The 280C Election

Overview:

The 280C election is essentially the government’s mechanism to prevent double dipping of Sec. 174/41 expenditures.  IRC Section 174 requires taxpayers to reduce their deductible research and development expenses by the amount of any research tax credit computed under IRC Section 41. Capitalized research expenses must also be reduced by the tax credit computed for the taxable year. An annual irrevocable election is available to taxpayers under IRC Section 280C(c)(3), enabling them to claim a reduced research credit in lieu of any reduction to the IRC Section 174 expense deductions.  This election allows for the CPA to circumvent the add back requirement. This election is made on a timely filed (including extensions) original income tax return (federal Form 6765). The Section 280C election cannot be made on an amended tax return. Also, once made, the election can only be revoked by approval of the IRS Commissioner. For tax years prior to 2018, the election reduces the maximum applicable credit rate by 35%.

The TCJA, which goes into effect for tax year 2018, eliminates the progressive corporate tax rate structure, reducing the maximum corporate tax rate from 35 to 21 percent. The lower corporate rate indirectly increases the net research credit benefit upon applying section 280C as the reduction is reduced from 35% to 21% as illustrated in the table below. 

Gross vs. Reduced credit: Which is most beneficial?

For corporate taxpayers in tax years prior to 2018, foregoing the 280C election could have potentially been more beneficial assuming the taxpayer’s marginal tax bracket was less than the maximum 35% rate.  By foregoing the reduction of the credit, the taxpayer would realize a benefit due to the spread between the 35% credit reduction rate and the taxpayer’s marginal tax rate. However, with the reduction of the maximum corporate tax rate to 21% for 2018 and with the elimination of corporate AMT, the net Federal tax due after applying the R&D credit will be the same regardless of whether the 280C election is made.  Thus, the primary reason a corporate taxpayer may want to make the 280C election is for state tax purposes. As federal taxable income is the starting point for calculating state taxable income in most cases, by making the Sec. 280C reduced credit election a taxpayer generally reduces its state taxable income by the amount of the credit.

For individual owners of pass-through businesses with R&D credits, electing the reduced credit under 280C will generally be most beneficial. Since the top marginal tax bracket for 2018 is 37%, and the reduction percentage under 280C is 21%, individual taxpayers will recognize a tax benefit based on this rate spread as illustrated in the example below.  This example assumes an R&D tax credit of $100,000. This example does not include the potential 199A deduction. Note that if a taxpayer’s 199A deduction is limited or excluded, the benefit associated with the 280C election increases.