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Claiming the Section 41 R&D Credit After the PATH Act: Leveraging Small Business Provisions

Calculation and Substantiation of QRAs and QREs, Using R&D Credits to Offset Payroll Tax and AMT Liabilities

THURSDAY, DECEMBER 1, 2016, 1:00-2:50 pm Eastern

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• Dec. 1, 2016

Claiming the Section 41 R&D Credit After the PATH Act

Brett Ritter, Tax Partner PricewaterhouseCoopers, Atlanta brett.ritter@pwc.com Bruce Warner , Managing Director Warner Robinson, Kansas City, Mo. bruce@warner-robinson.com Kenneth (Mike) Flesher, Tax Director Swanson Reed, Austin, Texas m.flesher@swansonreed.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

• I. Overview of Section 41

Research & Development Credit

• II. Four-part test to

determine QRAs Brett Ritter

PwC

• Sec. 41 Research Tax Credit - Overview
• First Enacted in 1981
• Congress’s Intent – encourage domestic R&D and keep high-paying

engineering positions in the US

• Federal Credit Cash Benefit – usually between 4.5% and 6.5% of

eligible costs

• Improves Cash Flow - reduces taxes payable
• Improves Effective Tax Rate – permanent benefit
• Numerous states (approx. 40) provide research and development

incentives

• Credit was temporary for first 35 years - broad bi-partisan support;

extended numerous times

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• Sec. 41 Research Tax Credit – Recent

Developments

• 2015 PATH Act - Significant Changes with most recent Section 41

Legislation

• Credit made permanent!
• May be used to offset AMT and/or Payroll Tax (in select

circumstances)

• Final Treasury Regulations
• Sec. 174 Regulations - clarifies Sec. 174 eligibility
• Favorable Sec. 41 Regulations
• Expanded opportunity to elect Alternative Simplified Credit
• Favorable Internal Use Software guidance
• Taxpayer Favorable Case Law – numerous taxpayer victories since

2009 that demonstrate the research credit’s broad applicability

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Overview – Section 41 Credits Currently Available

• Regular Research Credit:
• 20% credit - Net credit value of 13% of qualified research expenses

exceeding the base amount

• Base Amount - The product of a control group's average prior four

years’ gross receipts (GRs) and its fixed-base percentage or 50% of current year QREs (whichever is larger)

• Net Cash Benefit - 6.5% of QREs
• Alternative Simplified Credit (ASC):
• 14% credit - Net credit value of 9.1% of QREs exceeding base

amount)

• Base Amount - 50% of the average prior 3 years QREs
• Approximate Cash Benefit – 4.5% to 5.0% of QREs

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Overview – Eligible Costs and Activities

• Three specific types of eligible costs
• Wages
• Supplies
• Third-party contract payments

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Wages

Qualified wages are W-2 wages (Box 1):

• Eliminate overhead, 401(k) and other deferred compensation

Includes taxable fringe benefits, as well as:

• Vacation,
• Sick pay,
• Bonuses, and
• Taxable stock options.

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Qualified Activities - 3 Types 1. Directly Performing Qualified Research (Core R&D) 2. Direct Supervision 3. Direct Support

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Other Qualifying Activities

Direct Supervision: First line supervision of “Qualified Research”

• Excludes general and administrative
• Based on activity, not just title

Direct Support: …of Qualified Research & Direct Supervision

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Wages – Direct Support Examples of Direct Support:

• Machinist who builds prototypes
• Secretary who types lab reports
• Lab assistant who cleans test tubes

Examples of Indirect Support (Ineligible)

• Janitor who cleans the R&D facility
• Payroll personnel who prepare salary checks for company

researchers

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Wages Substantially All Rule (80% Test):

• If 80% or more of an employee’s time spent performing

services is spent on qualified services, 100% of the employee’s wages may be included in the research credit calculation.

• In applying the 80% test, eliminate all sick, vacation and other

compensation that does not relate to performing services. FSA 1997-36 (9/17/97)

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Supplies

Supplies are tangible personal property other than:

• Land or improvements to land, and
• Property of a character subject to the allowance

for depreciation Examples:

• General supplies (e.g., pens, paper, disks),
• Materials used in building prototypes,
• Extraordinary utilities, and
• Raw materials used in experimental

production lots formulated to test the appropriateness of a design

• Software license ineligible – not tangible

property, thus generally not a qualifying supply

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Prototype Construction Expenses

Why is this a “hot” issue?

• No complete definition of prototype (however, the definition and

understanding of this term has improved due to the new IRC §174 Regulations)

• Prototypes are often placed in service or sold – thus, the costs are

incurred to construct “property of a character subject to the allowance for depreciation”

• Usually significant expenses incurred for non-technical

employees and contractors

• When does research end? Testing designs/formulations versus

quality control testing (workmanship).

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Contract Research Expenditures

• 65% of amounts paid to anyone (other than an employee) for

qualified research or services.

• Taxpayer must retain “Risk and Rights” for the research undertaken
• n their behalf
• Taxpayer retains some right to the research results, i.e., can use

the IP without paying royalties; may use the

• Requires the taxpayer to bear the financial risk if the research is

not successful, i.e., no refunds if it doesn’t work.

