Contract Research – Year End Tax Tips

As to contract research incurred close to year’s end (whether fiscal or calendar) we often get questions on which costs can be counted as Qualified Research Expenses (QRE) in the current tax year. Under Treas. Reg. Section 1.41-2(e), a contract research expense is 65 percent of any expense paid or incurred in carrying on a trade or business to any person other than an employee of the taxpayer for the performance on behalf of the taxpayer of–

(i)  Qualified research as defined in §1.41-5, or

(ii)  Services which, if performed by employees of the taxpayer, would constitute qualified services within the meaning of section 41(b)(2)(B).

The “paid or incurred” language generally means paid or incurred within the meaning of Treas. Regs. §1.461-1(a)(1) and (2).  That is, costs are taken into account when cash-method taxpayers “pay” them and when accrual-method taxpayers “incur” them.  A cost is generally “incurred” for tax purposes when 1) the fact of the liability is fixed, 2) the amount of the liability is determinable with reasonable accuracy, and 3) the economic performance test (See Treas. Regs. 1.461-4) has been met with respect to such cost.

There is one other Section 41 specific rule however – if the research is ‘pre-paid’ and the taxpayer pays the contractor say in 2010 for research to be performed in 2011, Reg. Section 1.41-2(e)(4) Prepaid Amounts states that the cost can only count as a QRE in 2011 when the research is performed.

In sum, in reviewing your year-end payments to contractors, if the contract was at least underway in the current tax year and payments were made to the contractor towards that contract, accrual method taxpayers should be able to treat such costs as QREs in the current year if your books reflect the expense as a cost in the current year.

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