What are R&E Costs?
R&E costs are those incurred by companies intended to discover information that would eliminate uncertainty relating to development or improvement of a product, process, software, technique, formula, or invention. They include qualified research expenses (QREs), also known as direct research and development (R&D) costs, plus incidental overhead costs relating to R&D activity, according to Internal Revenue Code (IRC) Section 174 and related regulations.
According to IRC Section 41, QREs, or direct R&D costs, include in-house research expenses in four categories: (1) wages paid to employees performing qualified research services, (2) supplies, (3) computer rental or usage, and (4) 65% of research expenses paid to contractors.
R&E includes these QRE costs plus an allocation of overhead costs indirectly associated with (“incident to”) the R&E activities. The requirement to capitalize an allocation of indirect costs results in R&E costs being greater than direct R&D costs. Examples of allocable overhead include:
- Human resources and payroll department salaries and benefits
- Building depreciation
- Drawings, models, and lab materials
- Attorney’s fees
Allocations of overhead costs to capitalized R&E costs are determined using applicable statistical bases, such as employee headcount, square footage, and other factors.
Can the R&D Tax Credit Still be Claimed?
Yes, the new capitalization rules for R&E costs do not change a company’s ability to claim the R&D tax credit. The new rules do require any costs claimed for the R&D credit to be treated as R&E, which in turn requires all R&D costs to be capitalized and amortized as part of a company’s overall R&E costs.
Takeaways and Recommendations
- If a company discovers that it has R&E activities, it will be important to comply with the R&E capitalization and amortization requirements. This is the case regardless of whether the company claims the R&D tax credit.
- Businesses with R&E activities need to implement a reasonable way to identify indirect costs that are incidental to research, then allocate them for capitalization purposes using acceptable allocation factors.
- An R&D credit study may be a good place to start evaluating the existence of R&E costs for two main reasons:
- It will allow a company to receive an R&D credit, which may be helpful as a possible offset against the potential tax caused by capitalizing R&E costs.
- It will help a company identify the R&D/QRE portion of the costs to be capitalized and amortized for compliance with new tax rules.
- Congress is currently attempting to change the capitalization requirement and restore the prior tax law allowing full expensing of R&E costs retroactive to January 1, 2021.
If you have questions or concerns about R&E costs, please contact your tax advisor at Santora CPA Group for more information at (302) 737-6200.