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Contract Research Organizations

QREs are limited to 65% of the amounts paid to a contractor for research unless:

• Amounts paid to a qualifying research consortia qualify at 75%
• Amounts paid for qualified research which is energy research

qualify at 100% (for contractor fees paid after 8/8/05)

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Research Credit Calculation Illustrations

QREs are limited to 65% of the amounts paid to a contractor for research unless:

• Amounts paid to a qualifying research consortia qualify at 75%
• Amounts paid for qualified research which is energy research

qualify at 100% (for contractor fees paid after 8/8/05)

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Calculating QREs

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Regular Research Credit - Calculate Fixed-Base %

• General rule (except for start-up companies): Taxpayer’s fixed-base

percentage equals its total qualified research expenditures for tax years beginning after December 31, 1983 and before January 1, 1989 (i.e. 1984 – 1988), divided by its total gross receipts for those years

• Statutory maximum fixed-base percentage is 16%

Consistency Doctrine:

• Must determine gross receipts and QREs in the base period under the

same legal standards applied in the credit year (e.g., Internal Use Software)

• Consistent treatment ensures that the increase in research spending will be

accurately determined by having a consistent basis of comparison

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Fixed-Base Percentage Calculation

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FB % = $75,000,000 / $1,500,000,000 = 5%

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Calculate Base Amount

Determine Base Amount:

• Calculate the average gross receipts for the 4 years preceding the

credit year

• Includes all items of income less: returns and allowances; capital

gains and losses; extraordinary items; and

• Multiply the fixed-base % by the average annual gross receipts for the

4 years preceding the credit year NOTE 1: If the base amount is less than 50% of current QREs, then the base amount is 50% of current QREs (minimum base amount)

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Base Amount Calculation Illustrated

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Regular Research Credit (Sec. 280C Reduced Credit Election)

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Base Amount = Greater of $30,000,000 or 50% of QREs (50% X $35,000,000 = $17,500,000)

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• Sec. 280C Election

Adjust credit to account for section 280C (eliminates impact of double tax benefit – current expense deduction for refunded taxes): *Increase taxable income by amount of credit OR *If properly elected on a timely-filed original return, compute credit at 13% (rather than 20% rate)

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Alternative Simplified Credit (ASC)

• 14% credit - to the extent current year qualified research expenses

exceed

• 50% of average qualified research expenses for three preceding

taxable years

• ASC election
• elected on a timely filed return; or
• amended return where the period of assessment remains open

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How is the ASC calculated?

Example: Years QREs 2013 $100X 2012 $85X}→ 2011 $80X}→ average $80X 2010 $75X}→

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ASC Example Current-year QREs: $100X Minus: 50% of avg. (3 prior yrs) 40X Incremental QREs $ 60X Credit Rate 14% Tentative Credit $8.40X Minus: 280C Cutback (35%) ( 2.94X) ASC $5.46X

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• Sec. 41 Qualified Research Activities
• Four Part Test
• Technological In Nature – relies on principles of the hard science or

computer science

• Permitted Purpose – intended to discover information useful in

developing a new or improved business component (improved reliability, quality, or performance of a product or process)

• Technical Uncertainty – uncertainty as to capability, method or

appropriateness of design (as defined under Sec. 174)

• Process of Experimentation – systematic trial and error
• Better Cheaper Faster often qualifies!

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Technological in Nature

What does this requirement mean?

• Must involve science, engineering, or computer science
• Cannot involve pure cosmetic issues
• Cannot involve “research” in economics, finance, mathematics,

etc.

• Does not mean that the credit is limited to paying people in

“white lab coats”

• Key issue: Was conquering science and engineering issues

key to the success of the project?

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IRC §174 Activity Requirements

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IRC Sec. 174 IRC Sec. 41

• In order to be

considered for the IRC Sec. 41 tax credits, the activities/costs must be deductible under IRC Sec. 174

• IRC Sec. 41 has a

much more narrow definition of R&D than IRC Sec. 174

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Final 174 Treasury Regulations

• Clarify long-contested positions
• Results of research disregarded in determining eligibility
• Defined term “pilot model”
• Established Shrinkback Rule
• Clarified depreciable property rule’s application
• Significant opportunities for taxpayers
• accelerating deductions
• Sec. 41 R&E credits

Tax Manager Forum FY14 32

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• Sec. 174 - Results of Research do not disqualify

eligible Sec. 174 deductions

• Results of research irrelevant in Sec. 174 evaluation
• TG Missouri referenced in Preamble
• Materials and labor expenses to resolve design uncertainty

are 174 eligible – Examples include:

• Custom machine sold to customer
• Post implementation design refinements
• Pilot models sold, scrapped, and capitalized all eligible
• Improvement of machine used in taxpayers trade or

business

Tax Manager Forum FY14 33

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Sec 174 - Pilot Model Definition

• Expansive definition
• “Any representation or model or product produced to

evaluate and resolve product uncertainty regarding product development or improvement”

• Term includes a fully functional representation or model
• f the product or component
• Example: Prototype aircraft that cost $5 million to build

is eligible for Section 174 deduction even if sold or capitalized

Tax Manager Forum FY14 34

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Process of Experimentation

• Substantially all of the activities must be elements of a process of

experimentation for a purpose relating to: (i) a new or improved function, (ii) performance, (iii) reliability or quality.

