The Strategic Role and Regulatory Complexity of “Incident to Development” in Maximizing the U.S. Research Tax Credit

I. The Strategic Nexus of Incident to Development (I2D)

A. Introduction to I2D as an Economic Incentive Multiplier

The concept of Incident to Development (I2D) is a core definitional mechanism rooted in Internal Revenue Code (IRC) Section 174, which permits the deduction or capitalization and amortization of Research and Experimental (R&E) expenditures. Section 174 broadly captures “all costs incident to the development or improvement of a product,” encompassing pilot models, processes, formulas, software, and inventions.1 In the context of the R&D tax credit (IRC Section 41), I2D is strategically utilized to expand the base of Qualified Research Expenses (QREs). Its primary application lies in defining “qualified services” for employee wages under Treasury Regulation $\S$1.41-2(d)(2), which mandates the inclusion of costs related to “direct supervision” or “direct support” of qualified research activities, thereby bridging general administrative functions to the experimental effort.3 This linkage is critical because Section 41 QREs are generally limited to specific categories (wages, supplies, and contract research) and explicitly exclude broad general and administrative (G&A) overhead.4 I2D thus serves as a regulatory gateway, transforming essential support functions into claimable research costs, provided a strict nexus to the experimental process can be established.

B. Core Regulatory Thesis and Importance

The importance of I2D is derived from its potential to dramatically increase the value of the $\S$41 R&D credit, particularly through the “substantially all” rule for wages. This rule stipulates that if an employee performs qualified services (including I2D activities such as direct supervision or direct support) for 80% or more of their working time, then 100% of that employee’s annual wages can be claimed as QREs.5 This mechanism is vital for including high-value, salaried personnel—such as R&D managers, senior engineers, and department heads—whose primary function is oversight or technical assistance rather than hands-on experimentation.7 Without the I2D provisions, these non-experimental, yet integral, supervisory activities would be excluded or severely limited, leading to a substantial reduction in the QRE base. The IRS, recognizing the significant leveraging effect inherent in this rule, subjects I2D claims, especially those involving supervisory wages, to intense scrutiny, requiring meticulous, contemporaneous documentation to prove the “direct” connection and satisfy the 80% threshold.6

II. Regulatory Genesis and Definitional Clarity of I2D

A. The Foundation in IRC Section 174: Research and Experimental (R&E) Expenditures

The statutory definition of Research and Experimental (R&E) expenditures under IRC $\S$174 provides the foundational breadth for I2D. Section 174 defines these expenditures to encompass “all costs incident to the development or improvement of a product,” where a product includes any pilot model, process, formula, invention, technique, patent, or similar property.1 This R&E breadth is necessary to capture costs incurred outside of the immediate laboratory setting, such as the costs associated with obtaining a patent, including attorneys’ fees expended in making and perfecting a patent application.1

However, the definition of R&E expenditures under $\S$174 also establishes crucial exclusions. I2D explicitly excludes ordinary testing or inspection of materials or products for quality control, efficiency surveys, management studies, consumer surveys, or general and administrative (G&A) expenses that relate to a corporation’s activities as a whole and do not contribute directly to the research effort.1 The precise boundary between legitimate research support and routine business administration activities represents the primary zone of potential audit contention.

B. Bridging $\S$174 and $\S$41: Qualified Research Expenses (QREs)

To qualify for the $\S$41 R&D tax credit, expenses must first meet the criteria of QREs, which are limited to in-house research expenses (wages and supplies) and contract research expenses.3 Furthermore, the expenses must satisfy the “trade or business” requirement outlined in Treasury Regulation $\S$1.41-2(a)(1). This requirement has the same meaning as used for purposes of IRC $\S$162 (relating to ordinary and necessary business expenses). Importantly, expenses paid or incurred prior to commencing a new business (as distinct from expanding an existing business) are not considered paid or incurred “in carrying on a trade or business” for $\S$41 purposes, even if they might qualify as R&E under $\S$174.11 This ensures that I2D expenses are connected to an established, ongoing commercial activity of the taxpayer. Additionally, if research is performed for another person, and the taxpayer retains no substantial rights in the results, that research is ineligible.11

