Conducting an R&D Study Series - Part 5: Technical Interviews with SMEs

Once you have identified the qualified R&D projects and the personnel involved, the next crucial step is to quantify these efforts into Qualified Research Expenditures (QREs) and prepare the necessary tax forms to claim the credit. This involves calculating Wage Qualified Research Expenditures (Wage QREs) and Contract Research Qualified Research Expenditures (CR QREs).

Here's how to calculate the credit and prepare the forms:

Calculating Wage Qualified Research Expenditures (Wage QREs)

To determine the Wage QREs, you will take the percentages assigned for individuals and multiply them by their Box 1 W2 wages. This applies to employees who directly conduct, directly supervise, or directly support qualified research.

A key rule to remember is the sub-allocation rule (also known as a safe-harbor rule): if 80% or more of an employee's services during the tax year constitute "qualified services," then 100% of all services performed by that employee during that year may be treated as "qualified services". Therefore, if an individual is qualified at 80% or higher, their entire Box 1 W2 wage should be included as Wage QREs. This applies even if the remaining 20% or less of their activities do not constitute a process of experimentation for a qualified purpose.

Calculating Contract Research Qualified Research Expenditures (CR QREs)

Similarly, you will multiply the qualified percentage for contractors by the amounts paid to them to get your total Contract Research QREs.

However, there's a specific limitation for contract research: you are only allowed to capture 65% of the total CR QREs. This means you will need to remove 35% of the total amount paid to contractors for qualified research services.

For contract research expenses to qualify, the agreements with third-party contractors must demonstrate two key aspects:

• Your company must bear the economic risk, meaning payment is required even if the research is unsuccessful. Payments contingent on the success of the research generally do not qualify.

• Your company must retain substantial rights to the research results, such as the right to use the discovered knowledge without additional payment or authorization from the third party.

Preparing the Forms: Form 6765

Once you have calculated your Wage QREs and CR QREs, you can then start to prepare the forms. The primary form for claiming the R&D tax credit is IRS Form 6765, "Credit for Increasing Research Activities." You can print out or use the online forms available on the IRS website.

Form 6765 provides different sections for calculating the credit, generally allowing taxpayers to choose between two main methods:

• Section A: Regular Credit (RC) Method: This method calculates the credit as 20% of current-year QREs that exceed a base amount. The base amount involves historical data on QREs and gross receipts, sometimes going back several decades, and is often suitable for larger, established companies.

• Section B: Alternative Simplified Credit (ASC) Method: Introduced to simplify the calculation, the ASC method uses the average QREs from the prior three years. The credit is 14% of current-year QREs exceeding 50% of the average QREs from those preceding years. If there are no QREs in the prior three years, the credit is 6% of the current year's QREs.

Taxpayers can figure their credit using both methods and choose whichever gives a better result.

Form 6765 also includes Section C for current year credit aggregation and Section D for qualified small businesses electing the payroll tax offset.