R&D Credit – New IRS Safe Harbor for R&D Costs

On September 11, 2017, the commissioner of the Large Business & International (LB&I) Division of the IRS issued new guidance for taxpayers using ASC 730 to expense research and development costs on their financial statements. This directive (LB&I-04-0917-005) provides a safe harbor for determining qualified research expenses (QREs) used in calculating the Research Credit under § 41. The directive applies to taxpayers with $10,000,000 or more in assets that follow GAAP to prepare their financial statements, and it applies only to original, timely filed tax returns (including extensions) on or after the date of this directive. These taxpayers can voluntarily include a Certification Statement and various Appendices with their tax returns to take advantage of this safe harbor for the R&D credit, but if a taxpayer under audit following the Directive does not include these items, then it will be required to complete the statements at that time.

The Appendices provided in the Directive give instructions for taxpayers wishing to take advantage of this safe harbor for the R&D tax credit. In summary, taxpayers can include 95% of qualified individual contributors’ W-2 wages and stock options, as well as 95% of the same for first level supervisory managers. For upper level managers, taxpayers are limited to the lesser of (1) 10% of the total QREs for individuals and first level supervisors or (2) 100% of W-2 wage and stock options for upper level managers charged to ASC 730 Financial Statement Cost Centers. Taxpayers may include more than this limit in QREs, but, in such cases, 100% of upper level manager W-2 wage and stock options are considered to be $0 and any amount claimed for those managers will be subject to examination. Upper level managers are defined as managers that directly supervise an employee other than qualified individual contributors and whose wages are charged to ASC 730 Financial Statement Cost Centers. Managers who supervise both qualified individual contributors and another manager are considered upper level managers.

The Directive also covers supplies QREs for the R&D credit, which can be included at 100% of the ASC 730 value, for those supplies consumed in the research process. Unfortunately, contract research QREs are not covered by the safe harbor of this Directive. Taxpayers may still claim contract research QREs, but those amounts will be subject to examination.

Finally, taxpayers claiming the R&D tax credit must identify various excluded amounts when preparing the Certification Statement and appendices. These excluded amounts include items specifically excluded under §§ 41 and 174, contract research costs, wages used in calculating the work opportunity credit, patent costs, wages for research conducted outside the US, severance pay, and all prototype overhead expenses.

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