5 things life sciences companies need to know about the R&D credit

Congress is deep in negotiations over the R&D credit, which represents one of the most important tax incentives for life sciences companies. And while the credit expired at the end of 2013, it is almost certain to be retroactively reinstated sometime this year.

The House and Senate both have advanced legislation that would not only extend, but enhance the credit. The Senate bill would make up to $250,000 in R&D credits refundable against payroll taxes for new businesses with less than $5 million in gross receipts, while the House bill would make the alternative simplified credit permanent at an increased rate of 20%. So there’s hope the R&D credit becomes even more generous in the future. For now, though, here are the five things life sciences companies need to know about the R&D credit:

1. Your research activity must satisfy a four-part test.
In order to qualify for the R&D credit, your research activities must meet the standards laid out in a four-part test:
  • Permitted purpose — The purpose of your research activity must be to create or improve the functionality, performance, reliability, quality or affordability of a product, process, technique, invention, formula or computer software (unless it’s internal-use software).
  • Process of experimentation — The activity must be a process of experimentation designed to evaluate more than one alternative or hypothesis.
  • Technical in nature — The research must be technological in nature and fundamentally rely on the principles of physical or biological sciences, engineering or computer sciences.
  • Elimination of uncertainty — The research must be meant to eliminate uncertainty concerning the development or improvement of a business component.

2. It’s not enough to just do qualified research.
You also must be able to prove to the IRS that you did the research. That means substantiating your credit with documentation. There is no bright-line test for the required documentation in the tax code or regulations, so each taxpayer must analyze their own records. You’ll need documentation that:

  • Shows that you meet the four-part test
  • Shows that you don’t fall into one of the exceptions
  • Connects your costs to your activities

A good example is the issue of technical uncertainty. It’s not enough to know that your scientists or engineers had an uncertainty. You’ll need to have documents as evidence that the uncertainty existed.

3. Pharmaceutical companies can get audit comfort early in the process.
The IRS Large Business and International Division has issued a directive that instructs examiners not to challenge certain qualified research expenses (QREs) claimed by pharmaceutical companies.

The directive applies to taxpayers developing new pharmaceutical drugs and therapeutic biologics who are in the discovery and preclinical stage or clinical trial stage. The directive generally instructs examiners not to challenge QREs from these two stages if the taxpayer provides a certification statement in which the taxpayer segregates the amount of QREs in the first stage and the trial stage development and agrees to retain and readily provide underlying documentation upon request of the IRS.

4. You can carry forward R&D credits up to 20 years.
Many life sciences companies don’t expect to generate any taxable income in their startup and development phases. This doesn’t mean they should ignore the R&D credit. Even if you have no current taxable income and would get no benefit for the R&D credit this year, you should still claim your credit because it can be carried forward for 20 years. R&D credit carryforwards can greatly reduce taxes after a drug or device is approved and revenue explodes.  

5. You can now claim the alternative simplified R&D credit on an amended return.
The IRS recently released temporary and final regulations that offer taxpayers a new opportunity to claim the alternative simplified research credit (ASC) on an amended return. The ASC is an alternative to the traditional R&D credit that offers a 14% credit and relies on only three years of data. It relieves the administrative burden that comes with claiming the traditional credit for many taxpayers, but the IRS has never before allowed the ASC to be claimed on an amended return.

You are now permitted to claim the ASC on an amended return, but the opportunity is only available for open years in which no research credit was previously claimed. If you claimed a traditional research credit, you cannot now amend to claim the ASC. The regulations provide a tremendous opportunity for anyone who performed a study and found no opportunity for the traditional research credit in a prior year, but may qualify for the ASC.

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