Definition of Supplies Clarified for Purpose of R&D Credit

By Joe Stoddard, CPA, Salt Lake City, UT, and Mark Andrus, CPA, Portland, OR

Editor: Greg A. Fairbanks, J.D., LL.M.

Taxpayers that use supplies in their research and development (R&D) efforts should reevaluate the costs they include in their R&D credit computations in light of a recent Tax Court decision (TG Missouri Corp., 133 T.C. No. 13 (2009)). This ruling provides significant potential benefits to certain taxpayers claiming the R&D credit under Sec. 41—especially those that purchase supplies during their R&D efforts for prototypes, products, or equipment that they then sell to customers.

Tax Court Decision

TG Missouri manufactures injection-molded products such as steering wheels, air bags, and body side molding for customers in the automotive industry. As part of its business, the company also develops and uses production molds, contracting with third-party toolmakers. TG Missouri either sells the completed production molds to its customers or retains ownership of the molds. In either case, TG Missouri keeps the molds in its facilities and uses them for the production of automotive parts.

At issue in the case were certain supply costs TG Missouri claimed for the R&D credit on its 1998 and 1999 tax returns— specifically, the company claimed the amounts it paid to the third-party toolmakers for molds it subsequently modified and sold to its customers as qualified supply costs. The IRS disallowed the costs, arguing that the completed molds were subject to wear and tear, exhaustion, or obsolescence and had a useful life beyond one year. Thus, the IRS concluded, the supplies used in the molds were property “of a character” subject to the allowance for depreciation and thus not includible for the credit (although they were not depreciable assets for TG Missouri because it did not retain ownership of the molds).

The Tax Court, in siding with TG Missouri, determined that the molds were not subject to depreciation in the hands of the taxpayer; therefore, the amounts paid related to the molds were includible as supply costs for purposes of the R&D credit. The court’s opinion shows that the exclusion for supplies of a character subject to depreciation requires not only that the property generally be a type of property that is typically subject to depreciation but that it also specifically be depreciable property in the hands of the taxpayer.

Potential Impact

The TG Missouri ruling provides much-needed clarification for taxpayers using supplies in their R&D efforts. Despite the lack of statutory or regulatory language, the IRS has often taken the position that supply costs need to be totally used or consumed during the R&D efforts to be credit eligible. The ruling effectively puts an end to the “totally used or consumed” requirement because the supply costs allowed in TG Missouri were part of molds that the taxpayer subsequently sold to its customers.

Clearly, taxpayers that are developing and selling molds have the opportunity to reevaluate their supply costs and determine if additional costs can be included in their R&D credit calculations. However, this case has much broader implications beyond the obvious connection—essentially, any company that uses supplies in its R&D efforts may potentially benefit from the TG Missouri ruling.

The following scenarios illustrate how the ruling may favorably affect certain taxpayers.

  • Company A is in the business of developing and selling equipment and machinery. A’s R&D efforts involve building prototype units for testing and experimentation. If successful, certain prototype units are subsequently sold to customers. In following the logic of the court in TG Missouri, the crediteligible supply costs for raw materials that go into the prototype unit do not need to be reduced simply because the prototype was sold.
  • Company B is in the business of developing custom products for its customers; these design and development activities are qualified research activities for purposes of Sec. 41. The TG Missouri ruling effectively provides the potential to include all supply costs incurred in these product development efforts in B’s R&D credit calculations— even when the supplies are part of the end product that B sells to the customer. This is true whether B accounts for supply costs in a general inventory account or a specific R&D supply account.
  • Company C purchases a piece of equipment that it intends to modify to use in its production facility. After significant design and engineering efforts, C determines that it will not be able to meet the required specifications and thus decides to scrap the equipment. Even though this particular piece of equipment may have a useful life beyond one year in the hands of other taxpayers, it is not property of a character subject to depreciation for C and thus may be includible as a qualified supply cost for purposes of the R&D credit.

Contemporaneous Documentation Is Key

As with any costs claimed for the R&D credit, it is important to gather documentation supporting the costs included in the credit calculations. In order to sustain R&D supply costs upon IRS examination, taxpayers should have documentation showing how they used the supplies in their R&D efforts and be able to show that the supplies were not property of a character subject to depreciation.

TG Missouri is the latest in a series of R&D credit-related court decisions handed down over the past year providing much-needed guidance and clarification on the credit. Tax advisers with clients using supplies in their R&D activities should consult with the clients to determine the impact this ruling has on their R&D credit computations.


Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.

For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or
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