C. Strategic Divergence: Scope of I2D Costs

A key complexity arises from the regulatory divergence between the scope of I2D under $\S$174 and its application under $\S$41. Following changes such as the mandated capitalization and amortization of domestic R&E expenditures under $\S$174, taxpayers must track a broad scope of incidental costs for amortization purposes, including general overhead costs incidental to R&E activities, such as rent, utilities, property tax, and depreciation/amortization of property used to perform research.4

However, for the purpose of the $\S$41 credit, only incidental costs included within the specific definitions of “qualified wages” or “qualified supplies” are generally permitted. For example, while the depreciation of R&D equipment qualifies as an incidental cost for $\S$174 amortization, it is explicitly excluded from the QRE definition under $\S$41 because QREs for in-house research expenses are limited to wages, supplies, and certain computer usage fees, and supplies exclude depreciable property.5 This distinction necessitates a dual-track accounting approach: a broad capture of incidental costs for $\S$174 compliance, and a narrow, highly defensible selection of incidental costs (primarily wages) for $\S$41 credit claims.

III. Incident to Development (I2D) in QRE Maximization: The Wage Component

The most impactful financial application of I2D is through the expansion of eligible wages, which constitutes the largest portion of the QRE base for most taxpayers.

A. Defining Qualified Services (QS) and I2D

Wages paid or incurred to an employee constitute in-house research expenses only if they are paid for “qualified services.” The definition of qualified services is bipartite 3:

1. Engaging in qualified research (i.e., hands-on experimentation).
2. Engaging in direct supervision (DS) or direct support (DSU) of qualified research.

The second part—DS and DSU—is the practical application of the I2D concept to labor. Direct supervision typically involves the immediate, first-line management of R&D personnel, such as R&D managers or senior engineers, who review protocols and direct technical staff. Direct support typically relates to technical assistants, machinists who prepare experimental apparatus, or administrative staff whose function is specifically and integrally tied to the physical research effort, such as laboratory preparation or documentation.15

B. The Critical 80% “Substantially All” Rule (Treas. Reg. $\S$1.41-2(d)(2))

The strategic value of I2D is fully realized through the “substantially all” rule. If an employee performs qualified services (including the time spent on DS and DSU) for 80% or more of their compensated time during the taxable year, then the regulatory provision deems 100% of that employee’s annual wages to be qualified research expenses.3

This rule creates a substantial multiplier effect. Highly compensated engineers, scientists, and managerial personnel often spend less than 80% of their time actively running experiments but rely on I2D activities (DS and DSU) to push their total qualified time across the 80% threshold. For example, the inclusion of time spent by a director in reviewing designs and protocols—an I2D function—can be the critical factor in claiming 100% of their salary, rather than a limited percentage (e.g., 70% or 60%), thus drastically leveraging the QRE base.7 The analysis is performed on an employee-by-employee basis.5

C. The Audit Defense Distinction: Process of Experimentation (PoE) vs. QS

Effective audit defense requires maintaining a strict conceptual separation between two distinct 80% rules within Section 41.

First, the research activities themselves must satisfy the “substantially all” requirement related to the Process of Experimentation (PoE). This activity-based test requires that 80% or more of the research activities, measured on a cost or other consistently applied reasonable basis, must constitute elements of a process designed to evaluate alternatives to eliminate technical uncertainty.16

Second, once the project activity has been proven qualified (meeting the PoE test), the taxpayer uses the I2D definition (DS/DSU) via the separate $\S$1.41-2(d)(2) rule to determine the percentage of an employee’s wages that qualifies. Crucially, the regulations specify that the PoE substantially all requirement is applied without regard to the I2D wage rule of $\S$1.41-2(d)(2).17 This means the taxpayer’s claim relies on a two-step sequence: (1) prove the underlying research project is qualified via the PoE test, and (2) use the I2D provision to justify including 100% of the wages of the personnel who supervised or supported that project.

