The Final Step in Computing the R&E Credit

The Sec. 41 research and experimentation (R&E) credit presents practitioners with numerous challenges, especially as to substantiation and base amount issues. While many articles have addressed these concerns, the final step in the computation of the research credit has received little attention. This step is set forth in Sec. 280C and is intended to eliminate the potential windfall from claiming a current Sec. 174 deduction for research expenditures and a Sec. 41 research credit for the same expenses.

While Form 6765, Credit for Increasing Research Activities, navigates the practitioner through the Sec. 280C adjustment, recent IRS pronouncements indicate that tax advisers need to pay greater attention to this somewhat obscure provision. This item examines these rules and explores some easily overlooked issues.

Sec. 280C’s Affect on the Research Credit Calculation

Under Sec. 174, taxpayers can elect to deduct all qualified R&E expenses currently or to amortize them ratably over a period of not less than 60 months. This can be done without the Service’s consent, if the expenditures are currently deducted when first incurred. In addition, taxpayers can claim a Sec. 41 credit for incremental “qualified research expenses” (QREs). For purposes of this credit, these expenses are a subset of qualifying Sec. 174 expenses. This is evident from the definition of “qualified research” in Sec. 41(d), which provides that the expenses incurred in the activity must first qualify under Sec. 174 and also pass a (1) business component test (Sec. 41(d)(1)(B)(ii)) and (2) process-of-experimentation test (Sec. 41(d)(1) (C)). Further, the activities cannot fall within the scope of eight Sec. 41(d)(4) ineligible activities. Expenses that qualify under Sec. 41 are more limited than under Sec. 174. For example, 100% of contractor fees incurred to perform research qualify under Sec. 174, but only 65% of otherwise qualifying expenses are includible under Sec. 41(b)(3)(A).

Sec. 280C(c)(1) and (2) require taxpayers to reduce R&E deductions by the Sec. 41(a) research credit, when computed at the 20% statutory rate; this is often referred to as the 280C “addback” to taxable income. Taxpayers may, however, elect under Sec. 280C(c)(3) to take the Sec. 41 credit at a 13% rate in lieu of reducing deductions and computing the credit amount at 20%. The election must be made on a timely filed Form 6765 by writing at line 16, “Sec. 280C.”

Example 1—nonelective Sec. 280C adjustment: O is a calendar-year taxpayer. In 2005, O has $19 million net taxable income, after taking a $10 million Sec. 174(a) R&E deduction, as well as a $1 million Sec. 41 credit (20% x $5 million). O must “add back” $1 million of otherwise allowable deductions, resulting in a $20 million taxable income and a $7 million putative tax liability (taxed at the maximum 35% rate). O can claim the full $1 million Sec. 41 credit, for a $6 million net tax liability. The Sec. 280C adjustment may also increase O’s state taxable income.

Example 2—elective Sec. 280C adjustment: The facts are the same as in Example 1, except that O properly and timely elects to apply the 13% reduced-rate credit. As a result, O does not have to add back any portion of the Sec. 174 deduction. O will report $19 million taxable income and have a $6.65 million putative tax liability. O will claim the $650,000 reduced credit (13% x $5 million), for a $6 million net tax liability. Note: The ultimate Federal tax liability under these facts is the same, regardless of whether the elective or nonelective Sec. 280C rate is applied.

Is It Beneficial to Elect the Reduced Rate?

As illustrated in Examples 1 and 2, the net Federal tax benefit is generally unaffected by the Sec. 280C election for taxpayers in the top corporate tax bracket. The nonelective 20% rate is more beneficial for those in lower brackets; the addback will result in a net tax benefit greater than 13%. If, however, the taxpayer is subject to the alternative minimum tax (AMT), the reduced credit is advantageous. The nonelective Sec. 280C adjustment increases AMT income and the resulting AMT tax, but the offsetting credit cannot be used until the taxpayer returns to the regular tax. The Sec. 280C(c)(3) election ameliorates this taxpayer-unfriendly result.

