists at the outset.
  4. Not be excluded under �41(d)(4).
For the expense to be qualified, they must be incurred in carrying-on a trade or business at the time of the expense (�41(b)(1)), and either:
  1. Expenses incurred in house, in which case the expenses must be for either:

  1. Wages for employees engaged in qualified research or the direct supervision or support thereof; or
  2. For supplies used in the performance of qualified research, excluding land and tangible property which is subject to a depreciation allowance (�41(b)(2))

  1. Expenses paid to a third party for qualified research, but only 65% of those expenses qualify for the credit (75% if the third party is a qualified research consortium) (�41(b)(3)).
I. $200,000 lease of equipment for research lab
The expense of $200,000 for the lease of equipment for the research lab would have to satisfy the first test to determine if the equipment was directly used for qualified research in order to qualify for the credit (26 CFR 1.41-2(b)(1)). Assuming it was qualified, the expense would then be examined to determine if the amount qualified for the credit: The equipment is not a "wage" and therefore must fit in the definition of "supply" to qualify. Supplies are defined as tangible property other than land, improvements to land, and property of a character subject to the allowance for depreciation (�41(b)(2)(C)). Because equipment used in a research lab would qualify for depreciation under �167, the expense for the lease of the equipment fails this test. The fact that the equipment was leased and not purchased does not change this conclusion because �41(b)(2)(A) requires that the supplies be merely "paid for," not "purchased."
II. Cancellation fee of $400,000 for not using services of third party who was to perform some qualified research for ES
The $400,000 cancellation fee paid when ES decided not to use the services of a third party to perform some qualified research for ES does not qualify for the tax credit. Contract research expenses qualify for 65% of the tax credit if they are paid "for qualified research" (�41(b)(3)(A)), or for services which, if performed in-house, would constitute actually engaging in qualified services (26 CFR 1.41-2(e)(1)(ii)). Since the fee was paid neither in exchange for qualified research nor for engaging in qualified services, but rather to stop the third party from performing the services, the expense is not allowed for the credit.
III. 500 hours of CEO's time working with engineers in ES' lab on qualified research, where CEO salary is $1M and typical engineer makes $100K
The 500 hours which the CEO spent working with engineers in ES' lab on a qualified project may qualify for the credit, depending on the definition of the word "with." If the CEO was actually performing qualified research herself, as she might if ES is a relatively small company, then she would be directly engaged in qualified research and her wages would be qualified expenses. Assuming that the expense qualifies, if "substantially all" of the CEO's services were qualified, then all of the wages would be qualified (26 CFR 1.41-2(d)(2)). Because the CEO would likely spend at least 2000 hours a year on various projects, the 500 she spent on this project would not be "substantially all." Therefore, the amount of her wage expense which qualified for the credit would be pro-rated, e.g. (500/2000) x $1,000,000 = $250,000.
If, however, she was merely supervising the engineers in the lab, then the expenses would not qualify. Wage expenses for supervision do not qualify for the credit when the supervision is by a higher-level manager to whom first-line managers report, even if the supervising manager is a qualified research scientist (26 CFR 1.41-2(c)(2). A CEO making $1M is unlikely to be a first-line manager of an engineer making $100K, and therefore her supervision would not qualify for the credit.
Additionally, expenses must meet the �174 test for qualified expenses in order to meet the requirements for the �41 credit.  The CEO's salary is unlikely to meet the �174(e) reasonableness requirement, because it is likely that the work she performed could have been performed by an engineer making 1/10th of her salary.  Therefore, if the amount was allowed for the credit, only the reasonable portion thereof would qualify.

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