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.
Copyright 2009 LexisNexis, a division of Reed Elsevier Inc.
