Should a Taxpayer Elect the Alternative Incremental Research Credit?

Sometimes, a taxpayer is clearly performing qualified re-search, but has never claimed the Sec. 41 research credit (which terminates on Dec. 31, 2005, under Sec. 41(h)). Perhaps the taxpayers trade or business started before 1984 and its research activity records for the base period of 19841988 (see Sec. 41(e) (7)(B)) are almost nonexistent. The information might be sketchy and based solely on recollectioni.e., estimations of the number of engineers who worked at that time and their salaries, and partially recalled qualified research activities and the time spent on them. Can anything be done? Can a taxpayer claim a tax benefit based on estimates?

AIRC

Sec. 41(c)(4), the election to use the alternative incremental research credit (AIRC), is a possible solution. By making an AIRC election, a taxpayer does not need to estimate activities that transpired 20 years ago; instead, it uses expenses above certain averages. At first blush, this solution appeals to many tax advisers, who are more comfortable with hard data than with estimates. However, the AIRC election should be closely considered, because AIRCs are likely to be much smaller than if actual documentation were available. If AIRCs are compared to credits from the estimated base period, the taxpayer will probably find that the latter approach produces a greater result. Further, because under Sec. 41(c)(4)(B), the AIRC election may be revoked only with IRS approval, the taxpayer is setting a precedent for reduced credits for future years.

Tax advisers familiar with the research credit generally agree that the AIRC is not as lucrative as it first seems: over the past few years, the IRS has frequently granted permission to revoke the AIRC election, which seems to be a popular letter ruling request; see, e.g., IRS Letter Rulings 200537011 (9/16/05), 200442026 (10/15/04), 200327005 (7/3/03) and 200250026 (12/12/02).

Is the Risk of Estimating Credits Acceptable?

If a taxpayer wants larger credits, it will have to settle for an estimated base period. How risky is this approach? In Cohan, 39 F2d 540 (2d Cir. 1930), the Second Circuit allowed a deduction that, in essence, amounted to a well-reasoned estimate. According to the court, [i]t is not fatal that the result will inevitably be speculative; many important decisions must be such.

Generally, estimates have to be well-reasoned and based on all available information. Thus, there has to be a thorough investigation of the research conducted during the base period, including discussions with everyone involved at that time, and a thorough inspection of all historical documents, to piece together the best picture of the fixed-base percentage. As a reasonableness check, the factors that affected the business during the base period need to be examined, to ensure that they support the estimates. Such an investigation should include asking the taxpayer whether the figure feels right. Importantly, under Sec. 41(c)(5), there must be consistent treatment, requiring, under Sec. 41(f)(3), inclusion or exclusion of any trades or businesses acquired or disposed of during the intervening period.

If all these procedures are followed and documented, it will be difficult for the IRS to challenge the fixed-base percentage, because there will be no conflicting evidence available. The Services time will be better spent challenging current-year qualifying expenses, rather than attempting to second guess base-period assumptions. Experience has shown that the IRS devotes very little time to challenging fixed-base percentages.

Does the AIRC Have Any Value?

There will be times when the AIRC should be used, however. For example, if a taxpayer is a new owner of a business and tracking down former employees is impossible, there would be no one from the base period to verify research activities and, most likely, information would be insufficient for making a reasonable estimate. However, this should be the exception rather than the rule. Thus, if the taxpayer can, it should avoid the AIRC election, and take comfort in Cohan and a base-period estimate.

From Randy Zamarra, CPA, Daoro Zydel & Holland, San Francisco, CA