If you are a taxpayer planning on claiming the Research and Development (R&D) Tax Credit, you need to decide how to calculate the credit and which method is the best for your business. This is a critical step in preparing your tax return as the credit can be highly lucrative for a taxpayer facing a significant tax liability for the filing year.
Even more importantly, making an informed decision on the calculation method must be done before filing your IRS Form 6765. Once you file using your selected calculation approach, that choice can not be changed with an amended return after filing.
Calculation Methods
When a taxpayer elects to claim the R&D Tax Credit, the decision over calculation methodology needs to be addressed. There are two options to consider - the Regular Credit (RC) and the Alternative Simplified Credit (ASC).
Regular Credit (RC)
Choosing the regular credit calculation method offers a credit of 20% of the Qualified Research Expenses (QRE) over the base amount. To determine the base amount, a company must apply the historical percentage of QREs to an average of four years of annual gross R&D expense receipts prior to the filing year. For corporations that were conducting operations during the 1980s or earlier, additional information must be submitted.
Alternative Simplified Credit (ASC)
The most significant difference from the RC calculation method is the use of Qualified Research Expenses over a previous three-year record instead of the previous four-year average of gross R&D receipts. This would make the ASC method an appropriate choice for corporations that have insufficient historical percentage information to calculate the base amount in order to ascertain whether or not they qualify to claim the credit and submit their return.
Which Method is Best?
The choice of two methodologies gives companies the ability to cherry-pick the calculation that offers the greatest financial benefit. This decision can be made on a year-to-year basis, therefore, a business might choose to elect the ASC method one year and the RC method the next, whichever calculation works best for that filing year. But choosing the correct method takes some careful consideration. For instance, the ASC may offer a simplified methodology for calculating the credit, but it may not always offer the highest yield. In fact, companies with higher base amounts or incomplete information for the base period may find greater advantages than with the RC method. As for the RC method, this option will typically benefit new startups or companies with minimum base amounts.
Calculating the Credit using Alternative Simplified Credit (ASC) Method:
The Alternative Simplified Credit equals 14% of a company's QREs that were spent over the current filing year over 50% of the average Qualifying Research Expenses over the previous three-year period. In the event the company has no QREs for that period, the credit switches to a calculation of 6% of the Qualifying Research Expenses over the current filing year.
The calculation of the ASC is a four-step process in the following order:
- Compute the average QREs for the previous three tax years period
- Multiply the average QREs amount by 50%
- Subtract 50% of the three-year average from the claim year’s QRE amount
- Take the result and multiply that by 14%
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280C Election
Sec. 280C was enacted to prevent taxpayers from receiving a double-benefit from both a tax credit and a tax deduction for the same expenditures. Section 280C provides taxpayers with a reduced credit in lieu of reducing the deductions.
When the 280C is not elected, taxpayers must reduce 174 deductions by the amount of the credit claimed for the tax period. Alternatively, when making the 280C election, the credit amount is reduced by 21%, and no 174 deduction adjustment is needed.
The 280C election is made annually on Form 6765 and cannot be changed on an amended return. However, this election can be made on an amended return if a blank Form 6765 was filed in the original timely filed return (including extensions) and clearly indicated the taxpayer’s intent to make the Section 280C election in the future – also known as a “protective” election.
Defining Qualifying Research Expenses (QREs)
Employee wages and contract expenses may be eligible for the R&D tax credit if the labor is performed in the United States. Supplies, defined as tangible raw materials used in the R&D process that were not capitalized or depreciated, may qualify, as well.
General and administrative costs, on the other hand, typically are not eligible. This is true for activities that were wholly or partially conducted in support of qualified research.
Employee Wages:
For wages to qualify for the R&D tax credit, employees must perform qualified research activities, such as:
- Conducting or executing the qualified research (e.g., testing a manufacturing prototype)
- Directly supervising the qualified research (e.g., managing a team of software developers)
- Directly supporting qualified research (e.g., organizing test results on formulation trials)
Wages have the biggest effect on how much or how little credit a company can generate. In most cases, wages are the most significant single qualified expense category for most taxpayers. In order to determine how much of your total wage pool would qualify for the credit, you need several things:
- Employee Name
- Job Title
- State
- W2 Box 1 Wage
- Qualified Percentage of Time.
Consumed Supply Expenses:
Qualified supply expenses are defined as tangible properties directly used in research activities that were not capitalized or depreciated. For example, raw materials used to fabricate and test prototypes would be eligible, but the research facility itself, depreciable equipment or general office materials would not.
Subcontract Expenses:
Much like qualified wage expenses, qualified contract research expenses include time spent conducting or executing qualified research. The difference, however, is that these activities are performed by a third party, not the business entity itself.
According to IRS guidelines for contract research, businesses must maintain substantial rights to the research performed by the contractor and bear the economic risk of the contractor’s development.
Common Challenges When Claiming R&D Tax Credits
Although claiming this credit can offer considerable benefits for companies engaged in R&D efforts, the process can be challenging.
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What Happens to Unused R&D Tax Credits?
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