Though beloved by politicians, the accounting industry and taxpayers, the law surrounding the R&D tax credit has become a contested issue on various matters. Much of the debate between taxpayers, the accounting industry and the IRS centers around the credit’s definition of qualified research expenditures (QREs). Specifically, there has been confusion regarding the inclusion of prototype costs as supplies for the credit. However, a recent lawsuit, Trinity Indus., Inc. v. U.S., 691 F.Supp. 2d. 688 (N.D. Tx. 2010) has shed some light on the treatment of prototype costs.
Generally speaking, the R&D credit provides a 20% credit for all QREs in excess of a taxpayer’s base amount. A taxpayer’s QREs include any amount paid or incurred for supplies used in qualified research. The law of the Internal Revenue Code and the Treasury Regulations defines supplies as any tangible property other than property of a character subject to depreciation.
Traditionally, the IRS has taken restrictive positions on supply costs in its own internal guidance to its auditors. Specifically, the IRS has maintained that in order to qualify for the credit, supplies must not only be used, but also totally consumed during the research activity. In a 1998 field service advice, the IRS stated its position on supplies as follows: “[t]o be considered a qualifying supply, the item must be … totally used or consumed in the qualified research activity…”
The IRS has created a legal position-demanding that taxpayers “consume” supplies during research-around a concept that does not appear in the law. Not only is there no requirement in the Code or Regulations that supplies be consumed, there is no requirement that supplies be used to build prototypes. Similarly, in the IRS’s mandatory IDR for the R&D credit, Question 8(f) asks taxpayers to substantiate “the amount of QRE supplies consumed in the conduct of qualified research …”
The IRS’s use of the term “consumed” contrasts sharply with the statutory language, which requires that supplies be only “used” in research. The IRS’s internal use of terminology, which differs from the statutory language, muddies the waters for taxpayers who do not know what to expect when their R&D credit claim is under IRS exam. Because these views are not discussed in the code or regulations, alliantgroup has assisted taxpayer’s that may have misinterpreted the IRS’s view of supplies, and those without expert assistance will have a difficult time navigating the service’s positions and distinguishing them with the actual law. Based on the divergence between the actual law and IRS position, it is not surprising that taxpayers and some accounting and legal services providers are finding it difficult to identify allocable supply costs properly.
In the recent Trinity lawsuit, however, the District Court for the Northern District of Texas ruled that even prototypes which were sold to third parties could be claimed as supply costs. In Trinity, the taxpayer sought credits for the development of special order ships. For each project, the taxpayer claimed all of the supply costs related to the development and construction of the entire first article or prototype ship. Trinity sold its prototype ships when its designs proved to be successful and even treated the ships as part of its inventory for accounting purposes.
Throughout the opinion, the court rejected numerous IRS arguments, including the attempts to exclude allocated supply costs. With regard to supply costs, the court held that, under the “substantially all” rule found within Section 41(d)(I)(C), if at least 80% of a project is part of a process of experimentation, all costs associated with the project are eligible for the credit. The Government specifically argued that non-experimental aspects of the ship development (such as painting the ships or paying for insurance) are outside the scope of allocable costs found within Section 41. The court, however, allowed these non-experimental expenditures. The court reasoned that, “[i]f a first in class ship is sufficiently experimental, the risk of failure attaches to the entire project. The potential loss includes not just the experimental aspects, but also the paint.”
The court’s taxpayer friendly ruling in the Trinity lawsuit is welcome news for taxpayers as well as accounting and legal services professionals.
alliantgroup is the nation’s premier provider of specialty tax services. The company, headquartered in Houston, TX, works with alliantgroup accounting and legal services providers and their clients to ensure that they receive the full benefits of all available federal and state government sponsored tax credit and incentive programs, such as the research and development tax credit, export tax incentives, manufacturing tax incentives, federal and state hiring credits, sales and use tax refund reviews, and a dedicated tax controversy services team that assists in various legal matters, including IRS and State Tax Matters and various lawsuits. For additional information please visit www.alliantgroup.com.