In 1981, the Economic Recovery Tax Act established Section 41, which allows a non-refundable research and development (“R&D”) tax credit designed to benefit taxpayers incurring research activities. Expenses for salaries and wages, supplies, and contract research conducted on the taxpayer’s behalf are considered when calculating the R&D credit. Such expenditures are known as qualified research expenditures (“QRE”.) The current version of the law provides for two methods to calculate the R&D credit:
- Regular credit calculation ("Regular Method") and
- The Alternative Simplified Research Credit ("ASC").
On June 10, 2011 the IRS issued final regulations relating to the ASC. The final regulations generally adopt the proposed regulations issued in 2008, with minor revisions.
The ASC is an alternative election which may be made by filing Form 6765 with an originally filed tax return (including extensions) for the year in which the R&D credit applies. The election applies to all succeeding tax years unless revoked with the consent of the IRS. The election cannot be made or revoked on an amended tax return.
The ASC is equal to 14% of the excess of the QRE for the tax year over 50% of the average QREs for the three tax years preceding the year for which the credit is being determined. The application of ASC can also be illustrated by the following example:
A calendar year 2010 taxpayer has QRE as follows:
- 2010 - $100,000
- 2009 - $150,000
- 2008 - $100,000
- 2007 - $ 80,000
Based on this information, the average QRE for the preceding three year period is $110,000. Under the ASC, the current year credit is equal to $6,300 (14% x ($100,000 (current year QRE) -$55,000(50% of average QRE). Even though the expenses decreased from 2009 to 2010, the credit was still available for this taxpayer.
If a taxpayer had no QREs in any one of the three preceding tax years, the ASC is equal to 6% of the QRE for the current year. In the preceding example, if 2010 was the first tax year with any QRE, the credit would be equal to $6,000 (6% x $100,000).
Taxpayers with high gross receipts, reducing QREs, or those unable to substantiate the cumbersome record keeping requirements of the regular method should consider if the ASC is appropriate. For some taxpayers, one key benefit in electing the ASC is the removal of gross receipts from the equation if the gross receipts continue to reflect a rising revenue stream. The ASC also allows taxpayers to claim research credits if research costs remain the same, or even decline, when compared with prior years. Under the regular method, in general, a similar decrease in QREs can significantly limit or even eliminate the ability to claim the credit.
The regular method R&D credit rate is higher at 20%, however, due to the record keeping and income restrictions, the ASC method provides many taxpayers the opportunity to take advantage of credit benefits which did not previously exist prior to the introduction of this alternative method. A side by side comparison of the credit calculation under both methods is generally recommended, and should include an analysis of the increased compliance costs necessary to determine which method provides the greater benefit.
Further restrictions may apply should a taxpayer also consider utilizing a reduced credit. Under either method, taxpayers will be required to provide sufficient records substantiating the credit claimed.