Editors: Mindy Tyson Cozewith, CPA, M.Tax., and Sean Fox, MPA
Credits Against Tax
Since its enactment in 1981, the credit for increasing research activities (R&D credit) contained in Sec. 41 has provided an incentive for U.S. companies to conduct domestic research to develop and introduce new and improved products. The R&D credit has served as a business stimulus by retaining and creating U.S. jobs, generating intellectual property, introducing new products in the United States, and increasing the efficiency and competitiveness of U.S. companies in the world marketplace. (When this item was written, the Sec. 41 R&D credit had expired at the end of 2011, and no action had been taken to extend it; however, Congress has often retroactively reinstated the credit.)
Sec. 41(a)(1) provides an incremental tax credit for increasing research activities equal to 20% of a taxpayer’s qualified research expenses (QREs) for a given tax year above a base amount, which generally requires a taxpayer to have gross receipts in one of its tax years before the credit can be claimed. Because of the complexity of the rules for calculating the credit, Congress added the alternative simplified credit (ASC) as part of the Tax Relief and Health Care Act of 2006, P.L. 109-432. Under Sec. 41(c)(5), a taxpayer may elect to take an ASC equal to 14% of the excess of QREs for the tax year over 50% of the average QREs for the three preceding tax years. If a taxpayer has no QREs in any one of the three preceding tax years, the ASC equals 6% of the QREs for the tax year for which the credit is being determined.
Prior to the ASC, it was generally assumed that start-up companies that had yet to sell any of the products they were developing could not claim the R&D credit because they did not have any gross receipts and therefore could not compute an appropriate base amount as required under Secs. 41(c)(1) and 41(c)(3)(B). The ASC provides a welcome mechanism for claiming the credit under these circumstances. However, the ASC must be claimed on an originally filed return, meaning that, if a credit was not claimed on a prior open tax year return, a taxpayer cannot amend those returns to claim the credit.
The market-based economy in the United States has been built by people who set out to put their ideas into practice and develop products well before a market existed for those products. These types of entrepreneurial activities carry tremendous risks. An example today would be a technology or software company seeking to develop the next best software platform or an experimental drug maker developing a new drug. The ability to amend returns and claim the R&D credit in open years would provide a nice payback for these types of risk takers. While the company likely would not recognize an immediate benefit from the credit since it does not have any sales or profits, the credits generated may be carried forward 20 years.
A taxpayer’s gross receipts only matter in determining the appropriate base amount under Sec. 41(c). Once the base amount is calculated, gross receipts no longer factor into the credit calculation. Additionally, a company in its first year of operations that has QREs does not need to have gross receipts to calculate the R&D credit. The credit equals 20% of the excess (if any) of the QREs for the tax year over the base amount under Sec. 41(a). The base amount is the product of the fixed-base percentage and the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being determined. However, the base amount can never be less than 50% of the QREs for the credit year.
The fixed-base percentage is computed as the aggregate QREs for tax years beginning after December 31, 1983, and before January 1, 1989 (i.e., the base period), divided by the aggregate gross receipts for the same period.
As defined under Sec. 41(c)(3)(B), a start-up company is any company whose first tax year with both gross receipts and QREs begins after December 31, 1983, or any company that has fewer than three tax years between December 31, 1983, and January 1, 1989, with both gross receipts and QREs. For the first five tax years beginning after December 31, 1993, for which the start-up company has QREs, the fixed-base percentage equals 3%.
The fixed-base percentage in subsequent years is based on a moving average formula, starting in year 6, where it is one-sixth of the aggregate QREs divided by aggregate gross receipts for years 4 and 5. The fraction and the number of preceding base years increase incrementally until the fixed-base percentage in year 11 and thereafter is 100% of the QREs divided by gross receipts for any five years among the fifth through 10th years.
Lack of Gross Receipts
There has been much ambiguity as to whether the start-up company rules preclude a taxpayer from calculating or claiming the R&D credit when the taxpayer lacks gross receipts for its first year of operations or any open return year. Though nothing in the IRC specifically requires a start-up company to have gross receipts to claim the R&D credit or be considered a start-up company, the rules in Sec. 41(c)(3)(B) appear to imply that a company must have both gross receipts and QREs to qualify as a start-up company.
Regs. Sec. 1.41-3(a) provides additional conventions for new taxpayers. In the case of a taxpayer that has not been in existence for the prior four years, the average annual gross receipts are calculated based on the number of tax years the taxpayer has been in existence prior to the credit year. This also supports the position that lack of gross receipts does not preclude taxpayers from claiming the R&D credit because there is no mention that a tax year with zero gross receipts should be excluded. On the contrary, it adjusts the calculation simply based on the “existence” of the taxpayer.
The wording in Sec. 41(a) for the basic calculation does not explicitly mention gross receipts. Instead, only QREs and the base amount are part of the overall calculation. Because QREs by definition do not include the taxpayer’s gross receipts, gross receipts or a lack of gross receipts in a particular tax year can only affect the base amount. The base amount is the product of the fixed-base percentage and the average annual gross receipts of the taxpayer for the preceding four tax years. The fixed-base percentage for the first five tax years is 3%. The base amount calculation through the fifth year of operations expressed as a mathematical formula is: Base amount = 3% × (average annual gross receipts of the preceding four tax years that the taxpayer was in existence).
If the start-up company has no gross receipts in its first year of operations, then a taxpayer can still calculate its base amount with the above formula. In addition, the taxpayer may still be required to determine its base amount using other limitations. In very strong language, Sec. 41(c)(2) states that “[i]n no event [emphasis added] shall the base amount be less than 50 percent” of the QREs for the tax year in which the credit is sought. In other words, a taxpayer’s base amount can be more than 50% of its QREs, but if the calculated base amount is anything less than 50%, the base amount is limited to 50% of the QREs. As a result, a start-up company without any gross receipts in year 1 but with QREs, will calculate the R&D credit using the formula below: R&D Credit = 20% × (QREs – 50% of the QREs) or QREs × 10%.
Theoretically, a company qualifying as a “start-up company” could calculate the R&D credit without ever having gross receipts by applying the 50% QRE rule to determine the base amount. However, a real-world company would ultimately run out of money to continue funding its QREs after several years with no gross receipts.
For years, some practitioners have incorrectly assumed that the lack of gross receipts precludes taxpayers from taking the R&D credit. It is vital that practitioners be aware of this erroneous assumption and its potential implications on current and future tax positions. Specifically, practitioners should take a close look at situations in which they may have forgone the R&D credit because the taxpayer had no gross receipts to ensure that the taxpayer has obtained the maximum allowable credits available to it under Sec. 41.
Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.
For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.