Research Credit and the 1999 Act

Under Sec. 41, taxpayers can receive credit for a portion of their expenditures on certain types of qualified research. Generally, qualified research includes expenditures treated as expenses under Sec. 174. In addition to limiting expenditures eligible for the Sec. 41 credit to research or experimental expenditures eligible for treatment under Sec. 174, Sec. 41(d) contains three other requirements: (1) research must be for the purpose of discovering information technological in nature; (2) substantially all of the research activities must constitute an experimentation process; and (3) the experimentation must relate to a qualified purpose. Research for “a qualified purpose” relates to a new or improved function, performance, reliability or quality.

Qualified research expenses include qualified in-house research expenses and qualified contract research expenses that a taxpayer pays or incurs in carrying on any trade or business. In-house research expenses are (1) wages paid to (or incurred by) an employee for qualified services; (2) amounts paid or incurred for supplies used in qualified research; or (3) qualified amounts paid to (or incurred by) another person for the right to use computers in qualified research. Contract research expenses equal 65% (75%, for expenses paid to a qualified research consortium) of amounts a taxpayer pays to nonemployees for qualified research.

“Basic research” is any original investigation for the advancement of scientific knowledge not having a specific commercial objective. Such expenses include amounts a corporation pays to a qualified organization for basic research, provided (1) the payment is pursuant to a written agreement between the corporation and the qualified organization; (2) the qualified organization performs the basic research; and (3) the corporation is not an S corporation, personal holding company or service organization. A qualified organization is any qualified educational institution, qualified scientific research organization, scientific tax-exempt organization or qualified grant organization.

The Sec. 41 credit (computed on Form 6765, Credit for Increasing Research Activities) is the sum of the qualified research credit and the basic research credit. The qualified research credit equals 20% of any excess of qualified research expenses for the tax year over the base amount. The basic research credit equals 20% of any excess of basic research payments over the qualified organization base-period amount. The base amount is the fixed-base percentage (determined by dividing the taxpayer's aggregate qualified research expenses for tax years beginning after 1983 and ending before 1999, by its aggregate gross receipts for those years, not to exceed 16%), multiplied by the taxpayer's average annual gross receipts for the four tax years preceding the credit year. In no event is the base amount less than 50% of the taxpayer's qualified research expenses for the credit year. Start-up companies have special rules.

After determining the credit, under Sec. 280C(c)(1), a taxpayer must reduce its otherwise allowable deduction for qualified or basic research expenses by the credit amount. If the credit exceeds the amount allowed as a deduction for the tax year, the taxpayer must reduce the amount chargeable to capital account for the year for such expenses by the excess. A reduced credit is elective under Sec. 280C(c)(3); the taxpayer substitutes 13% in place of the 20% credit, removing the Sec. 280C(c)(1) requirement. Under the Small Business Job Protection Act of 1996, a taxpayer can elect an alternative incremental research credit (AIRC). If elected, the taxpayer uses a three-tier, fixed-base percentage credit rate of (1) 1.65%, when a taxpayer's current-year research expenses exceed a base amount computed with a 1% fixed-based percentage, not to exceed a base amount computed with a 1.5% fixed-base percentage; (2) 2.2%, when a taxpayer's current-year research expenses exceed a base amount computed with a 1.5% fixed-base percentage, not to exceed a base amount computed with a 2% fixed-base percentage; or (3) 2.75%, when a taxpayer's current-year research expenses exceed a base amount computed with a 2% fixed-based percentage. The election applies to the tax year in which the taxpayer made the election, unless revoked with IRS consent. A taxpayer can use Form 6765 to make this election, attaching the completed form to its timely filed original return (including extensions) for the tax year to which the election applies. The taxpayer may not revoke the election without the Service's consent. If the IRS grants a revocation, the taxpayer must attach such consent to its timely filed original return (including extensions) for the tax year of revocation. Similar to the regular credit, Sec. 280C(c)(1) causes the taxpayer to reduce the otherwise allowable deduction for qualified research or basic research expenses by the AIRC. A reduced credit is also elective under Sec. 280C(c)(3), by which the taxpayer multiplies the AIRC otherwise computed by 65%, likewise removing the Sec. 280C(c)(1) requirement.

Section 502 of the Tax Relief Extension Act of 1999 extended the research credit through June 30, 2004, effective for tax years beginning after June 1999; previously, the credit's termination date was June 30, 1999. Also increased was the AIRC's three-tier fixed-base percentage rates under Sec. 41(c)(4), by one percentage point each. Further, certain “suspension periods” for claiming the AIRC were set forth. Specifically, Section 502(d) provides that a taxpayer may not take an otherwise allowable research credit into account before Oct. 1, 2000, to the extent such credit is attributable to the first suspension period (July 1, 1999–Sept. 30, 2000), nor before Oct. 1, 2001, to the extent such credit is attributable to the second suspension period (Oct. 1, 2000–Sept. 30, 2001). However, on or after the earliest date for taking a credit into account, a taxpayer can file an amended return, an application for expedited refund, an adjustment of estimated taxes or any other means the Code allows.

From Brian E. Keller, CPA, Oak Brook, IL