• Substantially all means 80% or more measured on a cost or
• ther consistently applied reasonable basis
• 20% or less of the activities can relate to cosmetic issues, i.e.,

issues not related to functionality, performance, reliability or quality

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Process of Experimentation

Final Regs: The taxpayer must identify:

• The uncertainty concerning the development or improvement of

a business component;

• One or more alternatives intended to eliminate uncertainty; and,
• A process, fundamentally relying on science or engineering, of

evaluating alternatives (through, e.g., modeling, simulation, or systematic trial-and-error)

• Treasury Regulations examples include:
• Car Hood Design
• Cheese Grater Design

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Qualified Research Activities - Case Law Union Carbide

On March 10, 2009, Judge Goeke of the United States Tax Court issued a lengthy opinion in Union Carbide Corporation v. Commissioner, T.C.

• Memo. 2009-50.

The case concerned Union Carbide Corporation's (UCC) amended claims for research credits regarding manufacturing process improvement projects. The Court held that two of five manufacturing plant process projects qualified for the credit and provided very helpful guidance on issues such as the process of experimentation, recordkeeping and substantiation, rejection of the "discovery" test, base period reconstruction, and supplies.

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Qualified Research Activities - Case Law

The following themes came out of the UCC case:

• The court eliminated the discovery test
• Judge Goeke confirmed manufacturing process improvements are

qualified research

• Additional supplies used in research qualify for the credit
• Estimation for the base years is acceptable under Cohan
• Taxpayer may rely on internal representations and institutional

knowledge

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Qualified Research Activities - Case Law

TG Missouri Corp Production molds are purchased by an automotive parts supplier (taxpayer) from a third-party toolmaker Parts supplier incurs design and engineering costs to modify the molds Parts supplier sells completed production molds to its customer, an automobile manufacturer Parts supplier includes costs paid to the third-party toolmaker as qualified research expenses (supplies) Court rejected IRS argument that the expenses ineligible as Supplies QREs because they related to molds there were ultimately depreciable property in the purchasers hands

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Qualified Research Activities - Case Law

Trinity Industries District court held that substantial portions of the wages, supplies and contract research costs involved in developing and testing several prototype ships that were later sold were qualified research. The Court discussed the concepts of "business component," "integration," and the "substantially all" test. Business component - The court held that each "first in class" ship was a business component Integration - the court recognized, due to considerable flexibility in the configurations of the ships and complex interactions needed to make a ship operate successfully, there can be integration risk in the design of the vessel as a whole. “Substantially all” - Two of the six ships examined qualified for the credit and met the "substantially all" test.

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Qualified Research Activities - Case Law

Trinity Industries (Fifth Cir. 2014) In a taxpayer-favorable decision, the Fifth Circuit, applying the so- called consistency rule of Section 41(c)(6), held that base-period expenses for projects similar to claim-year projects for which the taxpayer was determined not to have incurred QREs should be excluded from the taxpayer's research credit calculation. The Fifth Circuit remanded the case to the district court to evaluate the testimony of two Trinity employees who compared the base-period expenses related to four projects to disallowed claim-year research expenditures the district court had excluded from the credit because the claim-year costs did not meet the "substantially all" requirement of Section 41(d).

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Qualified Research Activities - Case Law

• Taxpayer argument: District court erred in applying the consistency

requirement of Section 41(c)(6)

• Certain base-period vessel costs should be removed from the base

amount computation

• Two witnesses testified that 4 of 10 base-period vessels were no

more experimental than the claim-year vessels the district court disallowed

• Fifth Circuit agreed and remanded case to district court for factual

finding whether to credit witness testimony regarding the base- period vessels

• If the district court accepts the employees' testimony, the base-period

expenses will be reduced, thus increasing the taxpayer's credit.

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Qualified Research Activities - Case Law

• Trinity was primarily a documentation case
• The district court was forced to apply an “all-or-nothing” standard

due to a lack of records provided by the taxpayer

• Both the district court and appeals court decisions reject current IRS

exam positions

• Consistency doctrine — adjustments should be made in current

and base years

• Inventory for sale to customers may constitute supplies QREs

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Qualified Research Activities - Case Law

• Integration R&D opportunities
• Further supported by final Section 174 regs
• Witness/oral testimony may be used to help substantiate a

research credit claim

• IRS examiners often take the position that taxpayers must

provide tangible data (e.g., records) to claim a research credit

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Qualified Research Activities - Case Law

Suder

Closely held S-Corp (ESI) – developed telecom products/systems for use by mid-size and small businesses IRS characterized ESI’s development efforts as routine software development and disqualified ESI’s QREs Court evaluated 12 projects for credit eligibility – found 11 of the 12 qualified under Sec. 41. Court qualified many activities IRS examiners often disqualify including:

• Sr. Mgt strategy meetings and project follow up meetings
• Regression Analysis
• Beta Testing in customer environments

Court affirmed use of employee surveys in determining qualifying percentages Royalty element of Mr. Suder’s compensation determined unreasonable and not deductible under Sec. 174.

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Qualified Research Activities - Case Law

Suder - Section 174 Test (uncertainty and experts) Was there evidence that showed uncertainty regarding the capability, method, or appropriate design? IRS relied on the testimony of an expert with a Ph.D. in electrical engineering from MIT. He testified as follows:

• Taxpayer created products that merely matched products already

available from other vendors.

• He identified no technical challenge in those projects that would

require resolving uncertainty through experimentation.

• He stated that "ESI's strength is building low-cost, easy-to-use

telephone systems that match products introduced earlier by industry leaders such as Avaya and Cisco.”

