Self-Constructed Supplies Costs Are Not In-House Research Expenses

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 taxpayers research credit, Compliance argued that, based on Sec. 41(b), Regs. Sec. 1.41-2(b) and Sec. 41s legislative history, in-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 sellers overhead costs. However, Compliances position was correct; the taxpayers overhead expenses would not be allowed as QREs if the costs were incurred to self-construct supplies.

Law

Sec. 41(b) defines QREs to include in-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 incurred for supplies used in the conduct of qualified research; and (3) as prescribed by the Secretary, any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.

Under Sec. 41(b)(2)(B), qualified services means services consisting of engaging in qualified research, or engaging in the direct supervision or support of research activities that constitute qualified research. Engaging in qualified research means the actual conduct of qualified research (e.g., a scientist conducting laboratory experiments); see Regs. Sec. 1.41-2(c)(1).

Regs. Sec. 1.41-2(c)(2) provides that direct supervision, as used in Sec. 41(b)(2)(B), means the immediate supervision (first-line management) of qualified research (e.g., a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist. Direct support means services in the direct support of either persons engaging in the actual conduct of qualified research, or persons directly supervising persons engaging in the actual conduct of qualified research; see Regs. Sec. 1.41-2(c)(3). Direct support of research activities does not include general administrative services or other services only indirectly of benefit to research activities.

Wages paid or incurred for employees performing services in the (1) actual conduct of qualified research, (2) direct supervision of qualified research and (3) direct support of either persons engaging in the actual conduct of qualified research or persons directly supervising persons engaging in such research, are in-house research expenses; see Regs. Sec. 1.41-2(d). If an employee has performed both qualified services and nonqualified services, only the wages allocated to the performance of qualified services are in-house research expenses.

Sec. 41(b)(2)(C) defines supplies as any tangible property other than land or improvements thereto, and property of a character subject to depreciation. According to Regs. Sec. 1.41-2(b)(1), supplies and personal property are used in the conduct of qualified research if they are used in the performance of qualified services by the taxpayers employee (or by a person acting in a similar capacity); see Regs. Sec. 1.41-2(e)(5), Example 6. Expenditures for supplies or for the use of personal property that are indirect research expenditures or general and administrative expenses do not qualify as in-house research expenses.

Holdings

In-house research expenses: The legislative history to the Economic Recovery Tax Act of 1981, which enacted the relevant provisions of Sec. 41(b), explains that not all research expenditures deductible under Sec. 174 are eligible for inclusion in the research credit computation. Eligible expenditures must be paid or incurred in carrying on a taxpayers trade or business. Because Regs. Sec. 1.174-2(a)(1) permits a deduction for all such costs incident to the development or improvement of a product, all direct and indirect costs properly allocable to the research effort, including depreciation, overhead, administrative expenses, etc., are deductible under Sec. 174. Based on Sec. 41(b), Regs. Sec. 1.41-2(b) and Sec. 41s legislative history, the Appeals Settlement Guideline concludes that depreciation allowances, overhead expenses, general and administrative expenses and indirect expenses allocable to chemicals manufactured at a companys facilities are not in-house research expenses eligible for inclusion in the research credit computation.

Financial accounting treatment: Further, citing Thor Power Tool Co., 439 US 522 (1979), the Service also determined that the financial accounting rules do not dictate treatment for income tax purposes. Thus, despite the fact that for financial accounting purposes, the allocable overhead is treated as a cost of a self-constructed supply, the IRS noted that when the income tax treatment for an item is specified in the Code and regulations, the financial accounting rules are irrelevant. Thus, the Service stated, [i]n no event are depreciation expenses, overhead expenses, general and administrative expenses, and other indirect expenses in-house research expenses included in the research credit computation.

Accordingly, the IRS determined that there is little hazard of litigation to the government if it follows Compliances position that the indirect expenses incurred in the construction are not in-house research expenses. Additionally, it said that there is little reason to believe that a court would adopt anything other than a literal reading of Sec. 41 and, thus, limit the allowable amount to the direct expenses attributable to self-constructed supplies. Thus, the Service concluded that Compliances position on the issues should be sustained.

Implications

The conclusion of the Appeals Settlement Guideline is consistent with the IRS Coordinated Issue Paper on the subject (issued June 18, 2004), denying the credit eligibility of depreciation, administrative expenses, overhead and other indirect manufacturing costs. Thus, taxpayers have known for some time that the IRS intended to attack these types of expenses. The guideline now makes it clear that the Service does not intend to offer appeals settlements on this issue.

From David Hudson, Washington, DC