Federal R&D Tax Credit:
"General" R&D Credit
"General" R&D Credit Computation Options
Regular ("traditional") or Alternative Simplified Credit (ASC) Method. The federal R&D tax credit is an expense-driven incremental credit derived from qualifying research expenses (QREs). However, the amount of the credit depends on several factors and is calculated using either the Regular ("traditional") method or the Alternative Simplified Credit (ASC) method.
The Regular method's incremental credit equals 20% in excess of its applicable base amount. The base amount is the product of the taxpayer’s “fixed base percentage” and the average annual taxpayer’s gross receipts for the four preceding years. The taxpayer’s fixed base percentage is based either on its ratio of research expenses to gross receipts during 1984-1988 ("historical base period") or a modified ratio for taxpayers generally not in existence during 1984-1988 to determine its fixed base percentage. The base amount also cannot be less than 50% of the taxpayer’s QRE for the current taxable year. For taxpayers using the Regular method, many are constrained by the 50% minimum base and essentially apply a flat credit rate.
For companies attempting to calculate the Regular method credit, obtaining and retaining historic information in the event of an IRS examination can be burdensome, and seemingly implausible. Moreover, for taxpayers engaged in prior or prospective corporate acquisitions and dispositions, this historic information may need to be consolidated with data from acquired businesses or segregated for a disposition. Retaining historic information may be even more challenging for businesses that form part of a controlled group (or under common control) and therefore must aggregate credit information. As such, this requirement to gather, support, and reasonably calculate current and future open year credits based on prior years, potentially historical tax returns and financial statement support (going back multiple decades) raises compliance costs and may even reduce the net benefit of the credit when attempting to claim it on the return.
However, a second method was enacted in 2006, known the Alternative Simplified Credit (ASC) method. The ASC method attempts to address some of these concerns as a secondary option. Taxpayers may instead elect the ASC method, which equals 14% of QRE that exceed a base amount (defined as 50% of the average QRE for the three preceding taxable years). Though the ASC rate may be reduced to 6% if a taxpayer has no QRE in any of the three preceding taxable years.
The three prior year moving average base to calculate the incremental ASC credit often makes it easier for taxpayers to exceed the base, and to reasonably document and support the calculation methodology, as it is calculated from more recent research expense data. Though the ASC method still may require aggregation of controlled group or common control credit information (similar to the Regular Method), the ASC method does not require gross receipts to calculate its credit, which eliminates one area of potential controversy between the IRS and taxpayers. As such, the ASC method is often a popular alternative to the Regular method.
Most corporate taxpayers use the ASC method compared to the regular method, despite the ACS’s potentially less favorable tax benefits (in terms of statutory, effective, and average credit rates). Because the compliance costs of the Regular method calculation can often be substantial, many companies use the ASC method more frequently as a simplified approach than the Regular method.
Summary Federal R&D Tax Credit Calculation:
The R&D credit is an incremental benefit that equals the applicable credit rate times the amount of qualified research expenses (QRE) above a moving base amount based on prior years. The credit is incremental as an incentive to maintain or increase a company's investment in research and development activities. Once the amount of spending on R&D begins to decline, each year's subsequent credit will also decline in correlation and may even be completely phased out. R&D credits from the current year may carryforward up to 20 years until fully utilized.
Taxpayers may choose one of two methods to calculate the credit:
(1) Regular (“traditional”) method
Credit rate is equals 20% and the base amount is the product of the taxpayer’s “fixed base percentage” and the average of the taxpayer’s gross receipts for the four preceding years.
If the taxpayer meets the criteria as a "start-up" company, the fixed base percentage is 3% for the first 5 years and is subsequently modified each year by applicable statutory ratios.
If the taxpayer does not meets the criteria as a "start-up" company, the fixed base percentage is a ratio of its research expenses to gross receipts for the 1984-1988 period subject to other statutory requirements.
The base amount cannot be less than 50% of the taxpayer’s QRE for the taxable year.
(2) Alternative Simplified Credit (ASC) method
Credit rate equals 14% of QRE that exceed a base amount defined as 50% of the average QRE for the three preceding taxable years.
ASC rate is reduced to 6% if a taxpayer has no QRE in any of the three preceding taxable years.
Federal 280C(c)(3) Election: Increased Value for Pass-Through Business Owners
When a taxpayer claims the R&D tax credit on their return, generally the credit must be add-back into taxable income through a schedule M-1 adjustment. However, IRC 280C(c)(3) also provides taxpayers with the option to instead claim a “reduced” R&D credit and forego the M-1 add-back. Although the 280C(c)(3) election reduces the R&D Credit by 21% (max corporate tax rate as of 2018), it generally proves a more beneficial return for most taxpayers. Individual taxpayers (i.e., shareholders of pass-through entities) with effective federal income tax rates more than 21% often realized a larger overall benefit through the 280C(c)(3) election. Moreover, the 280C election may also provide a greater simplification for return preparers and help avoid additional implications upon future potential tax adjustments. Note, the 280(c)(3) election at the state level varies on benefit and availability depending on applicable jurisdiction tax laws and regulations.
Because the Tax Cuts and Jobs Act (TCJA) of 2017 enacted a reduction in the corporate rates from 35% to 21%, the 280C(c)(3) reduction in credit also decreased correspondingly to 21% as noted above. Because TCJA reduction in corporate rates created a larger spread when comparing the top rate on individual income reduction (39.6% to 37%), there's now a larger 280C benefit when elected. As such, the pass-through of the credit to business shareholders will also receive a larger benefit through the 280(c)(3) election.