How can thinking about baseball help maximize Research Tax Credit benefits?
From Little League to the big leagues, baseball has always been a beloved sport in America. The crack of the bat, the roar of the crowd, and the thrill of the game can captivate even the most casual fan. But did you know that baseball can also offer valuable insights to maximize research tax credit benefits for your business?
One such example is the Research Tax Credit (RTC), a federal tax credit that rewards companies for pushing the boundaries of products, processes, software, formulas, and inventions (or business components). However, qualifying for the RTC isn’t as simple as just applying for it. To take advantage of the credit, companies must identify and document their qualified research expenditures (QREs), which include employee wages, contracted research expenses, and supply costs.
For employee wages to qualify for the RTC, employees must perform qualified research activities falling under one of three distinct categories: direct research, direct supervision, or direct support. And this is where the baseball analogy comes in.
Think of the three categories as the different personnel on a baseball team. The players, the coaches, and the equipment managers all play distinct but vital roles in the game. In the same way, employees who perform direct research are like the players, who are the bulk of the team and do most of the work. Direct supervisors are like coaches, providing guidance and oversight to ensure the players are performing at their best. And finally, direct support personnel, like the equipment managers, are crucial to the game being played, but aren’t directly involved in the action. They provide support to ensure everything runs smoothly.
By understanding the differences between these categories, companies can better identify how each employee’s qualified time meets these categories, ultimately maximizing their RTC benefits.
Direct Research
Let’s start with the players, the athletes on the field. Engineers, or other individuals who perform qualified research activities under the label of direct research, are the baseball players of the team. Engineers executing trials, simulations, and/or experimentations is similar to when the players on the diamond perform a drawn-up play from their playbook. Both are structured sequences of events, but uncertainty lies within the outcome of the act. Will the batter hit a home run? Or will the team end up striking out? Will the engineer’s experiment succeed, or will it fail? Within each experiment or athletic sequence, there is an opportunity to better comprehend the interplays of a set of unknown conditions. What went wrong? What changes can be made to the experiment, or the play, to receive a better outcome?
According to section 41, direct research is any technical or experimental activity that can be directly related to the improvement of a business component. For example, an engineer recording the productivity levels of a piece of manufacturing equipment for use in data analysis to improve the machine’s throughput may be considered direct research. Since the individual’s research is directly tied to the enhancement of technical machinery, their efforts are recognized as qualified.
Another example would be the development of a new product design using the help of Computer Aided Design (CAD) software. The engineers or scientists responsible for developing, refining, and perfecting the physical design of a new product can be directly associated with qualifiable direct research.
Of the three time allocation categories, direct research is undoubtedly the most significant. The majority of employees claimed for the Research Tax Credit (RTC) are engaged in direct research activities, which are essential for experimentation, research, and development to occur. Without these employees, direct supervision would be impossible, and support systems necessary to facilitate and maintain the research process would be unnecessary. Therefore, the value of direct research cannot be overstated, as it forms the foundation for successful research and development activities.
Direct Supervision
Every team needs a set of experienced coaches to develop plays for games, coordinate practices, and manage on and off the field duties. Engineering managers perform similar duties by developing trial and simulation processes, coordinating research and development (R&D) actions, and managing everyday engineering tasks.
Direct supervision relates to the immediate supervision of qualified R&D activities. Individuals whose time may be identified as direct supervision include first-line management, or persons directly responsible for providing direction, instruction, and experience to the individuals actually performing the process of R&D. This could also include project and program managers who are responsible for organizing and analyzing R&D activities within their team. These individuals may schedule trials, organize product and process improvement meetings, and suggest engineering-backed enhancements to those same products and processes without doing any of the technical work directly themselves.
An example of Direct Supervision that was deemed unqualified by court decision can be found in Moore v. Commissioner (February 2023). From 2014 to 2015, Mr. Robert, the president of Nevco, estimated 50% to 65% of his time was spent supporting and supervising new product development. In the Moore v. Commissioner case, the taxpayer claimed the RTC for wages paid to engineers and technicians for direct supervision of testing activities. The taxpayer argued that Mr. Robert’s time spent on direct supervision of the testing process was eligible for RTC, but the IRS challenged this claim.
The Tax Court ultimately ruled against the taxpayer, stating that the taxpayer failed to provide sufficient evidence to support the RTC claim for Mr. Robert’s time spent on direct supervision. The court found that the taxpayer did not demonstrate how Mr. Robert’s activities directly related to the development of new or improved business components, which is a requirement for RTC eligibility.
Despite the taxpayer’s argument that Mr. Robert’s time qualified as direct supervision, the court determined that his activities were not directly related to the conduct of qualified research and development activities. As stated in the judgment summary, “the court finds that Mr. Robert’s activities were not directly related to the conduct of qualified research and development activities.”
