A company is able to obtain benefits from the Research and Development Tax Credit as long as they have Qualified Research Expenses (QREs). The IRS defines 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.
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 that 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.
The taxpayer and the contracted party must have an agreement before the performance of the qualified research commences. The IRS states that only 65% of the contract research expense may be eligible for the Research and Development Tax Credit calculation.
- States that the research is being performed on the taxpayer’s behalf.
The taxpayer must retain the rights of the research being performed. The taxpayer retains the rights if it retains the know-how of the conducted research. This means that the taxpayer will be able to use the product of the research without paying any licensing fees or royalties to the third party contracted.
- Requires the taxpayer to bear the expense of any risk involved with the research.
The taxpayer bears the financial risk for the research if payment is not contingent on the success of the research. The taxpayer must bear the cost even if the research isn’t successful. Payment is considered to be contingent on the success of the research if the payment for the contracted party is for the product to be created or result to be provided as a result of the research. Thus, if the research were to fail the taxpayer bears the expense of any risk involved with the research.