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Qualified Research Activities - Case Law

Suder - Section 174 Test (uncertainty and experts) Court stated: “Dr. Jackson (IRS expert) offers no factual basis in his report for these assertions.” The court found his report “unreliable.”

• He did not compare a single circuit board designed by Avaya or

Cisco to a board designed by ESI's hardware engineers.

• No comparison of software code written by Avaya or Cisco to code

written by ESI's software engineers.

• Used term “routine” to describe development without any

definition of the word.

• IRS expert’s testimony refuted by “credible evidence in the record”

i.e. statements from the ESI engineers.

• The court found, “The record contains extensive evidence of the

uncertainties present in each of the 12 projects.”

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Qualified Research Activities - Case Law Suder Process Of Experimentation (software development process) IRS argued that “ESI chose among design alternatives by applying engineering know-how, publicly available knowledge, or by committee,” and asserted that this was not a process of experimentation. Taxpayer argued and the court accepted, that a companywide development process established the POE standard: “ESI clearly had in place a very detailed, multi-level, systematic process for development of all facets of its phone systems which involved 1) conceptually hypothesizing how numerous technical alternatives might be used to develop new and improved phone systems, 2) testing these alternative in a scientific manner, 3) analyzing the results, 4) refining the initial hypothesis or discarding it for another if necessary, and 5) repeating the same, if necessary.”

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Qualified Research Activities - Case Law

Suder – Process of Experimentation Court did not accept IRS position that the work involved only “engineering know-how.” ESI's engineers were from well-respected companies such as Texas Instruments and Raytheon and had a great deal of knowledge. They applied this knowledge, and the institutional knowledge of ESI, to the design of new products. Neither Section 41 nor the regulations thereunder require taxpayers to "reinvent the wheel.“ Court cited to integration risk discussion in Trinity Industries. Court distinguished ESI’s work from the non-qualified projects in Norwest and United Stationers. ESI developed new software vs. modification of existing software.

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Qualified Research Activities - Case Law

Suder - POE (80% test and debugging) Hardware and software were tested extensively by ESI's product assurance lab. Alpha tested by ESI's engineering department. Beta tested by willing beta testers. ESI's hardware and software engineers reproduced bugs that were found during testing, fixed them in order of priority, and returned the hardware and software to be retested. Debugging products in production: “The engineers continued fixing bugs in products that were available for sale to the public.” Although the court agreed that debugging for products in production is not POE, it found that 80% or more of the activities in the projects constituted elements of a process of experimentation.

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Qualified Research Activities - Case Law

Suder - Nexus and substantiation IRS argued: Taxpayer did not substantiate the QREs claimed Taxpayer failed to produce sufficient evidence to make reasonable estimates for QREs. Taxpayer failed to provide any nexus between the expenses claimed and qualified research

• Mr. Wende (SVP product operations and

development)lacked the tax or accounting educational background and experience to make accurate wage QRE percentage allocations

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Qualified Research Activities - Case Law

Suder - Nexus and substantiation

• Wende found to be a “highly credible and reliable witness.”
• Wende used a diagram that showed:
• the employees for which ESI claimed wage QREs for 2004-07
• the department or area in which each employee worked
• each employee's percentage allocations for 2004-07.
• Wende identified the employees on the diagram, described their

roles and responsibilities, and explained how he determined their percentage allocations.

• the court determined that Wende “was intimately familiar with ESI's

business and its employees.”

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Qualified Research Activities - Case Law

Suder - Judgment sample

• ESI claimed QREs for 76 projects during the years at issue.
• The parties selected 12 of the 76 projects for trial.
• Parties stipulated that these 12 projects are representative of the 76

projects for purposes of determining whether ESI performed qualified research under Section 41(d).

• Use of judgment sample by the courts is becoming common:
• Union Carbide (5 projects for 106 projects)
• Norwest (8 projects of 67 projects)
• Geosyntech (6 projects for 370 projects)

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Qualified Research Activities - Case Law Suder - Unreasonable compensation

• The taxpayers did not fully prevail in this case because the Tax Court

held that a considerable portion of the S corporation’s owner’s compensation was not reasonable under Section 174(e), which significantly reduced ESI’s claimed research credits.

• The unreasonable compensation finding by the court was based on

reasoning from several cases involving reasonable compensation determinations in closely held businesses.

• ESI is a Subchapter S corporation that files a Form 1120S return,

and Suder owned 90% of its stock.

• It does not appear that this analysis could be used to exclude

compensation of a highly compensated employee of a publicly traded company who owns at most a very small percentage of the company’s stock.

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• III. NEW IRS REGULATIONS ON

INTERNAL USE SOFTWARE INCLUSION IN QRE CALCULATIONS

• IV. SAMPLING AND ALLOCATION

METHODS FOR QRES

Bruce Warner, Warner Robinson (913) 522-6420 bruce@warner-robinson.com

Allocation Techniques and Sampling in R&D Studies

Allocation – How to Allocate R&D Costs?

• Start with - what do the client’s records look like?

