What Are Qualified Research Expenses (QREs)?
Qualified Research Expenses (QREs) are specific costs incurred by a business in the United States while conducting activities that meet the Internal Revenue Service (IRS) criteria for research and development (R&D). These expenses are foundational to claiming the federal Research and Development (R&D) Tax Credit, serving as a significant component within the broader category of Taxation. The identification and proper documentation of QREs are crucial for companies aiming to reduce their Tax liability and enhance cash flow. QREs typically include wages paid to employees for qualified services, costs of supplies used in the research, and certain contract research expenses20.
History and Origin
The concept of incentivizing corporate Innovation through tax benefits, rooted in the idea of fostering Economic growth, gained significant traction in the United States in the early 1980s. The federal R&D tax credit, for which Qualified Research Expenses are central, was initially established by the Economic Recovery Tax Act (ERTA) of 1981. This legislative act aimed to encourage companies to invest more in Research and development activities19. Although initially temporary and subject to numerous expirations and extensions, the R&D tax credit was made a permanent part of the U.S. tax code by the Protecting Americans from Tax Hikes (PATH) Act of 201518. This permanence provided businesses with greater certainty regarding the availability of this valuable Tax incentive.
Key Takeaways
- Qualified Research Expenses (QREs) are specific costs incurred by businesses for research and development activities that meet IRS criteria.
- They serve as the basis for calculating the federal R&D Tax Credit, offering a dollar-for-dollar reduction in a company's tax liability.
- Common QREs include wages for qualified services, the cost of supplies consumed in research, and a percentage of contract research expenses.
- To qualify, research activities must generally pass a "four-part test" established by the IRS, focusing on technological uncertainty and experimentation.
- Proper documentation of QREs is critical for businesses seeking to claim the R&D tax credit and ensure Compliance.
Interpreting Qualified Research Expenses
Interpreting what constitutes Qualified Research Expenses involves understanding a specific four-part test established by the IRS. For an expense to qualify, the underlying research activity must generally meet these criteria:
- Permitted Purpose: The research must aim to create a new or improved function, performance, reliability, or quality of a business component (such as a product, process, software, technique, or formula).
- Technological in Nature: The research must rely on the principles of physical or biological sciences, engineering, or computer science.
- Elimination of Uncertainty: The activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a business component.
- Process of Experimentation: The research process must involve a systematic trial-and-error approach or other evaluative methods to achieve the desired outcome.
Expenses for activities that do not satisfy this test, such as research related to style, taste, cosmetic design, or routine data collection, are generally not considered QREs16, 17. Businesses must carefully categorize their Business expenses to determine which are Deductible expenses that qualify as QREs.
Hypothetical Example
Consider "InnovateTech Inc.," a software development company. In the current tax year, InnovateTech is developing a new artificial intelligence algorithm designed to optimize data processing for financial institutions.
The expenses incurred directly related to this project include:
- Wages: $500,000 paid to software engineers and data scientists directly involved in designing, coding, and testing the new algorithm. These Wages represent compensation for qualified services.
- Supplies: $20,000 for specialized server components and cloud computing resources consumed during the development and testing phases. These are considered supplies used directly in the research.
- Contract Research: $80,000 paid to a university lab for specific computational modeling research integral to the algorithm's development. According to IRS rules, only 65% of contract research expenses typically qualify.
Calculating the total Qualified Research Expenses (QREs) for InnovateTech Inc.:
- Qualified Wages: $500,000
- Qualified Supplies: $20,000
- Qualified Contract Research: $80,000 * 65% = $52,000
Total QREs = $500,000 + $20,000 + $52,000 = $572,000.
This total of $572,000 would then be used as a key input when calculating InnovateTech's potential R&D Tax credits for the year.
