The IRS defines Qualified Research Expenses (QREs) as the sum of “in-house research expenses” and “contract research expenses”. Those in-house research expenses include:
- Wages – Taxable or subject to self-employment tax of individuals performing, directly supervising or supporting the qualified research.
- Supplies – Amount paid or incurred for materials used in the conduct of qualified research.
- Contract Research – Payments for the conduct of research. The taxpayer must be at risk when conducting the research.
Wages
Wages are often the largest component of the qualified research expense in an R&D Tax Credit Study. Wages will constitute as an “in-house research” expense if employees were paid for “qualified services”. Wages mean all taxable wages as reported on a W-2 form. It also includes bonuses, stock option redemption and any wages subject to withholding.
The references used to check a company’s wages include W-2s, payroll records, personnel interviews or any other document that tracks employee costs. If a company or a company’s department specifically specializes in R&D activity, then W-2s will be the best document to refer to. If an employee or a company only does partial R&D activity payroll records and personnel interviews will be the best evidence to determine their wages as qualified expenses.
Supplies
Supplies are any materials used in the conduct of qualified research. Supplies are qualified if they are used by employees conducting “qualified services”. The supply must be directly related to the “qualified services” conducted by the employee.
A company’s general ledger or trial balance are the best documents an R&D tax consultant could use to check a company’s supplies. A general ledger may contain entries of supplies the company incurred for R&D projects. If the client is a company that consistently conducts R&D, they will have a designated account within the general ledger where all the R&D supplies are allocated. Since all general ledger entries are backed by an invoice, this document is the most detailed reference to check if the company has incurred in any qualified research expenses (QREs).
Contract Research
The IRS defines a contract research expense as 65% of any expense paid for the performance of qualified research on behalf of the taxpayer. The IRS provides a three-part test which determines what is considered a contract research expense. The contract research agreement with a third party:
- Must be agreed on prior to the performance of the qualified research.
- States that the research is being performed on the taxpayer’s behalf.
- Requires the taxpayer to bear the expense of any risk involved with the research.
The best source to confirm a company’s contract research expense is 1099 documentation or vendor invoices. The 1099 will give a more detailed account of what a specific vendor worked on throughout the year, by summarizing all the payments incurred within that tax year. If an outside contractor worked on R&D and non-R&D projects, the R&D tax consultant can use 1099 or vendor invoices to allocate which costs are considered QREs and can be used for the R&D Tax Credit Study.