– Taxpayer may have costs by project, or only costs by department or cost center – The company may or may not have a time tracking system

• IRS would prefer to see R&D costs by project but a cost center

approach may be used if there is a nexus between those costs and a ‘business component’

– Regs require that the R&D costs relate to a new or improved ‘business component’ – This may mean a specific project, but could mean a higher level initiative, process, product, method, technique, invention, formula, software – Ex: To develop Product A, client has teams working on items b,c,d – but product A is the item offered for sale = bus component – Ex 2: Three related software modules make up the client’s CRM software suite – this CRM suite offered for sale/license can be the bus component

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Allocation Techniques and Sampling in R&D Studies

Allocating to Business Components – Cost Center Approach

• No prohibition against using a department or cost center method –

See Briefing Paper on Taxpayer Approaches to Capturing Costs for the Research Credit IRS Pub. dated 5/24/2005

• First determine which departments have qualified activities
• Next which products or business components does that department

develop?

• Have client (i.e., Dept Manager) allocate his/her department costs (i.e.,

wages of employees) to one or more business components for that year

– This can be done via a survey or via interviews or combination – The department may already track spend across products for other purposes (which can be leveraged)

• IRS hot button issue is when taxpayer does not make any attempt to

allocate the department’s costs to business component(s)

– IRS position is supported in part by Bayer case (very difficult time with this issue and judge sided with IRS on one motion)

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Allocation Techniques and Sampling in R&D Studies

• If the client doesn’t track hours, can have them complete a time

survey to do this allocation – allocate employees to the appropriate business component – Line of cases allowing use of reasonable estimates (Cohan rule/case, Fudim, McFerrin, Union Carbide, Suder) – Estimates need to come from the employees/managers with first hand knowledge of the activities – Back up estimates with other supporting documentation:

• Have manager review calendars, project timelines, launch dates,

employee evaluations/reviews

• Allocation should be done first before considering sampling (Bayer

case)

• Key takeaway – allocations – lack of a time tracking system at your

client doesn’t mean they can’t claim the R&D credit

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Use of Sampling Techniques in R&D Studies

• Two uses of sampling:

– Sampling to calculate qualified costs including extrapolating sample costs to other projects/departments to arrive at total QREs for the year – Sampling to determine which projects to document; client can calculate total QREs but needs to determine an approach to documenting qualified projects

• Two types of sampling:

– Statistical sample – Judgment sample

• Two key IRS documents – authority for using sampling:
• Rev. Proc. 2011-42 – statistical sampling
• 2012 Field Directive – use of sampling in research credit cases –

pertains more to judgment sampling in R&D cases

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Use of Sampling Techniques in R&D Studies

• Stat Sampling under Rev. Proc. 2011-42

– Following the IRS guidance in this Rev. Proc. allows taxpayers to use a stat sample when conducting the R&D study – Applicable to calculating R&D costs and extrapolating those costs to determine the total QREs and R&D credit amount

• Steps Needed:

– Pick the sample unit:

– Could be the employee, the project, the wage amount, job title, etc. – Could even have more than one sample unit if more than one strata (see below)

– Create strata: – Group similar items together; can stratify based on wage bands, project types, project size, job titles, criteria for qualifying (internal use in one strata, non-internal in second strata, supply costs separate from wage costs) – Results of each strata are typically applied to that strata only – Certainty strata – strata of largest projects which will be examined in full – Random strata – use random number generator program to randomly pick several smaller projects from random strata population; Extrapolate these results to rest of random population

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Use of Sampling Techniques in R&D Studies

– Define sample size for each strata:

– Goal is to pick enough items to achieve a 95% confidence level (95% confident that the sample results reflect the rest of the population) – The lower the number of items selected, the lower the confidence level and higher the margin of error

– Apply results to population (Note if relative precision exceeds 10%,

taxpayer has to give back some of the sampling error)

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Use of Judgment Sample

IRS Field Directive on use of sampling in R&D cases

– This paper states if the number of projects is very high, a true stat sample may still not be administrable; how to narrow down number of projects to review? – Or if number of projects is too small and precision would not be sufficient, then use a judgment sample – Taxpayer can also use these techniques in doing the R&D study – Generally used for which projects to fully document; not commonly used for extrapolating dollars and arriving at total qualified costs (QREs)

• Steps Needed:

– Goal is to document projects to achieve the greatest coverage of QREs claimed – Can (and likely should) use strata – stratify based on like projects or like units – Gather documentation, do interviews, prepare memos on largest projects in each strata – Example:

• Total population – 50 projects
• Create 3 strata; pick top 5 largest projects in each of the three strata to document;

assume this provides 85% coverage of all QREs

• Last 15% of QREs? Could randomly pick projects using random number generator
• IRS audit would likely also focus on largest projects, so you have documented 85% of

your biggest projects; some risk that IRS would pick some projects out of the other 15%, but those are only 15% of your QREs. Have taxpayer retain other documentation

• n these smaller projects.

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Internal Use Software Regs

• New final regs issued October 2016 (T.D. 9786) help define internal

use software and provide new tests for qualifying

• Prospective only (tax years post Oct 4, 2016)
• What is Internal Use Software?

– Prior IRS interpretation was pretty broad – if the software wasn’t licensed or sold, IRS would treat as internal use – Also subject to tougher tests to qualify – had to show the software was unique and novel and differed from prior software on the market – Result – many software projects were disallowed, backlog of cases at Appeals

• New definition of internal use software under Regs:

– Only internal use if it’s back office software used by the taxpayer to run the business, general/admin type software systems – If the software is used by clients/third parties/customers who interact with the software – it’s not internal use – So web based apps where customers access data/functions online would not be considered internal use anymore

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What is Internal Use Software under the Final Regs?