Example of I2D Application: Leveraging Supervisory Wages

Consider a Chief Technology Officer (CTO) responsible for a division undertaking the development of new manufacturing process improvements. The CTO’s annual salary is substantial. The CTO’s time allocation is rigorously documented: 10% involves directly engaging in hands-on prototype testing; 70% is spent on reviewing technical design specifications, directing the experimental team’s goals, and approving alternative methodologies (Direct Supervision—an I2D activity); and 20% is spent on corporate strategic planning and quarterly shareholder reports (General & Administrative). The total time dedicated to Qualified Services, including the I2D component, is $10\% + 70\% = 80\%$. Since the CTO’s qualified services meet the 80% “substantially all” threshold defined in Treasury Regulation $\S$1.41-2(d)(2), the taxpayer is permitted to claim 100% of the CTO’s annual wages as a QRE.3 Had the CTO spent 19% on G&A, the total qualified services would fall to 79%, and only 79% of the wages would qualify, highlighting the crucial cliff effect of the 80% threshold.

The table below illustrates the application of the substantially all rule to various employee roles:

Application of the Substantially All (80%) Wage Rule (Reg. §1.41-2(d)(2))

IV. Application of I2D to Supplies and Indirect Costs

While the primary leverage of I2D is achieved through wages, the concept also extends to material costs, although its application is significantly more restricted than under $\S$174.

A. Qualified Supplies (IRC $\S$41(b)(2)(C))

In-house research expenses include “any amount paid or incurred for supplies used in the conduct of qualified research”.14 The term “supplies” is defined as any tangible property other than land, improvements to land, and depreciable property.13 I2D applies here by allowing the inclusion of materials that are necessary for the development process but may not be the final component of the product itself.

For instance, supplies that qualify as I2D include raw materials consumed in the creation and testing of a prototype that is destroyed during experimentation, or specialized chemicals and consumables used up in technical analysis or laboratory preparation. Even if the individual responsible for preparing or handling these materials is classified as “direct support” personnel under the I2D wage rule, the cost of the supplies themselves can be included if they are used or consumed in the conduct of qualified research.13

B. Exclusion of General Overhead and Depreciation

A fundamental restriction under $\S$41 is the exclusion of most indirect costs, including general overhead, rent, utilities, and general depreciation. Although $\S$174 R&E expenditures broadly encompass incidental overhead costs for capitalization purposes 4, IRC $\S$41 specifically limits QREs and generally excludes these types of indirect costs.5

Similarly, the wages of administrative and clerical staff, such as accounting, finance, human resources, or legal teams, are normally treated as indirect costs and are ineligible for the $\S$41 credit, as these costs do not contribute directly to the research and development effort.1 The only path for general operational costs to enter the QRE calculation is by being embedded within the wages of an employee who satisfies the I2D 80% rule (e.g., a lab technician who spends 85% of their time maintaining and cleaning the research environment, which is classified as Direct Support). This required high standard of direct correlation reinforces the idea that incidental costs must be “integral” to the project to qualify.15

V. Compliance Imperatives: Documentation, Allocation, and Audit Defense

The strategic benefit gained from maximizing QREs via I2D inclusion is commensurate with the heightened audit risk. Recent judicial precedent and evolving IRS guidance underscore the necessity of robust, factual documentation.

A. Factual Substantiation of Qualified Services

The Internal Revenue Service (IRS) explicitly instructs auditors that eligibility for qualified services must be determined based on what an employee actually does, rather than relying solely on job descriptions or titles.5 This requirement places the burden on the taxpayer to substantiate the 80% threshold for all supervisory and support roles claimed under the I2D provisions.

Defensible claims require meticulous, contemporaneous documentation proving that supervisory time (DS) or support time (DSU) was directly linked to qualified research activities. Suitable evidence includes detailed payroll records, employee time logs, project calendars, performance evaluations, and technical records detailing involvement in design reviews or experimental setup.6 The documentation must withstand scrutiny proving the activity contributed to eliminating technical uncertainty—the hallmark of qualified research.17

B. Procedural Risk and the Need for Upfront Specificity

Recent court decisions, such as Harper and Premier Tech, Inc., have focused attention not merely on the technical merits of the underlying research but on procedural compliance. These cases emphasize the risk of IRS procedural objections if initial refund claims lack the specificity required under Regulation $\S$301.6402-2(b)(1). This regulation requires the claim to set forth “in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof”.8

I2D costs, particularly executive and supervisory wages, often rely on complex time allocation methodologies. These allocations are prime targets for procedural attack if the initial filing is vague or incomplete.8 Therefore, a taxpayer must proactively document the specific methodology used to calculate the 80% qualified services threshold for each employee claimed, detailing which portion of their time constituted Direct Supervision or Direct Support, effectively addressing this procedural hurdle upfront.

