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TAX CLINIC

provided by the IRS’s Large Business & for increasing research activities. The qualified research activities separately
International (LB&I) division in Field research credit is generally computed for each business component. Sec. 41(d)
Attorney Advice (FAA) 20212501F. based on the amount of qualified re- (2)(B) defines a business component as
The FAA makes clear that taxpay- search expenses (QREs) exceeding any product, process, computer software,
ers must analyze the requirements for a base amount that is derived from technique, formula, or inventory that is
qualified research activities under the historical taxpayer data. Taxpayers held for sale, lease, or license, or that is
four-part test of Sec. 41(d)(1) separately compute the research credit either under used by the taxpayer in its trade or busi-
for each business component that a the regular method as described in Sec. ness. For example, a motorcycle engine
taxpayer uses as a factual basis for a 41(a) or the alternative simplified credit builder may identify a new engine prod-
research credit claim. Further, the FAA (ASC) method in accordance with Sec. uct as a business component.
explains that a taxpayer’s use of statisti- 41(c)(4). The mechanics of the research Further, the FAA observes that quali-
cal sampling in accordance with Rev. credit calculation are dependent upon fied research activities must generally
Proc. 2011-42 does not change the the method elected by the taxpayer. meet the four-part test, which consists
requirement that the four-part test must Due to the constantly evolving IRS of the following requirements:
be satisfied separately for each business audit environment and the conten- ■ Sec. 174 test: Research expenditures
component. The FAA also states that tious nature of qualified research, it is must qualify as research or
the application of the four-part test to critical that taxpayers maintain suf- experimental (R&E) expenses under
business components does not change ficient records to substantiate research Sec. 174. R&E expenses are costs
when the IRS uses a statistical sample to credit claims. Substantiation sufficient associated with activities intended
audit a research credit claim. to satisfy an IRS audit can be extensive, to discover information that would
The discussion below provides a which is why statistical sampling is an eliminate uncertainty concerning the
basic overview of the research credit and attractive approach. When performed development or improvement of a
then explains how to efficiently satisfy properly, statistical sampling provides an product (see Regs. Sec. 1.174-2(a)).
the IRS requirements for the credit, accurate estimate of QREs while reduc- ■ Technological-information test:
using statistical sampling, considering ing the need to review extensive contem- Activities must be undertaken for the
the guidance contained in the recently poraneous documentation. However, the purpose of discovering technological
issued FAA. analysis of sampled records still requires information. As indicated in Regs.
an evaluation of the four-part test at the Sec. 1.41-4(a)(4), information that
Business components, qualified business-component level. relies on principles of the physical
research, and the four-part test As summarized in the FAA, Sec. or biological sciences, engineering,
Sec. 41 and the regulations thereun- 41(d)(2)(A) and Regs. Sec. 1.41-4(b)(1) or computer science is generally
der provide a nonrefundable credit generally require taxpayers to determine considered technological in nature.
■ Business-component test: Taxpayers are
required to undertake development
activities to discover information
used in the development of a new
or improved business component, as
defined above.
■ Process-of-experimentation test:
“Substantially all” (i.e., 80% or more)
of the activities must constitute
elements of a process of experimenta-
tion conducted for a new or improved
function, performance, reliability, or
quality (see Secs. 41(d)(1)(C) and
41(d)(3)(A)).
As summarized in the FAA, the
specific requirements with respect to IMAGE BY MONSITJ/ISTOCK
the process-of-experimentation test,
including the “substantially all” re-
quirement, can only be applied at the

12 February 2022 The Tax Adviser