– Back office software - software developed by taxpayer primarily for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business – Examples:

• Financial management functions (i.e., functions that involve the

financial management/recordkeeping)

• HR management functions
• Support service functions that support the taxpayer’s day-to-day
• perations (such as data processing)

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What is NOT internal use software?

– Software that is licensed, leased, sold (so commercial software or apps that are licensed or sold to customers) – Software used in a production process or in R&D (software used on production line, testing tools developed for testing formulas in a lab, etc.) – Integrated hardware/software products (so embedded software is not internal use) – Third party software – software to enable the taxpayer to interact with third parties or to allow third parties to initiate functions or review data – Success or failure is not a criteria – it’s the taxpayer’s intent – intent at the outset was to develop software for license – if project is cancelled/fails, still would not be considered IUS

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Examples of Non-Internal Use – Third Party Use of Software

– Evaluate whether the intent of taxpayer was to develop the software for internal use or third party use at the beginning of the development – Examples in Regs – third party is using the software to perform functions or review data (so not IUS): Third party (customer) is using the software to:

• execute banking transactions
• track the progress of a delivery of goods
• search a taxpayer’s inventory for goods
• store and retrieve a third party’s digital files (cloud computing or software

as a service potentially)

• purchase tickets for transportation or entertainment
• receive services over the Internet

– Third Party Use which is still considered internal use software:

• Setting up a web site; IRS considers this as a marketing purpose so it’s still

a back office function

• Contrast – web application where customer is performing a function or

reviewing their data or executing some transaction – would not be considered a marketing function

• Vendor accessing an inventory management system – still considered IUS

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Dual Function Software

• New regs added a ‘dual use’ or dual function test if the software is both

used for internal use and used by third parties (or in part meets another exception)

• If taxpayer can split the costs into the internal use function and the third

party function(s), then that portion of the software used by third parties is not considered internal use

– Internal use tests only get applied to that portion which is used by the taxpayer for back office functions.

• Safe Harbor – Regs added a safe harbor – if the software is dual function

but taxpayer can’t break out the costs into these 2 buckets. If taxpayer at least can show that third party use would be at least 10% of the total use

• f the software, then safe harbor rule would apply:

– Safe harbor – allows taxpayer to claim 25% of the total R&D costs that went into the software development – Again note if the taxpayer can reasonably break out the costs into the 2 buckets, then no need to use the safe harbor rule

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Three part test for IUS

• If it’s internal use software (IUS), there is a three part additional test to qualify:

– Innovation Test – Significant Economic Risk – Not commercially available

• New Regs made innovation test more straightforward and less subjective:

– Instead of tougher ‘unique or novel’ standard, the innovation test is using the legislative history definition – does the software result in a reduction of costs or improvement in speed or other substantial improvement

• Significant Economic Risk – due to technical risk, uncertainty of recovery of project funds

(so relates to whether there was technical risk)

• Final IUS regs imply a higher threshold of uncertainty vs. the technical uncertainty

standard of the 4 part test. The modifier ‘substantial’ uncertainty according to the IRS should denote uncertainty about the capability or methodology. IRS will consider ‘design’ uncertainty but may be tougher on taxpayers who argue the project involved only issues on what was the appropriate design of the software.

• No bright line test for how much uncertainty is considered substantial.
• Commercial Availability Test – the system can’t be commercially available off the shelf.

Client has to do new software development (modules or apps that are not just purchased software)

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Final Regs - Process of Experimentation Requirement for Software Projects

• New Regs on internal use software decided to opine on all software –

provides examples illustrating what IRS believes is or is not R&D

• Experimentation Test: Iterating, testing, evaluating alternatives to

eliminate a technical uncertainty – this happens all the time in software development – but question is what types of software experimentation will meet IRS standards?

• New regs provides examples:

– Evaluating several vendor software packages and picking one - is not R&D/no experimentation (Ex. 5 and 6) – Designing a new algorithm to handle load balancing = experimentation (Ex. 7) – Implementing a new ERP system involving routine mapping, data transfer, using existing templates - is not R&D (Ex. 9) – Same facts (ERP system) but developing an interface involving a new data caching software layer is R&D – is R&D but need to shrink back to that qualified activity and still need to carve out the routine ERP implementation work (Ex. 10)

• Key Point – the IRS may focus more on the experimentation test for all

software claimed as R&D (not just internal use)

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Qualified Activity Examples - Software

• Development of new software product(s)/modules
• Enhancements/improvements to existing software products/modules
• Product updates and new releases with enhanced or new features,

functionality, performance, scalability or security

• Rearchitecture efforts related to new platforms, technologies
• Creation of a new or unique architecture
• Using new or even existing technology in a unique way
• Projects to develop functionality unique and new to the industry
• Development of new middleware or use of commercial middleware in a

unique way

• Data mining, data warehousing, or other efforts to improve data storage

and retrieval;

• Development and testing of new algorithms
• Qualified software development cycle includes requirements & design,

development, testing, and refining. Usually includes testing through BETA testing

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DOCUMENTATION & SUBSTANTIATION OF CREDIT CLAIMS

Mike Flesher Swanson Reed Tax Services

m.flesher@swansonreed.com

903.217.9633

m.flesher@swansonreed.com

December 1, 2016

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Basic Rule

“If you can’t or won’t document an expense, don’t claim it!”

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December 1, 2016

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Documentation / Substantiation Involves

• A serious attitude about claiming a credit
• Determination to be “audit proof”
• Time spent maintaining a logical &

responsive record keeping system, separate cost centers

• Readiness to support a claim on a moment’s

notice . . . any time & all the time!