C. Allocation Methodologies for Incidental Costs

While directed primarily at $\S$174 capitalization, IRS Notice 2023-63 provides helpful clarification on acceptable “reasonable and consistent” methodologies for allocating incidental costs. Although many incidental costs are excluded from the $\S$41 QRE calculation, the guidance provides a framework for justifying the attribution of shared administrative and operational labor that does meet the I2D definition.

Acceptable allocation methods that can be used to substantiate I2D claims include: specific identification of costs; using qualified wages as a percentage of total wages; or using R&D headcount or R&D square footage as a percentage of total headcount or total square footage.4 Employing these consistent methodologies is crucial for demonstrating that the inclusion of I2D labor expenses is systematic and provides a stronger defense against challenges regarding the inclusion of inherently shared or indirect costs.

VI. Strategic Recommendations: Clarifying and Explaining I2D More Fully

To fully clarify and defend the use of Incident to Development provisions, corporate tax departments must shift from reactive documentation to proactive compliance focused on procedural certainty. The strategic next steps involve three concurrent efforts:

A. Internal Policy Formalization and Compliance Manuals

The first step is to develop a formal, detailed internal policy that rigidly defines “Direct Supervision” and “Direct Support” within the context of the company’s specific R&D processes. This policy must explicitly map these I2D activities to the elements of the Four-Part Test—specifically how supervisory review or support staff activities contribute to the elimination of technical uncertainty.8 This formalized approach ensures consistency across departments and tax years, instructing personnel on the explicit boundaries between claimable I2D time and non-qualified General & Administrative (G&A) time.

B. Implementing Granular Time-Tracking for I2D Wages

It is essential to mandate an electronic time-tracking system that requires supervisory and support personnel to categorize their time not just generally as “R&D,” but specifically and discretely as (i) Engaging in Qualified Research, (ii) Direct Supervision (I2D), (iii) Direct Support (I2D), and (iv) Non-Qualified/G&A.6 This segregation of duties and activities generates the contemporaneous evidence necessary to satisfy the 80% substantially all requirement and provides undeniable proof against IRS requests during an audit.8 Relying solely on approximations or retroactive studies is insufficient given current scrutiny.

C. Proactive Technical and Financial Documentation Nexus

To mitigate the procedural risks established by recent case law (e.g., Harper), taxpayers must proactively prepare a comprehensive technical memorandum with the initial Form 6765 filing. This document must detail the computational methodology for allocating I2D wages and articulate the specific facts sufficient to apprise the Commissioner of the exact basis for the claim.8 This proactive substantiation should include calculations showing how high-value supervisory wages met the 80% threshold through I2D activities, preempting procedural objections and shifting the audit focus back to the technical merits of the research.

VII. Synthesis of I2D Scope and Limitations

The utilization of Incident to Development is crucial for achieving an optimal QRE base, but success hinges on adhering to strict regulatory boundaries that sharply distinguish $\S$41 credit eligibility from the broader $\S$174 expenditure definition.

Incident to Development Scope Comparison (IRC §174 vs. IRC §41)

The analysis confirms that while $\S$174 permits the capitalization of a wide range of incidental costs (overhead, depreciation, patent fees), $\S$41 limits QREs primarily to wages and supplies that are directly connected or incidental to the development efforts. Therefore, the strategic value of I2D rests almost entirely on its ability to pull highly compensated supervisory and support wages fully into the QRE calculation through the use of the 80% “substantially all” rule for qualified services. Taxpayers must navigate this regulatory complexity by ensuring that their documentation systems rigorously distinguish and substantiate the direct nexus of these incidental services to the qualified research activity to maintain compliance.

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