Does this regulation disqualify your R&D Credit?

We work with some excellent CPAs. In fact, one of the first things we do is reach out to your CPA to resolve any questions early on and strategize to see whether the R&D tax credit is a good fit for you. We recently received a question from one of these great CPAs as to whether the doctor in question was just adapting his procedure for a single patient.


The answer (in detail below) is no. Healthcare providers almost always systematize what they do - either formally or informally. This article describes how this process lends itself to R&D.


Summary. The exclusion for adaptation refers to the process of modifying the business component for a particular customer. Qualifying healthcare research activities describe a care technique that is applied broadly to a qualifying subset of patients in the practice. These care techniques result from a process of hypothesis development as to how a new alternative might be used, testing that hypothesis in a scientific manner by delivering care in a clinical setting, analyzing the results, and then either refining the hypothesis or discarding it and develop a new hypothesis and repeating the previous steps. Healthcare is incredibly complex. Most successful healthcare providers create a checklist or procedural guide in their practices. These checklists or clinical guides are not invented from thin air - they are the result of dedicated efforts, requiring education, experience, training, evaluation of outcomes, and iterative changes. The medical community has recognized the value of these types of efforts (see The Checklist Manifesto, Atul Gawande, MD). When we work with doctors, we typically identify techniques. Techniques are "the body of specialized procedures and methods used in any specific field, especially in an area of applied science." These are repeatable processes, applied broadly in the practice - often resulting in formal or informal checklists or practice guidelines. There are thousands of examples. Depending on the doctor, a few examples could include preparing and delivering a dental crown, certain treatments for arthritis, and laser or superficial radiation therapies in dermatology offices. We are not identifying how a physician or dentist treats a single patient, rather, the diagnostic processes and delivery of care protocols that the doctor employs to identify good care candidates and generally ensure that a reproducible standard of care is obtained. We look for techniques that demonstrate innovation - in other words, the doctor has actively modified the procedure and is monitoring outcomes - changing the procedure if the outcomes are not equal to expectations. The Audit Techniques Guide: Credit for Increasing Research Activities (https://www.irs.gov/businesses/audit-techniques-guide-credit-for-increasing-research-activities-i-e-research-tax-credit-irc-41-qualified-research-activities) discusses adaptation as follows (emphasis added):

(The) exclusion (for adaptation) applies if the taxpayer's activities relate to adapting an existing business component to a particular customer's requirement or need. This exclusion does not apply merely because a business component is intended for a specific customer. A contractor’s adaptation of an existing business component to a taxpayer’s particular requirement or need is not qualified research.

The audit guide refers the investigator to IRC Section 1.41 4(c)(10), Examples 3 and 7 (https://www.law.cornell.edu/cfr/text/26/1.41-4#). In summary, Example 3 talks about a successful R&D project. The company in the example is a food manufacturer. They change a component in their manufacturing line to modify the end product (from large-shred to fine-shred). The company is not sure the project will work out, they bring in a new piece of equipment, and they try it out to see if it works. The manufacturer analyzes the outcomes to choose the best functional process. Healthcare application: Let's say we have a plastic surgeon performing liposuction. The surgeon has been performing traditional liposuction for years, but now he has learned about high-definition liposuction to make those abs pop. There are at least four different techniques for high-definition liposuction and a number of equipment manufacturers boasting different outcome promises. Like the manufacturer, the physician is modifying their business component by changing a major component. The physician adds equipment, changes surgical techniques, and modifies the post-operative protocol. The physician, like the manufacturer, analyzes outcomes. He does so in 2-month, 6-month, and 1-year postoperative evaluations. Example 7 is an unsuccessful R&D project. This example discusses a software company that modifies a website in a certain way without evaluating or testing alternatives. The explanation indicates that the activity failed because the company "did not conduct a process of evaluating different ... alternatives in order to eliminate uncertainty regarding the development of software." Court precedent has clarified the following: Treasury Regulations section 1.41-4(a)(5) states that a process of experimentation is one designed to evaluate one or more alternatives to achieve a result that is uncertain at the beginning of the research activities. Evaluating one alternative is sufficient - which makes this example somewhat questionable. (See the legislative history concerning this issue at H. Conf. Rept. 99-841 (Vol. II), supra at II-72, 1986-3 C.B. (Vol. 4) at 72. "This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.") Healthcare application: With our plastic surgeon, the doctor attended CE, spoke with learned colleagues, and evaluated different surgical techniques and/or equipment. There is no absolute standard of care or federal dictate on how the procedure needs to be performed - meaning that the doctor was choosing between alternatives that all claimed to provide positive outcomes, but there was no guide for the physician's practice or business. Not only did the physician have to evaluate procedural techniques, but he also had to evaluate care delivery workflows based on his office, staff, and practices. In fact, the same legislative history cited earlier and in the landmark Union Carbide Corp. and Subsidiaries v. Comm’r, (2009) TC Memo 2009-50 gives the following example (emphasis added): "(C)osts of experiments undertaken by...physicians in developing and testing a new drug are eligible for the credit because the researchers are engaged in scientific experimentation."

Conclusion. Appropriately identified clinical techniques satisfy the larger requirements of the Section 41 regulations. Specifically to the question of adaptation:

  1. There is uncertainty as to whether the technique will be successful. Uncertainty is a requirement of Section 41 and, specifically, the exclusion for adaptation. The various care protocols in existence, conflicting research literature, and absence of industry-wide guidelines leave the physician to develop their own protocol for the care technique.

  2. The care techniques discussed are not developed for a particular customer's (patient's) requirements. The doctor performs these techniques regularly in their practice. They have developed protocols to describe the delivery of this care in general.

  3. One or more alternatives are evaluated. The doctor has considered other protocols/equipment. One other protocol is enough - and it could be the one that the doctor is in the process of developing through this research activity.


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