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As With All Income Taxes

• “Stay in an audit frame of mind!”
• “I can possibly be required to

explain anything I report!”

• Audits are typically “come as you

are.”

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December 1, 2016

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Impartial Documentation

• Externally-produced documents

are always more credible than internal ones

• Invoices, gov’t forms, etc., are

not subject to manipulation, as are internal spreadsheets

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December 1, 2016

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Presenting Data

• Sort by the fiscal operating

period, whether that be calendar year or fiscal year

• Filing systems should cut-off in

like manner

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December 1, 2016

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Four Areas to Document

• Is the object of the R&D claim really R&D?
• Labor costs
• Supplies-durable equipment
• Contracted services

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Is the Object of the Claim Really R&D?

• Speak to the four-part test, this is literally the

test to pass

• Written, technical justifications work best &

ideally should be submitted with the return to preempt IRS concerns in advance

• Patents (automatic pass), results of trial runs,

websites, brochures, designs, schematics, diagrams, blue prints, minutes from meetings

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December 1, 2016

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Labor Costs

• Calendar year filers: w2’s
• Fiscal year filers: payroll registers

synchronized to the fiscal year, test for tie-back to the w2’s on the front & back ends of the fiscal year

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December 1, 2016

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Labor Costs

Allocation to R&D

• Some employees work 100% on R&D,
• thers don’t, and therein lies the

challenge

• Design a consistent methodology for

explaining the %’s assigned to employees who not fully dedicated to R&D

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December 1, 2016

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Labor Costs

Assigning %’s Less Than 100%

• Memorandums discussed with the

employee

• Time schedules
• Software that tracks hours, calculating

per cent-to-total hours & multiplying a ratio times the gross salary

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December 1, 2016

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Labor Costs

High Risk

• Assigning the same % to every

employee because employees are unique individuals, implies laziness

• n the taxpayer’s part
• Assigning anything greater than 25%

to the salary of a CEO or Plant Manager

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December 1, 2016

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Supplies & Durable Equipment

• Supplies: safest to claim, consumed

entirely on the R&D projects, invoices are the best documentation

• Durable equipment: claimable but with

additional risk

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December 1, 2016

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Supplies & Durable Equipment

Durable Equipment Precautions

• Identify the portion of use on R&D, hours

meter, memorandum

• Ideally scrapped or sold after the R&D,

don’t fall suspect to refurbishing your company with new equipment & charging it to R&D

• Computers are the traditional “red flag”

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December 1, 2016

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Supplies & Durable Equipment

Durable Equipment Documentation

• Purchased outright: invoice or bill of

sale within the fiscal year

• Purchased on credit: the principal

portion of an amortization schedule for the fiscal year being reported

• Reverse the claimed expenses against
• rdinary business expenses

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December 1, 2016

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Contracted Services

• Typically, invoices or 1099’s
• For collusion with universities,

contracts & scope of work

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Summary

• If you can’t/don’t document or

substantiate an expense, don’t claim it

• Maintain a responsive & logical filing

system, so documentation can be retrieved on a moment’s notice, select the right employee for this job

• Consistent & methodical processes draw

the least attention

m.flesher@swansonreed.com

December 1, 2016

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SMALL BUSINESS STRATEGIES & APPLYING CREDITS AGAINST AMT OR PAYROLL TAX LIABILITY

Mike Flesher Swanson Reed Tax Services

m.flesher@swansonreed.com

903.217.9633

m.flesher@swansonreed.com

December 1, 2016

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Examining the Law

• Much has been written about the law,

not all of which can be found in the law

• As much as possible, we will limit our

discussion to what the law says

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December 1, 2016

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“Relief from AMT & Payroll Tax Liabilities” aka

Protecting Americans from Tax Hikes (PATH) Act of 2015

• House amendment # 2 to a Senate

amendment to H.R. 2029, Military Construction & Veterans’ Affairs and Related Agencies Appropriate Act of 2016

• 233- page document

m.flesher@swansonreed.com

December 1, 2016

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Broad Scope of Coverage

• § 143: Bonus depreciation for grafting nut &

fruit bearing trees

• § 165: Classification of certain race horses as

3-year property

• § 172: Increase in the limit of excise taxes on

rum from Puerto Rico & the Virgin Islands

• § 183: Credit for 2-wheeled plug-in electric

vehicles

m.flesher@swansonreed.com

December 1, 2016

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Broad Scope of Coverage

• § 308: Early retirement distributions for the

U.S. Capitol police & others

• § 335: Modification of the definition of hard

cider

• § 402: Prohibition of IRS employees from

using personal email accounts for official business & claiming deductions

m.flesher@swansonreed.com

December 1, 2016

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Limit of Our Focus

Title I Extenders Subtitle A-Permanent Extensions Part 3-Incentive for Growth, Jobs, Investment, and Innovation

§ 121: Extension & modification of research credit

Pages 20-28 in my version

m.flesher@swansonreed.com

December 1, 2016

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§ 121 Divided Into 4 Subsections

(a)Permanency of the law (b) Alternative Minimum Tax (AMT) (c) Payroll taxes . . . amends § 41 (d) Effective date

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The Short Sub-paragraphs

§ 121 (a) and (d)

