Monday, January 29, 2018
The Economic Recovery Tax Act of 1981 introduced the “Credit for Increasing Research Activities.” The credit is better known as the research and development credit, or simply the “R&D” credit. It’s a general business credit that, for a business with under $50 million in average annual gross receipts, offsets both regular tax and alternative minimum tax. For certain defined smaller businesses, it can offset the employer portion of Social Security taxes up to $250,000 (with some limitations). The purpose of the credit as enacted is still the same today – to incentivize research and experimentation by providing a tax credit for activities that develop a new component of a taxpayer’s business or improve an existing component’s performance, functionality, reliability or quality. I.R.C. §41(d)(3)(A).
While the credit is available to a wide array of businesses, including farming businesses, what is the scope of its application? Does it apply to a farmer that utilizes cover crops or installs a bioreactor? What about a farmer that uses nitrification inhibitors? If the farmer receives a cost-share amount from the government, does that impact the ability to claim the R&D credit?
Today’s post takes a look at the R&D credit and its potential application to farming and ranching operations.
Mechanics of The Credit
As noted above, the R&D credit applies to activities (including research and software development) that develop a new business component or improve an existing component’s performance, functionality, reliability or quality. Treas. Reg. §1.41-4(a). What is a business component? It’s “any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license,” or which is used by the taxpayer in the taxpayer’s trade or business. An activity qualifies for the credit by means of a four-part test: (1) the activity must develop or improve the functionality, quality, etc., of a business component; (2) the activity must rely on technological principles; (3) substantially all of the activity must employ a process of experimentation that is designed to evaluate one or more alternatives; and (4) the process of experimentation must be designed to eliminate uncertainty (regarding the company’s capability, methodology, or appropriateness of design of a business component). I.R.C. §41(d).
Expenses that are incurred with respect to a qualified activity are used to compute the R&D credit and are termed “qualified research expenditures” (QREs). QREs can result for in-house activity as well as expenses incurred via contract. For in-house activity, QRE includes W-2 wages paid to employees that are either directly involved in an activity (including research) that develops a new business component, or supervise it or support it, as well as the cost of supplies and payments for qualified services (e.g., consultants and engineers). I.R.C. §41(b); see also Suder v. Comr., T.C. Memo. 2014-201.
Note: Under certain federal farm programs, especially those programs designed to provide environmental benefits, the USDA shares in part of the expense associated with complying with the program. While the expense associated with establishing a conservation/environmental structure/program on the farm might otherwise qualify as a QRE, the portion that the government subsidizes (via I.R.C. §126) would not be a QRE because the taxpayer did not incur the cost. In addition, as noted below, qualified expenses would be limited to a test plot rather than applying to expenditures incurred for the entire farm.
Once the qualified activities and QREs are determined, the credit is six percent of eligible expenses for each of the first three years that qualified research activities are conducted. I.R.C. §41(c)(5)(B)(ii). After that, the alternative simplified method that sets the R&D credit at 14 percent of the excess of QREs for the tax year over 50 percent of the average QREs for the three preceding tax years multiplied by 65 percent (factoring in a reduction via I.R.C. §280C). I.R.C. §§41(c)(5); I.R.C. §41(h).
Bill is trying to determine his R&D credit for 2018. Assume that Bill incurs QREs of $50,000 in 2015; $62,500 in 2016 and $75,000 in 2017. The average over those three years is $62,500. 50 percent of that three-year average is $31,250. For 2017, he incurred $75,000 of QREs. From that amount, Bill subtracts 50 percent of the average QREs for the prior three years, or $31,250. That amount is then multiplied by 14 percent (.14 x $31,250 = $4,375). The $4,375 amount is then multiplied by 65 percent (the I.R.C. §280C credit reduction), which yields an R&D credit of $2,843.75.
The R&D credit is claimed on Form 6765 and the associated instructions are instrumental in properly computing the credit and completing Form 6765 properly.
If a farmer doesn’t incur at least the level of QREs that Bill did in the example, it may not be worth the extra recordkeeping and tax preparation cost of claiming the credit.
As an additional point, for privately held businesses that have $50 million or less in average gross receipts for the three preceding tax years can use the R&D credit to offset the alternative minimum tax. Also, start-up companies, or those with less than $5 million in gross receipts for the current tax year and no gross receipts for the five preceding years may use R&D credits against their payroll tax liability up to $250,000.
Application to Agriculture
As noted above, the R&D credit applies costs incurred associated with research to develop new products or improve existing ones. It’s important that the research involves technological information or some sort of application that is intended to develop new or improved business products or processes. It’s also important that the research activities have a process of experimentation that relates to a new or improved function, performance, reliability, efficiently or quality.
So what kind of research activities on a farm will generate qualified expenses for the R&D credit? It is those research activities that are new to the farm and involves testing of something before it can be used on a larger scale. For farmers, the credit could potentially have a wide application – farmers often are “tinkering” or investigating ways to improve productivity or efficiency of crop and/or livestock production. Common examples might include testing new fungicides and seed treatment in an attempt to control insect disease; testing precision planting equipment in an effort to find ways to increase efficiency and/or yield; experimenting with organic fertilizer or with a with a cover crop to determine the impact on soil fertility and/or soil erosion; trying new cultivation techniques such as strip tillage; experimenting with irrigation and drainage and determining the impact on soil productivity and/or erosion; coming up with new weed/pest management techniques; experimenting with crop genetics; testing various planting dates, plant population, and row spacing to determine the impact on plant growth and development; testing combines and other harvesting equipment to minimize crop waste and/or decrease harvest time; working on customized animal feed formulations; developing customized software; researching and designing new grain bins. The list could go on, but you get the point.
The R&D credit can have a broad application to many activities that occur on a farm or ranch. But, don’t expect the IRS to allow the R&D credit to be applied to the whole farm. The credit is for research and development – in other words something that would occur in a laboratory. The entire farm is not a laboratory, but a test plot is. It is likely that the IRS will argue that the qualified research activities (which give rise to QREs) would have to occur in a test plot, with expenses (including qualified wages, and the cost of chemicals, fertilizer, seed, etc.) allocated to the specific area of the test plot. That will result in a small number for most farmers, especially in the Midwest. Higher value crops, such as potatoes, onions and fruits, might have bigger numbers, but the point remains that the QREs (and, hence the R&D credit) must be associated with a test plot and not the entire farm.