Contract research and the R&D credit.

• Author: O'Connell, Frank J., Jr.
• Position: Reseach and development

Sec. 41(a)(1) provides a tax credit for increasing research activity, generally equal to 20% of the excess (if any) of the qualified research expenses over a base amount. Sec. 41(a)(2) provides a credit for the incremental payments made to qualified organizations for basic research. Separate rules determine which expenses qualify for these credits and how to calculate the base period and respective incremental amounts. As such, the "qualified research credit" under Sec. 41(a)(1) and tire "basic research credit" under Sec. 41(a)(2) are separate and distinct.

Basic vs. Contract Research

Under Sec. 41 (e)(7)(a), basic research is "any original investigation for the advancement of" scientific "knowledge not having a specific commercial objective." Generally, basic research expenditures include the three general categories of in-house research costs specified in Sec. 41(b)(2)(A)--wages, supplies and certain lease payments.

Conversely, qualified research includes both basic research expenditures and an amount for contract research; under Sec. 41(b)(3)(A), this equals "65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research."

Under Sec. 41(b)(3)(A), if an expenditure were to be classified as a basic research expenditure, the amount that exceeds the qualified organization's base-period amount is not treated as a qualified research expense, nor is it used in the computation of the base-period amount. However, if a particular payment fails to meet the basic research rules, the taxpayer may treat it as contract research for qualified research credit purposes it" it otherwise qualifies under the applicable rules.

Contract Research Expenditures

Typically, a contract research expense would be qualified research under Regs. Sec. 1.41-2(e)(2) if the contract: (1) is entered into prior to the performance of the research; (2) provides that research be performed on the taxpayer's behalf and; (3) requires the taxpayer to bear the expense, even if the project is unsuccessful. Based on this guidance, it is possible for certain contract research payments to be deemed qualified research expenditures for the contractor/funder, researcher, neither or both.

Based on the terms of the arrangement between the funder and the researcher, there are two primary questions: who retains "substantial rights" to the research results and who bears the economic risk of the project (i.e., will payment...