Practical Applications
Qualified Research Expenses are primarily applied in the context of the federal R&D tax credit, a crucial provision for businesses across various sectors. Companies utilize these expenses to reduce their Corporate tax burden. This tax credit is available to a wide range of industries, including manufacturing, technology, software development, and even agriculture, provided they are undertaking activities aimed at developing new or improved products, processes, techniques, formulas, or software15.
For example, a manufacturing firm developing a more efficient production line, a pharmaceutical company researching a new drug, or a tech startup refining a mobile application are all potential candidates for leveraging QREs. The process often involves detailed tracking of employee time spent on qualified activities, meticulous record-keeping of supplies consumed, and careful documentation of contract research agreements. Businesses typically report their qualified research expenses and calculate the R&D tax credit using IRS Form 6765, Credit for Increasing Research Activities14. The IRS provides specific instructions for this form to guide taxpayers in accurately claiming the credit12, 13. This credit can significantly impact a company's Net income and overall financial health.
Limitations and Criticisms
Despite the benefits, there are limitations and criticisms associated with Qualified Research Expenses and the R&D tax credit. One significant challenge for businesses is the complexity of identifying and documenting qualifying activities and expenses. The IRS provides a strict "four-part test," and misinterpreting these rules can lead to disallowed credits and potential penalties. The burden of proof lies with the taxpayer to demonstrate that their expenses meet the specific criteria for qualified research10, 11.
A notable change introduced by the Tax Cuts and Jobs Act (TCJA) of 2017 (effective January 1, 2022) requires businesses to capitalize and amortize (deduct over time) their research and experimentation expenditures, rather than immediately expensing them in the year incurred9. This change impacts how R&D expenses, including many QREs, are treated for tax purposes, spreading the deduction benefit over five years for domestic research and fifteen years for foreign research. This amortization requirement has been a point of criticism, with some arguing that it discourages new R&D investment by delaying the tax benefit and increasing the administrative complexity for businesses8. Furthermore, issues may arise in correctly classifying expenses, especially when research activities also contribute to the creation of Intellectual property or other long-term assets, which have different accounting and tax treatments on Financial statements.
Qualified Research Expenses (QREs) vs. Research and Development (R&D) Tax Credit
It is common to confuse Qualified Research Expenses (QREs) with the Research and Development (R&D) Tax Credit, but they are distinct concepts. QREs are the inputs to the R&D Tax Credit. They are the specific costs that a company incurs while performing qualified research activities, such as wages, supplies, and contract research. Without these qualifying expenses, a business cannot calculate or claim the credit.
The R&D Tax Credit, on the other hand, is the output or the benefit derived from having incurred QREs. It is a nonrefundable tax credit that provides a dollar-for-dollar reduction of a company's federal income tax liability. The credit is calculated as a percentage of the QREs that exceed a certain base amount, which varies depending on the calculation method used (e.g., the regular credit or the alternative simplified credit). Essentially, QREs are the building blocks, and the R&D Tax Credit is the financial reward for investing in Research and development.
FAQs
What types of expenses generally qualify as QREs?
Generally, QREs include wages paid to employees for directly performing or directly supervising qualified research, the cost of supplies used and consumed in the research process, and 65% of amounts paid to third-party contractors for conducting qualified research on the taxpayer's behalf6, 7. Certain computer leasing costs for qualified research may also be included5.
Can a project that failed still generate QREs?
Yes, research activities can still generate Qualified Research Expenses even if the project ultimately fails or does not result in a new product. The eligibility for QREs is based on the nature of the research activities themselves (i.e., whether they meet the four-part test), not on the successful outcome of the project. This encourages businesses to undertake innovative but potentially risky endeavors4.
Are all research-related expenses considered QREs?
No, not all expenses related to research and development activities qualify as QREs. Expenses for research conducted after commercial production begins, research adapting existing business components, and research reproducing existing business components do not qualify3. Additionally, expenses for activities related to foreign research, market research, or ordinary testing are typically excluded2. Businesses must adhere to strict IRS guidelines to ensure expenses are properly classified as QREs for tax purposes1.