Research and Development Credit

By: William J. Harmatuk, CPA (Sep, 2010)

As December 31, 2010 comes and goes so will many of the tax benefits of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). In addition, the Research and Development Tax Credit expired as of December 31, 2009, unless Congress extends the credit once again. The credit was introduced in 1981 and has been renewed on a temporary basis ever since. In September of 2010, the White House proposed making the research and development credit permanent and possibly expanding the credit. With new legislation, there would be no need to extend the credit as we have seen over the years.

Under the rules that expired December 31, 2009, research expenses would include related wages, supplies used to conduct qualified research and contract research expenses (limited to 65% of amounts paid to non-employees and 75% if payments are paid to a qualified research consortium). To qualify, research and development must have met the following tests:

  1. Qualify as expenses under Internal Revenue Code Section 174.
  2. The research must be for discovering information that is technological in nature.
  3. The research must include elements of a process of experimentation that relates to new or improved functions, performances, reliability or quality.
  4. The research must be useful to the taxpayer in the development of a new or improved business component.

The research credit was not allowed for the following:

Surveys or studies.

  1. Research funded by another person or governmental entity.
  2. Research taken place after commercial production commences.
  3. Research that adapts to an existing process or product for a particular customer.
  4. Research that is a duplication of a product or process that currently exists.
  5. Research that is specific to certain internal-use computer software.
  6. Research within the social sciences, humanities or arts.
  7. Research conducted outside the United States, Puerto Rico, or a United States possession.

If the research and development credit is extended under the guidelines in place at December 31, 2009, a business would receive a tax credit of 20% of the qualified research expenditures (QREs) that exceed their “base amount” for the year plus 20% of the basic research payments and payments to an energy research consortium. The “base amount” equals the average annual gross receipts of the four tax years preceding the tax year which the credit is being determined multiplied by the “fixed base percentage” for the taxpayer. The fixed base percentage calculation varies depending on whether you are an existing company or a start-up company.

For an existing company, the fixed base percentage is determined by dividing the aggregate qualified research expenses for all tax years that begin after 1983 and before 1989 by the aggregate gross receipts for the same years.

A start-up company is one that has both gross receipts and qualified research expenses in either, a) the first time in a tax year beginning after 1983 or b) fewer than three tax years beginning before 1989 and after 1983. The fixed base percentage for a start-up company is 3% of the qualified research expenses for the first five tax years that begin after 1993. Beginning in the sixth year the formula changes annually for five years and in the eleventh and later years beginning after 1993 the percentage is determined by taking the aggregate qualified research expenses for the tax years beginning after 1983 and before 1989 by the aggregate of gross receipts for the same years.

In addition to the above approach, the taxpayer can also elect to use the alternative simplified credit that provides a tax credit of 14%. Once elected, the alternative simplified credit will always apply unless revoked. Both calculations should be calculated to determine the maximum credit allowed. 

New legislation signed into law September 27, 2010 allows a five-year carry back for non-publicly traded entities with gross receipts less than $50 million for the last three years. Another important change is the end of the individual Alternative Minimum Tax limitation of the general business credit for the 2010 tax year for those qualifying. Any unused credits are carried forward 20 years. Any credits that remain unused after the 20 year period are taken as a deduction in the first year following the expiration year.

We realize that this can be quite overwhelming so we suggest you consult your Dermody, Burke and Brown advisor if the credit applies to your business.

 

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.

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