Self-constructed supplies costs are not in-house research expenses.

• Author: Hudson, David

The IRS recently issued an Appeals Settlement Guideline (10/3/05) setting forth its views on whether expenses related to self-constructed property may be claimed as supplies for purposes of the Sec. 41 credit for increasing research expenditures. Specifically, the guideline states that amounts paid or incurred as (1) depreciation expenses, (2) general and administrative expenses, (3) employee benefit expenses, (4) travel and entertainment expenses and (5) overhead and other indirect expenses relating to "self-constructed supplies" are neither in-house research expenses, nor qualified research expenses (QREs) under Sec. 41(b).

Facts

The taxpayer had built a plant to manufacture chemicals. It used the plant to produce chemicals for use in qualified research and treated them as supplies used in the conduct of qualified research. In determining the amount incurred for those chemicals for its tax year ended Dec. 31,2001, the company allocated its direct and indirect manufacturing costs to the supplies in accordance with its financial accounting procedures, and treated the full amount allocated to the chemicals as the cost of supplies and, thus, as part of its QREs.

During an examination of the taxpayer's research credit, Compliance argued that, based on Sec. 41(b), Regs. Sec. 1.41-2(b) and Sec. 41's legislative history, n-house research expenses (as defined in Sec. 41(b)) do not include (1) depreciation expenses, (2) general and administrative expenses, (3) employee benefit expenses, (4) travel and entertainment expenses, (5) overhead and other indirect expenses related to self-constructed supplies. These expenses may not be treated as such by virtue of their treatment for financial accounting purposes, according to Compliance.

The taxpayer argued that the cost of purchased supplies used in qualified research activities can be QREs under Sec. 41(b), and could be claimed as such even if the cost included the seller's overhead costs. However, Compliance's position was correct; the taxpayer's overhead expenses would not be allowed as QREs if the costs were recurred to self-construct supplies.

Law

Sec. 41(b) defines QREs to include n-house research and contract research expenses. Under Sec. 41(b)(2), in-house research expenses are: (1) wages paid or incurred to an employee for qualified services performed by such employee; (2) amounts paid or recurred for supplies used in the conduct of qualified research; and (3) as prescribed by the Secretary, any...