Research and Experimental Costs in a Business
Frequently, a business incurs costs for activities that are intended to provide information to help eliminate uncertainty about the development of a new product or the improvement of an existing product. Whether costs qualify as research and development costs depends exclusively on the nature of the activity to which the costs relate, not to the nature of the product being developed or to the level of technological advancement.
What are Research and Experimental Costs?
Generally, research and experimental expenditures include all costs related to the development of or the improvement of a product. A “product” includes a formula, an invention, a patent, a pilot model, a process, a technique, and similar items. Although the costs of obtaining a patent, including attorneys’ fees paid to apply for the patent, are research and experimental expenditures, the costs of buying another individual’s patent are not research and experimental costs. The Internal Revenue Service has determined that certain costs do not qualify for treatment as research and experimental expenditures. These non-qualifying costs include advertising, consumer or efficiency surveys, management studies, quality control studies, research on literary or historical projects, and the acquisition of another’s patent, model, production, or process.
How to Handle Research and Experimental Costs
Once costs have been properly identified as qualifying for research and experimental treatment, the Internal Revenue Code gives the taxpayer a choice as to how they can be handled for federal income tax purposes. Generally, the costs of research and experimentation are considered capital expenses. The expenditures connected to a capital expense are recovered through periodic deductions for amortization for a period of at least 5 years. However, a taxpayer can choose to deduct research and experimental costs as a current business expense in the first tax year in which they are paid or incurred. If the taxpayer fails to make a timely election to deduct those expenditures in the first year in which they are incurred, he cannot deduct them in later taxable years without approval from the IRS. If a taxpayer pays or incurs costs for increasing qualified research activities, he may be entitled to take a credit for those expenditures. Qualified research must be undertaken to discover information that is technological in nature, and its application must be intended for use in developing a new or improved business component of the taxpayer. In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.
Drilling and Exploration Costs
The costs of developing oil, gas, or geothermal wells include wages, fuel, repairs, hauling, and supplies incident to and necessary for the preparation of the wells. A taxpayer who is developing these wells in the United States has the choice of treating the costs as capital expenditures and recovering them through depreciation or depletion or deducting the costs as current business expenses. The only costs that qualify for a current deduction are those without a salvage value. In addition, a taxpayer can choose to deduct the cost of drilling exploratory bore holes to determine the location and delineation of offshore hydrocarbon deposits even if the taxpayer has no intention of producing hydrocarbons. However, certain amounts paid to a contractor are not eligible for a current deduction and must be capitalized. A taxpayer who chooses to capitalize expenditures for intangible drilling costs must deduct them through amortization and depreciation over a 60-month period beginning with the month in which the expenses were paid or incurred. Once the taxpayer who is developing gas and oil wells has chosen between taking a current deduction for intangible drilling costs or capitalizing them, the choice is binding for the year made and all the years to follow. However, he can revoke the election for geothermal wells.
When a taxpayer chooses to capitalize the drilling and development costs of a geothermal well that was placed in service during the tax year, he may be entitled to take a business energy credit on those expenditures. If a well turns out to be nonproductive and the taxpayer has chosen to capitalize the intangible drilling costs connected with that well, he is entitled to deduct the drilling costs as an ordinary loss in the year in which the well was completed.
If the costs of determining the existence, location, extent, or quality of any mineral deposit lead to the development of a mine, they are usually treated as capital expenditures and recovered through depletion as the mineral is removed from the ground. However, the taxpayer can choose to deduct exploration costs in the United States paid or incurred before the development stage began. This rule does not apply to oil, gas, or geothermal wells. When the mine begins producing, the taxpayer must recapture any exploration costs he chose to deduct. In addition, the taxpayer must recapture deducted exploration costs if he receives a bonus or royalty from mine property before it reaches the producing stage.