This case highlights the importance of thoroughly documenting and justifying employee time spent on direct supervision activities for RTC claims. Companies must provide clear evidence demonstrating how these activities directly relate to the qualified research and development activities to meet RTC eligibility criteria. Maintaining accurate and detailed records can help companies avoid potential challenges from the IRS during audits and examinations.
Direct Support
Lastly, individuals categorized as direct support can be easily related to the support staff of the baseball team. Just as equipment managers take care of the uniforms and other athletic equipment, individuals in direct support may sanitize experimentation equipment and prepare workstations for upcoming scheduled trials. A structured support team is essential to any team’s success.
Direct Support includes services in the direct support of either persons engaging in actual conduct of qualified research, or persons who are directly supporting persons engaging in the qualified research.
Examples of direct support include transcribing and organizing experimental data derived from simulations and trials, sanitizing, and preparing equipment for use in upcoming experimentation, or constructing experimental components to be later used in qualified research. Work identified as direct support may be supplemented by documentation including sanitation and maintenance logs, compiled data spreadsheets, physically developed parts, and much more.
However, direct support does not include general and administrative services, or other services that only indirectly benefit R&D activities, regardless of whether general and administrative personnel are part of the research department.
While there are no specific cases that focus solely on the disallowance of direct support activities for RTC purposes, the IRS has disallowed RTC claims in the past based on this category. To be eligible for the RTC, direct support activities must be integral and essential to the conduct of qualified research and development activities. This means that companies must be able to demonstrate how their direct support activities directly facilitate and support their qualified research and development activities. Although direct support activities are often more tangible and easier to document than direct supervision activities, companies must still provide sufficient evidence to support their RTC claims for direct support activities. Proper documentation and justification of time and expenses associated with direct support activities are critical for RTC eligibility.
What about First-Line Supervision?
When claiming the Research Tax Credit, it’s crucial to properly distinguish between employees engaging in direct research and those providing direct supervision. In particular, the IRS closely scrutinizes the role of first-line supervisors in R&D projects.
When claiming the RTC for direct supervision activities, it is essential to distinguish between first-line supervision and higher-level supervision. The regulations permit taxpayers to claim RTC for wages paid to first-line supervisors who have direct responsibility for supervising the conduct of qualified research activities.
The IRS closely examines the documentation provided by the taxpayer to determine whether the employees claimed as direct supervisors meet the first-line supervision standard. The IRS examines the employees’ job responsibilities, level of discretion and control over the research activities, and technical expertise to supervise the research properly.
Additionally, the taxpayer’s documentation must clearly demonstrate the employees’ direct responsibility for supervising qualified research activities. If the documentation is insufficient or does not clearly demonstrate the employee’s role as a first-line supervisor, the IRS may disallow the RTC claim for that employee.
Therefore, it is imperative for taxpayers to maintain detailed documentation of the time and activities of employees claimed as direct supervisors. The documentation should demonstrate that these employees meet the first-line supervision standard and have direct responsibility for supervising qualified research activities.
If a taxpayer has employees who are performing both direct research and first-line supervision functions, it becomes essential to identify and document the specific hours spent on each activity. This distinction is critical because the IRS often challenges the inclusion of first-line supervisors in the direct supervision category, arguing that their role is too removed from the actual research activity to qualify. Consequently, it’s essential to carefully track and document the specific time spent on direct research and direct supervision to ensure the validity of any RTC claim.
Who are the Indirect Employees?
Indirect time is an essential factor that needs to be considered when making a claim for the Research Tax Credit under Section 41. It includes activities that support or contribute to the research process but do not involve direct research, direct supervision, or other qualified activities. For example, time spent on administrative and clerical duties, quality control, training, and maintenance of equipment would all fall under indirect time.
To understand this concept, let’s bring in the baseball analogy again. In baseball, the players on the field (direct research) and the coaches (direct supervision) are critical to the game’s success. However, there are also several other people involved in the game, such as the umpires, the batboys, and the stadium staff. These individuals all have important roles in supporting the game, but they are not directly involved in playing or coaching.
Similarly, in an RTC claim, there may be individuals who contribute to the research process in supporting roles, such as administrative assistants, IT personnel, or janitorial staff. While their contributions are important to the research project’s success, they may not be directly involved in the qualified activities required for claiming the Research Tax Credit.
It’s crucial to differentiate between direct and indirect time when claiming the Research Tax Credit, as only qualified activities related to direct research and direct supervision can be included. Failing to do so could result in a disallowed claim and potential penalties.
Our Team at DST Advisory Group
With the various regulations and requirements, the RTC can seem daunting. Our team of Tax Engineers, Tax Associates, and Tax Attorneys are here to help. Our team works with you to maximize your legitimate Research Tax Credit Claim and ensure your R&D study is fully substantiated. Working together, we will “hit it out of the park”to maximize research tax credit benefits.