Overview of the mechanics of the credits
The Federal R&D Tax Credit allows for two different calculation methods based on the taxpayer's date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation. The two methods are (1) The Regular Research Credit (“RRC”) Calculation and (2) the Alternative Simplified Credit (“ASC”). The RRC calculation provides a credit of up to 20% of the taxpayer’s qualified research expenditures that exceed a calculated base amount. The ASC is based on 14% of the amount in excess of the base for the current taxable year.
A taxpayer can calculate the credit under both methods to determine which provides the maximum credit. Though the ASC election applies to the current tax year and all later years, the election may be revoked for a later year by calculating and filing the RRC on Form 6765.
RRC Method Defined: The RRC allows for a 20% R&D tax credit applied to the excess of current year QRE over the base amount. The base amount is determined by multiplying a fixed-base percentage by the average annual gross receipts of the taxpayer for the four taxable years preceding the tax year for which the credit is being calculated. Generally, gross receipts are defined as gross receipts less returns and allowances (i.e. line 1c on Forms 1120, 1120-S, and 1065).
The calculation of the fixed base percentage depends on whether the taxpayer is an existing company or a start-up company. A start-up company is defined as a taxpayer that had both gross receipts and qualified research expenses for the first time in a tax year beginning after 1983, or for fewer than three tax years beginning after 1983 and before 1989.
The fixed-base percentage for a start-up company is calculated as follows:
- For the first 5 tax years beginning after 1993 for which you have qualified research expenses, the percentage is 3%.
- For the 6th tax year beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for the 4th and 5th such tax years by the aggregate gross receipts for those tax years, then divide the result by 6.
- For the 7th tax year beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for the 5th and 6th such tax years by the aggregate gross receipts for those tax years, then divide the result by 3.
- For the 8th tax year beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for the 5th, 6th, and 7th such tax years by the aggregate gross receipts for those tax years, then divide the result by 2.
- For the 9th tax year beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for the 5th, 6th, 7th, and 8th such tax years by the aggregate gross receipts for those tax years, then divide the result by 1.5.
- For the 10th tax year beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for the 5th through 9th such tax years by the aggregate gross receipts for those tax years, then divide the result by 1.2.
- For the 11th and later tax years beginning after 1993 for which you have qualified research expenses, divide the aggregate qualified research expenses for any 5 of the 5th through 10th such tax years by the aggregate gross receipts for those tax years.
The fixed-base percentage for an existing company (any company that isn’t a start-up company) is figured by dividing the aggregate qualified research expenses for the tax years beginning after 1983 and before 1989 by the aggregate gross receipts for those tax years. The fixed-base percentage for all companies (existing and start-up) must be rounded to the nearest 1/100th of 1% (that is, four decimal places) and can’t exceed 16%.
In computing the fixed-base percentage, taxpayers are required to account for prior year QRE in a manner consistent with the accounting for the credit year. This applies even if a research credit was not claimed for the prior years. For example, a qualifying supply expense included in QRE for the current year will also need to be included in base period QRE to the extent that the supply was used in a similar qualifying manner. Without the consistency requirement, the fixed-base percentage could potentially be distorted.
Similarly, acquisitions and dispositions must be accounted for in calculating base period QRE and gross receipts. If a taxpayer acquires the major portion of either a trade or business or a separate unit of a trade or business of another person, then the taxpayer’s base period QRE is increased by the amount of QRE incurred or paid by the acquired business. Also, the gross receipts of the taxpayer are increased by the amount of gross receipts of the acquired business. Similarly, if the taxpayer disposes of the major portion of a trade or business and furnishes information to the acquirer, the taxpayer may decrease its base period QRE and gross receipts by the amount attributable to the disposed portion.
ASC Method Defined: The ASC method’s credit calculation is slightly less complicated than the RRC method. Under the ASC method, the R&D credit is equal to 14% of the portion of QRE that exceeds 50% of the average QRE for the prior three tax years. If the taxpayer has no QRE in any one of the prior three years, the applicable percentage is 6% instead of 14%. Once the taxpayer has three prior years of QRE, 14% may be used. As with the RRC method, a taxpayer is required to be consistent in calculating prior QRE as compared to credit year QRE.
Rules published February 27, 2014, allow companies to go back and claim R&D credits on amended returns under the alternative simplified credit (ASC) method for all open tax years. This was a game changer for company’s that previously missed out on claiming the R&D tax credit because of a lack of substantiation in the base years. The new rules ease this burden. However, they stipulate that a taxpayer may not make an ASC election for a tax year on an amended return if it already claimed a credit for that tax year using the traditional method.
For a company that has been in existence since the early 1980s, it can be challenging to calculate the fixed base percentage due to the age of the information required. Thus, the ASC may be the more appealing credit calculation method. Additionally, as previously mentioned the ASC method may produce a larger credit depending on the calculated fixed base percentage and the average annual gross receipts. It is important to evaluate the credit produced by both methods in order to maximize the benefit.
PATH Act, TCJA, and Payroll Offset & Permeance: The PATH Act permanently extended the R&D tax credit and made two very important changes effective December 31, 2015. In years past the credit was retroactively extended on a regular basis.
The legislation allows small businesses to take the R&D tax credit against their alternative minimum tax (AMT) liability for tax years beginning after December 31, 2015. The AMT restriction has long prevented qualified companies from utilizing the R&D tax credit; the legislation removed that hurdle for eligible small businesses (“ESB”). An ESB is defined as a corporation that is not publicly traded, a partnership, or a sole proprietorship with average annual gross receipts not exceeding $50 million for the three taxable years preceding the current taxable year. For a partnership or S corporation, the gross receipts test must be met both by the entity and by the partner or shareholder for the tax year.
The PATH Act also allowed for startup businesses with no federal tax liability and gross receipts of less than $5 million in the claim year to take the R&D tax credit against their FICA payroll taxes for tax years beginning after December 31, 2015, essentially making it a refundable credit capped at $250,000 for up to five years (must be on original return, extensions included).
As a result of the Tax Cuts and Jobs Act (“TCJA”) in 2018, the corporate AMT was repealed. With the repeal, non-ESB businesses that were limited by AMT can now offset regular tax with the R&D credit. However, taxpayers with an income tax liability of more than $25,000 will still be subject to the 25/25 limitation— i.e. taxpayers can offset the first $25,000 of tax, plus up to 75% of the tax in excess of $25,000—so they won’t be able to reduce their tax liability all the way down to zero. For example, a taxpayer with $100,000 of federal tax liability for the tax year can offset up to $81,250 of tax ($25,000 + (75% x ($100,000 - $25,000)).