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Stephen Ehrenberg
Stephen Ehrenberg

Expanded R&D tax credit option

A new option gives taxpayers a second chance to take advantage of the R&D credit.

June 26, 2014
by Stephen J. Ehrenberg, CPA

Since its enactment as part of the Economic Recovery Tax Act of 1981 (ERTA), P.L 97-34, the federal research and development (R&D) tax credit has been available to taxpayers incurring qualifying research expenses (QREs) in the United States.

However, the federal R&D tax credit is still not a permanent part of the tax law and must be extended each year by Congress; it was last extended through Dec. 31, 2013. While taxpayers eagerly hope for another extension (or the less likely enactment of a permanent credit), the IRS issued new regulations in T.D. 9666, which will generally allow taxpayers to elect to use the alternative simplified credit (ASC) rules to calculate an R&D credit on an amended return. This expansion of the time in which the ASC election can be made will make it possible for more taxpayers to elect to use the simpler ASC rules.

How it works

Under Regs. Sec. 1.41-4, to qualify as research expenses, the expenses must pass all four of the following tests:

  • Technical uncertainty test: The process must be intended to discover information that would eliminate uncertainty surrounding the development or improvement of a product;
  • Technological in nature test: The activity is undertaken to develop information that is technological in nature, which requires the process of experimentation used in the research to rely primarily on principles of physical or biological sciences, computer sciences, or engineering;
  • New or improved business component test: The resulting technological information is intended for use in the development of a business component to be used in the taxpayer’s business for sale or license to customers; and
  • Process of experimentation test: The activities must substantially involve an experimentation process.

Even taxpayers that meet this rigorous four-part test may still not qualify for the credit. Other requirements involve the timing and purpose of the QREs, which necessitates a complex analysis before taxpayers can be sure they qualify for this tax benefit.

R&D tax credit calculation alternatives

Once the annual expenses meet the definition of QREs, Sec. 41(c) permits taxpayers to choose one of three methods to calculate the credit:

  • Traditional credit;
  • Startup credit; or
  • ASC.

Each method requires eligible QREs to exceed the base period amount in order to qualify for the R&D tax credit. In particular, the traditional and startup base period calculations often require taxpayers to review and analyze documentation and records as far back as the early-to-late 1980s.

ASC benefit

To ease some of these recordkeeping and documentation requirements, the IRS provides an alternate means to determine the R&D tax credit. Under Regs. Sec. 1.41-9(b), for tax years ending after Dec. 31, 2006, taxpayers may elect the ASC, which reduces or eliminates the need to maintain records for tax years that have long since closed under the statute of limitation.

Whereas the traditional and startup credits require taxpayers to maintain long-term historical records, the ASC requires only that QREs exceed “50 percent of the average qualified research expenses for the 3 taxable years preceding the taxable year for which the credit is being determined” (Sec. 41(c)(5)(A)). For instance, if a taxpayer elects the ASC for the 2013 tax year, QREs must exceed the base period amount from the 2010–2012 tax years.

Expanded ASC eligibility

While the ASC alleviated some of the recordkeeping burden, Regs. Sec. 1.41-9(b)(2) limited the numbers of taxpayers that were eligible to make the ASC election by requiring it to be made on an originally filed return and prohibiting it to be elected on an amended return. Furthermore, relief for a late election was not available to taxpayers under Regs. Sec. 301.9100-3.

In response to taxpayer feedback, the IRS issued regulations, effective June 3, 2014, that remove this restriction on making the election on original returns. As a result, eligible taxpayers that incur QREs now will be permitted to amend returns to elect the ASC by completing the applicable section of Form 6765, Credit for Increasing Research Activities. However, there are restrictions to amending open returns to elect the ASC, including that a taxpayer cannot make the election on an amended return if the taxpayer elected the traditional or startup method in an originally filed return.

Taxpayer action

While businesses wait to see if Congress will extend the federal R&D credit beyond Dec. 31, 2013, taxpayers have an opportunity to claim the R&D credit by electing the ASC for open years on amended returns. Careful analysis should be done before making this election because this new opportunity to benefit from the credit still requires taxpayers to meet the R&D credit documentation and substantiation requirements.

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Stephen J. Ehrenberg, CPA, MBT, is a tax principal in the Los Angeles office of Holthouse Carlin & Van Trigt LLP.