If the taxpayer elects the reduced-credit rate, there is no need to adjust state income to reflect the Sec. 280C adjustment. While most states require that the state return include the same adjustment to taxable income required under Sec. 280C, some states do not require a Sec. 280C addback. (States that do not adopt Sec. 280C include: Alabama, Illinois, Louisiana, North Carolina, Oregon, South Carolina, Tennessee, Utah and Virginia. Nevada, South Dakota and Wyoming have no corporate income tax. Arkansas and Washington disallow the Sec. 174 deduction. California, Massachusetts and Minnesota modify Sec. 280C. All other states adopt Sec. 280C).

For taxpayers that file numerous state tax returns, being relieved of the obligation to amend them may be the single most significant benefit of the Sec. 280C election. The problem is that only taxpayers that have elected to compute the credit at the Sec. 280C rate on a timely filed original return can take advantage of the election on an amended return to avoid the burden of multiple state filings. Whether an effective election can be made on Form 6765, reporting a zero credit, is unresolved. This type of prophylactic election may be challenged by the IRS.

The one potential advantage of the nonelective Sec. 280C adjustment is that the reduction in Sec. 174 deductions can have a positive effect on the allocation of those expenses under Regs. Sec. 1.861-17, thus increasing the taxpayer’s foreign tax credit.

Making a Valid Election

The Sec. 280C election must be made on a Form 6765 included with a timely filed, original return, including all extensions. While Sec. 280C provides that an election must be made on a timely filed return, Form 6765 and its related instructions do not so state. The instructions indicate only that an election is made by writing “Sec. 280C” next to the credit amount on line 16.

AIC

Taxpayers can elect to forgo the conventional Sec. 41 credit in favor of the Sec. 41(c)(4) alternative incremental credit (AIC). The AIC is an alternative (not supplemental) research credit calculation, founded on an increment based strictly on the average of the prior four years’ gross receipts and a small, statutorily set percentage, at three different thresholds: (1) 2.65% of the QREs between 1% and 1.5% of the average of the prior four years’ gross receipts; plus (2) 3.2% of the QREs between 1.5% and 2%; plus (3) 3.75% of the QREs above 2%.

According to Sec. 280C(c)(4)(B), the election to claim the AIC in lieu of the standard credit calculation must also be made on a timely filed, original return. Unlike Sec. 280C, however, it is binding on the taxpayer for that year and all subsequent years, until revoked by IRS consent. In being locked into this regime, taxpayers must also comply with Sec. 280C and make the same “addback” adjustment, if they do not elect to take the reduced-rate credit.

The AIC is computed under three different rates at three escalating base amount increments. The Sec. 280C(c)(3) adjustment to the rate is made by taking 65% of the total AIC credit computed at each of the three escalating levels. This election is made on a timely filed Form 6765, by annotating line 39 with the inscription “Sec. 280C.” If the 280C election is made, the taxpayer does not have to make any other addback adjustment.

Can the Election Be Revoked?

The Sec. 280C election applies only to the year covered on Form 6765. It does not carry over to the next year and must be affirmatively made annually. Once made, the election is irrevocable for that year. Accordingly, if a taxpayer amends a return to claim a larger research credit, it must compute it at the reduced rate if Sec. 280C was properly elected on a timely filed original return for that year.

IRS Guidance

The IRS’s Large and Mid-Size Business Division issued to examiners a directive on invalid Sec. 280C(c)(3) elections on amended returns/refund claims. The directive indicates that preparer penalties under Secs. 6694 and 6701 may apply to improper elections in appropriate cases. Moreover, it indicates that practitioners who make invalid Sec. 280C(c)(3) elections on amended returns or refund claims, and/or who advise taxpayers to do so, are taking positions directly contrary to both the Code and long-standing Treasury regulations; accordingly, referral of such conduct to the IRS’s Office of Professional Responsibility is warranted.

The Service also requires all amended returns claiming research credits to be filed with the Ogden, UT, Service Center, under instructions set forth in Notice 2002-44. Those instructions directed that all amended returns include a copy of the Form 6765 filed with the original return. This will enable the Service Center to determine whether the taxpayer is entitled to the Sec. 280C elective rate in computing the research credit, by determining if the Sec. 280C election was made on the original return. The fact that the IRS imposes a special requirement for amended returns to ensure compliance with Sec. 280C, reflects its deep concern over noncompliance with this provision.

From Michael Goldbas, J.D., Hartford, CT, and Greg Alan Fairbanks, J.D., LL.M., Washington, DC