Exclusion of Meals Furnished by an Employer from Gross Income
In general, the value of meals provided by or on behalf of an employer to an employee, the employee’s spouse, or his or her dependents is not included in the employee’s gross income if two conditions are met. First, the meals must be furnished on the premises of the employer, and second, the meals must be furnished for the convenience of the employer. The exclusion only applies to meals furnished by an employer and not to cash reimbursements for meals. Under the Internal Revenue Code, if more than one-half of the employees are provided with meals for the convenience of the employer, then all meals given on the premises are treated as furnished for the convenience of the employer. If this test is not met, then only the employees who were provided meals for a substantial noncompensatory business reason of the employer are permitted to exclude the value of the meal, and the employer’s deduction for the cost of providing the meal is subject to a 50 percent limitation. Meals provided to employees by the employer without charge are considered to be for the convenience of the employer if they are furnished for a substantial noncompensatory business reason of the employer rather than as a way to provide additional compensation to the employee. A substantial noncompensatory business reason requires a connection between the employee being able to properly perform his or her duties and the acceptance of the meal. The meal does not have to be indispensable to the performance of the employee’s duties. The requirement is for a business nexus between the meal and job performance. In addition, the Internal Revenue Service pays no attention to whether the employer characterizes the meal as non-compensatory.The Internal Revenue Service and various courts have looked at numerous factors to determine if the provision of meals was for a substantial noncompensatory business reason, including:
- Whether the meal was provided before, during, or after the employee’s work period;
- Whether the employer required the employee to live on the business premises as a condition of employment;
- Whether the meal was provided on the business premises so that the employee would be available to respond to an emergency arising during mealtime;
- Whether the meal was provided on the business premises because the business demands required a meal period that was too short to permit the employee to eat in another location;
- Whether the employee could not otherwise secure an a proper meal within a reasonable time period;
- Whether the employer furnished the meal to an employee to promote good will or morale;
- Whether the employer provided the meal to attract prospective employees;
- Whether the employer furnished the meal under an employment contract or statute that characterized meals as compensation.
Partnership Tax Year
Generally, a partnership is required to use the same tax year as a majority of its owners. If one or more of the partners having the same tax year owns a majority interest in the business, the partnership must use the tax year of those partners. A majority interest is defined as an interest in more than half of the partnership’s profits and capital. When the owners are individuals, their tax year is usually the calendar year. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a five percent or more interest in the profits or capital of the partnership. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership must generally use a tax year that results in the least aggregate deferral of income to the partners.
Exceptions to the General Rule
Under certain circumstances, a partnership may be able to use a tax year different from that required by the majority interest, principal partners, or deferral of income tests. A partnership may elect a different tax year if it has a business purpose for doing so. The Internal Revenue Service considers facts such as the natural business year of the partnership, its annual business cycle, its seasonal nature, or other facts and circumstances for selecting a particular tax year. Certain partnerships may make an election under Section 444 of the Internal Revenue Code to use a fiscal year other than the year required under the general rules. A fiscal year elected under Section 444 may generally have a deferral period of no greater than three months or the deferral period of the partnership’s current tax year, whichever is less. When this election is made, the partnership must make additional tax payments intended to compensate for any income deferrals resulting from the election. A partnership is allowed to use a tax year other than its required tax year if it elects a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under Section 444.
Employer-Provided Child Care Credit
In order to encourage businesses to provide child care for their employees, Congress has recently created a tax incentive for those employers who make certain qualified child care expenditures. The amount of the credit allowable in a tax year is the sum of 25 percent of qualified child care expenditures plus 10 percent of qualified resources and referral expenditures. The credit is limited to a maximum of $150,000 for any tax year.
Qualified Child Care Facility
In order to qualify as a child care facility giving rise to a tax credit, the facility must be one whose principal use is to provide child care assistance. It must meet the requirements of all applicable state and local laws, including any licensing requirements. The principal use requirement can be waived if the facility is located in the principal residence of the operator of the facility.
A child care facility will only be qualified for the purpose of the tax credit if three requirements are fulfilled. First, enrollment in the facility must be open to the taxpayer’s employees during the tax year. Second, if the facility is the taxpayer’s principal trade or business, at least 30 percent of the enrolled children must be dependents of the taxpayer’s employees. Finally, the use of the child care facility cannot discriminate in favor of highly-compensated employees.
Qualified Child Care Expenditures
In order to qualify for the credit, expenditures must be incurred: to acquire, construct, rehabilitate or expand property used as a taxpayer’s qualified child care facility; for the operating costs of a qualified child care facility, including the costs related to employee training, scholarship programs, or providing compensation for employees with high levels of child care training; or under a contract with a qualified child care facility.
Recapture of Acquisition and Construction Credit
If a taxpayer terminates the operation of his qualified child care facility or changes its ownership during a tax year, a recapture event has occurred. In that case, the tax liability of that tax year must be increased by an amount determined by a recapture calculation established under the Internal Revenue Code. The recapture calculation is limited to those amounts that were actually claimed to reduce the taxpayer’s liability. An event that triggers a casualty loss with respect to a qualified child care facility is not a recapture event unless the qualified facility is not replaced within a reasonable period of time.