Research & Development Tax Credits for Farms: A Case Study

Northeast farmers are one of the most innovative and resilient groups in the country. Often, they test new ideas to see what sticks, whether it be new varieties or varying production techniques.  Some of these new ideas can qualify for the federal Research and Development (R&D) tax credit.

In today’s blog, we’ll take a look at a recent U.S. Tax Court case that involved a large poultry operation that can shed some light into the R&D tax credit.

The Facts

This case involved George’s, one of the largest fully-integrated poultry processing companies in the country. They were testing different feed additives, probiotics, vaccines and other methods to improve bird heath. As a result, they claimed R&D tax credits that were met with mixed results from the tax court.

R & D Overview and Test

The R&D credit is a business credit that can be calculated one of two ways. In this case, the taxpayer chose the alternative simplified method, which equals 14% of the excess of the taxpayer’s qualified research expenses (QREs) in the credit year over 50% of the average QREs from the three preceding years. If there is no qualified research in each of the three preceding years, the credit is reduced to 6% of the QREs in the credit year.

The second way the R&D credit can be calculated is that it is equal to 20% of the excess of the taxpayer’s QREs for the taxable year over a calculated base amount. To optimize the expenses that make up the credit, many taxpayers elect to take a reduced credit of 79%.

QREs are comprised of:

1. Wages paid or incurred to an employee for qualified service
   • Qualified services are those engaging in qualified research or;
   • In the direct supervision or direct support of qualified research.
2. Supplies used in the conduct of qualified research, including all tangible property other than land, improvements or depreciable property
3. Contract research expenses

Qualified research is determined under a four-part test:

1. The 174 Test. Expenditures can be treated as expenses under IRC 174 relating to research and experimental expenditures. The activity must be intended to discover information that would eliminate uncertainty. Uncertainly exists if the information available to the taxpayer does not establish the capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design.
2. Technological in Nature. The research must be undertaken for the purposes of discovering information that is technological in nature. The process of experimentation must rely on the principles of hard sciences, such as engineering, physics, chemistry, biology or computer science.
3. Business Component¹. The application of the information must be intended to be useful in the development of a new or improved business component. A business component is any “product, process . . .technique, formula, or invention to be held for sale, lease, or license, or used in the taxpayer’s trade or business.”
4. Process of Experimentation. Substantially all (80%) of the process must evaluate alternatives to resolving the uncertainty. The process must improve function, performance, reliability or quality and not cosmetic items.

The test is applied separately to each business component and if not met at that level, there is a “shrinking back” rule that then applies the test to the most significant subset of elements.

Lessons Learned

One of the highlights of the case was that the court accepted the premise that feed costs were production expenses as it applied “pilot model” rules to the broilers. Since the flock was raised for the particular purpose of evaluating a technical uncertainty, the expenses were allowed for the credit. In these HatchPak and Tylan trials, the taxpayer tested specific feed additives and vaccines to reduce disease and improve performance, testing specific flocks, running trials during contact periods and comparing the results of the treated flocks to other differently treated flocks. “The broilers subjected to the HatchPak and Tylan trials are pilot models within the meaning of Treasury Regulation §1.174-2(a)(4) because the uncertainty could be resolved only by testing on the broilers after they reached their end weights.”

Examples of what didn’t work include the Floramax trials: The court noted that there was “nothing in the record that identifies the experimental flocks in the Floramax trials… [or] on which company-related farms Floramax was administered. [T]hese flocks were not given a special diet that we can use to identify the flocks in the Floramax experiment…

The court also noted that the QREs weren’t able to be substantiated and that they would not “wing it with an estimate ungrounded in the record.” It is critical that contemporaneous records are kept by the taxpayer.

Takeaways

Despite this case involving poultry, all producers in the Northeast can glean insights into the R&D tax credit process from this case. Some of the work being done may qualify for tax credits, but only if the documentation is there to adequately support it.

Another interesting lesson learned is that QREs for supplies may be claimed even if no wage QREs are claimed.

Practicality

The R&D tax credit is part of the general business credit and generally is nonrefundable, making it a much more worthy endeavor for producers who are currently paying income tax. It can be carried forward for up to 20 years, after first carrying them back for one year.

¹The taxpayer must establish the business component it sought to develop. The product a taxpayer produces is a separate business component from its production process. To the extent “a research trial seeks to improve the process alone, QREs do not include the costs of the experiment the taxpayer would have incurred to manufacture the same product by the same standard method.”