Tax Insights

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Research and development credit – superheroes bond

research and development, R&D, tax, Batman, Ironman, IRSI have to face up to the reality that accountants are not known as being an adventurous bunch. That, however, doesn’t stop us from thinking about superheroes even if it’s unlikely that a CPA will ever be seen as the individual who saved the world from mayhem and mischief with the use of a pencil and a great tax software program. I recently envisioned how Batman might fare in an IRS audit under the hobby loss rules and the results for our superhero were not good. I imagine he might commiserate with colleagues regarding the audit loss and the taxes he now owed. It was at this point that I started to wonder how the conversation about research and development between Bruce Wayne (Batman) and Tony Stark (Iron man) might go.

Bruce Wayne: I can’t believe my IRS audit ended with me on the losing end and facing a tax bill with interest and penalties.

Tony Stark: That’s a tough break but surely you must have some research and development credit to mitigate or perhaps eliminate the additional tax.

Bruce Wayne: Tony, I’ve never heard of a research and development credit. Perhaps your accountants over at Stark Industries are of the creative type. I can’t believe the tax code would give you a credit for research and development. I’m a superhero. It’s what I do – innovate.

Tony Stark: It’s true, Bruce. Let me tell you how it works.

What qualifies as research and development?

The research and development credit has been around since 1981.It was designed to stimulate research and development activity and serve as an incentive for U.S. companies to maintain their technological competiveness.

The Internal Revenue Code Section 174 defines qualified research using a four-part test.

  1. The activity must relate to new or improved business components in one or more of the following areas: function, performance, reliability and quality
  2. The activity performed must fundamentally rely on the principals of physical science, biological science, computer science and engineering
  3. The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design
  4. Substantially, all of the activities must be elements of a process of experimentation involving evaluation of alternatives, confirmation of hypotheses through trial and error, testing and/or modeling and refining or discarding of hypotheses.

Qualified research expenses are amounts that are paid or incurred by the taxpayer during the taxable year in carrying on a trade or business relating to (1) in house research and (2) contract research. The expenditures for in-house research consist of amounts paid or incurred for wages, supplies and amounts paid or incurred to another person for the right to use computers to conduct qualified research.

Calculating the credit

There are two standard methods of calculating the credit and an alternative method the company may elect. The regular credit is comprised of two basic components: 20% of the excess in qualified research expenses for the current year over a base period amount plus 20% of the excess of basic research payments made in the current year over a base amount paid to universities and other qualified organizations. The reduced credit is equal to the qualified research expenses less a base period amount multiplied by 13%.

The alternative simplified credit allows taxpayers to calculate the credit by multiplying 14% by the difference between the qualified research expenses and the average of the previous three years of qualified research expenses multiplied by 50%.

Tony Stark: Bruce, it’s a tax credit! It can be used to reduce your tax liability dollar for dollar. Wayne Enterprises is a pretty big organization so there could be some restrictions related to the alternative minimum tax. You’ll need to check that with your accountants. It gets even better. While the credit varies, most states have a research and development credit, too. It’s what we do at Stark Industries – technological innovation. It only seems just that we get a tax credit for developing the suit that allows me to save the world. It’s not so bad that it saves me some tax dollars as well.

Bruce Wayne: Tony, that’s incredible! If what you’re telling me is true, then it seems that all the expenditures that we’ve made for developing shifting optical lenses in the cowl, freeze grenades, the batarang and bat suit after bat suit innovations all are candidates for qualifying research expenditures. I’m going to get on the phone to the accountants right now – they’re the real superheroes. I know, Tony, that in our “other lives” we’re competitors, but maybe someday we’ll be together – fighting the evils of the world, comparing tax savings.

And so it goes – two superheroes learning a little more about the tax code. It leaves me with a good feeling, knowing somewhere there’s a superhero accountant.

Cheryl Dickerson, CPA