• § 121 sub-paragraph (a): simply says that

the temporary provisions of § 41 are stricken

• § 121 sub-paragraph (d): simply says

that the changes imposed are effective after December 31, 2015, i.e., tax year 2016 & beyond

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Permanency of the R&D Credit Provision

• Since its inception with the Economic

Recovery Act of 1981, the R&D credit authorization was renewed 16 times, with

• ne exception in 1995.
• The PATH Act makes claiming the R&D

credit a permanent feature for which financial planning can be laid

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December 1, 2016

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Relief from Alternative Minimum Tax (AMT)

§ 121 (b)

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Something for older, more established companies

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Alternative Minimum Tax (AMT) the basics

• Intent is to insure that higher income

earners pay some taxes

• Adds tax-exempt incomes to the taxable

base & denies some deductions & credits

• Calculated with Form 6251

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Alternative Minimum Tax (AMT) Who is impacted

• Corporations
• Individuals who earn around $180,000+

per year, based on personal situations

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R&D Credit Allowed as an Offset

• § 121 (b) “Credit allowed against

alternative minimum tax in case of eligible small business (ESB).”

• Applies to ESB with less than $50 million

in gross receipts

• R&D credit becomes one of the few

shelters against AMT

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December 1, 2016

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CCorps benefit directly by qualifying as an ESB

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Shareholders, Partners of an SCorps or Partnership

• Benefit indirectly by the R&D credit

lowering entity taxable income & passing through a higher benefit

• Shareholders & partners must separately

satisfy the gross receipts test to offset their personal AMT liabilities

• References . . . § 41 (h) sub-paragraphs

(3)(A)(ii) & (5)(B)(i)

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Relief from Payroll Taxes § 121 (c)

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Largest sub-paragraph of § 121 Series of amendments to § 41 Something for younger, less established companies

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Who Benefits

• Qualified small businesses (QSB) whose

gross receipts in the year of the claim are less than $5,000,000

• Did not have any gross receipts prior to

the five-year period ending in the year of the current claim . . . § 41(h) sub- paragraph (3)(A)(i)(II)

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The Benefit

• Young companies typically have no

income, hence no income taxes to offset

• Young companies do have payroll taxes
• R&D credits offer a venue to offset an
• perating expense

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Limitations

• Can allocate up to $250,000 of gross

R&D credit against payroll taxes

• Only employer-paid FICA taxes are

subject to offset

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Payroll taxes 101 Federal Insurance Contributions Act (FICA)

• the Social Security or old age, survivors,

and disability insurance (OASDI) tax equal to 6.2% of gross wages

• the Medicare or hospital insurance (HI)

tax equal to 1.45% of gross wages

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Timing

amended § 41 (f)

• Inserts sub-paragraph (1): “ . . . there shall

be allowed as a credit against the tax imposed by subsection (a) for the first calendar quarter which begins after the date on which the taxpayer files the return specified in section 41(h)(4)(A)(ii) an amount equal to the payroll tax credit portion determined under section 21 41(h)(2).”

• aka, the credit can be claimed against payroll

taxes owed in the first quarter after the tax year in which the credit was calculated

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Other Limitations amended § 41 (f)

• inserts sub-paragraph (2): the credit

cannot exceed the tax

• inserts sub-paragraph (3): unused

credits are carried forward

m.flesher@swansonreed.com

December 1, 2016

Likely Scenarios

December 1, 2016 114 m.flesher@swansonreed.com

A B Taxable income $0 $0 Payroll taxes $45,000 $45,000 R&D credits $20,000 $65,000 Immediate use $20,000 $45,000 Carry-forward $0 $20,000 Absorb tax $25,000 $0

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“Implementing Instructions”

• Until recently, none were available, and

we could only speculate that the credit would be claimed on either the Form 6765 (R&D) or Form 941 (payroll taxes).

• Since then, the IRS has released drafts of

both forms with the proposed changes!

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DRAFT 2016 Form 6765 (R&D credit)

• Inserts a section D at the end
• Adds LN 41: “Check this box if you are a

qualified small business electing the payroll tax credit.”

• Adds LN 42: “Enter the portion of line 36

elected as a payroll tax credit (do not enter more than $250,000).”

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DRAFT 2017 Form 941 (payroll tax)

• Adds LN 11: “Qualified small business

payroll tax credit for increasing research activities”

• Adds LN 12: “Total taxes after

adjustments and credits”

• 2017 instructions are still unavailable

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Limits the Credit to the Least of . . .

• An amount specified by the taxpayer, up

to $250,000

• The FICA tax for the current quarter
• The outstanding balance of the research

credit determined for the current tax year plus carry-forwards from prior years

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Planning Considerations

• The R&D tax credit is a known benefit for tax

year 2016, and in the case of most qualified small businesses & taxpayers with AMT, it is a win-win

• pportunity
• Determine if you’re eligible for an R&D tax credit

and, if so, get an estimate of the size

• Estimate the amount of your credit that you’ll

want to allocate to payroll taxes in Form 6765

• Update your payroll software to include the 2017

Form 941, put your payroll team on alert RE LN 11

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Summary

• The Protecting Americans from Tax Hikes

(PATH) Act of 2015 offers material benefits for taxpayers, primarily for qualified small businesses looking to offset tax liabilities

• The IRS has already laid the ground work for

claiming credits

• As with most episodes in life, the time to

begin planning is “now”, not after

• pportunity passes you by

m.flesher@swansonreed.com

December 1, 2016