The Right and Wrong Way to Allocate Wages for R&D Credits
When applying for research and development (R&D) tax credits, submitting the amount of qualified employee wages is a basic requirement to determine the amount of credit. This is typically calculated by multiplying the amount of employee wages by the ratio of time spent performing qualified services to the employee’s total time spent in all services for the tax year.
The IRS outlines in Section 41 that an applicant may use “another method of allocation that the taxpayer can demonstrate to be more appropriate”. One taxpayer used an alternative method that was rejected by the IRS Office of Chief Counsel.
The taxpayer’s method of arriving at in-house qualified research expenses involved the overlay of several estimates to separate the amount of wages performed by employees for qualified and nonqualified services. They used two steps:
- Step 1 – The controller estimated the total liability for wages incurred for the performance of qualified services by identifying employees that he believed performed qualifying services and the fraction of time performed by each.
- Step 2 – The controller then multiplied the estimate calculated under step 1 by a fraction, claimed to accommodate any time spent on activities that may have resembled the performance of qualified services but that did not involve qualified research.
The Chief Counsel noted that the underlying methodology in the first step of the taxpayer’s approach may be appropriate, but not the second step. Instead of actual time spent, they used random samples of projects that varied both in terms of costs and qualified research expenses (QREs).
The IRS ruled that the taxpayer did not track and could not determine what portion of an employee’s time was spent performing qualified services on a specific project. Instead, they estimated how much time each employee spent performing qualified services. To adjust for the lack of tracking, the taxpayer analyzed a random sample of projects employees worked on to determine whether an employee performed qualified services during some part of the project.
The taxpayer’s conclusion about the portion representing QREs was based on an analysis of a portion of its projects that involved qualified research. This did not account for costs of the projects varying, and simply because a certain portion of projects involved qualified research did not mean that the same portion of expenses were QREs.
How to Get Approved
While using an alternate allocation measure may save time and be convenient, the best way to ensure approval for R&D credits is to follow the measures outlined by the IRS in Section 41. Learn more about the R&D tax credit or contact an Anders advisor to find out if your project can benefit.