Form 6765 and the R&D credit.

The Sec. 42 credit was designed to encourage and reward businesses that increase their research and development (R&D) expenses in relation to their gross receipts and attempt to make technological advances in their respective industries. Form 6765, Credit for Increasing Research Activities, with its countless number of calculations, can dissuade taxpayers from trying to qualify for Sec. 41.

This item intends to assist tax advisers in developing quick methods to determine the amount of research expenses that will qualify for the credit, as well as whether the alternative incremental or the regular credit is most beneficial. Part of Form 6765 is reproduced on p. 590. (This item does not address all of Sec. 41 's Complications.)

Research Payments

One area often overlooked is whether C corporations can receive the credit for basic research payments to qualified research organizations. Generally, Form 6765, Line 7, contract research expenses, is limited to 65% of the consulting fees paid. However, if such work is performed through a university or other qualified Sec. 501(c)(3) organization and relates directly to the taxpayer's industry, the 65% limit can be avoided by including the expenses in Line 1, basic research payments paid or incurred to qualified organizations. However, Line 1 research payments are subject to special base-period limits on Line 2, qualified organization base-period amount. Research payments that do not exceed the base-period limit can be grouped into Line 7, contract research expenses, thereby qualifying for the regular research credit.

Another major caveat occurs in Sec. 41(e)(2)(A)(i), which states ".... such payment is pursuant to a written agreement between such corporation and such qualified organization...." Thus, a contract and payment amount must be established between the C corporation and research organization at the outset. It can be in the client's best interest to choose a nonprofit organization over a consulting firm, to receive the maximum tax benefit, when contracting out large research projects.

Research Expenses

When applying for the research credit, it is imperative to capture all potential research expenses. Every employee should be examined to determine the portion of his or her annual wages that can be attributed to qualified research services. Supplies and computer rentals/leases used in research projects, as well as 65% of consulting research costs, are eligible. Those expenses, when taken as a credit, yield an 18.6% greater benefit than claiming a deduction. Exhibit 1 below illustrates this concept, assuming a 35% tax rate.

For every dollar spent on research costs, the taxpayer receives a tax benefit of 41.5 cents. Taking the credit appears to be an obvious decision, until the fixed-base-period percentage limit is taken into account.

"Start-Up" Company?

Sec. 41 (c)(3)(A) states "... the fixed-base percentage is the percentage which the aggregate qualified research expenses of the taxpayer for the taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for such taxable years." However, a corporation is deemed a start-up company if it does not have both gross receipts and qualified expenses in at least three years after 1983 and before 1989. Obtaining the qualified research expenses flora fiscal years 1984-1988 can often be an administrative difficulty when no standardized cost segregation is put toward R&D expenses. When it is reasonable that there were no qualified expenses for the base period, it is almost always more beneficial to treat the company as a start-up rather than taking the alternative incremental credit in Form 6765, Section B (the alternative incremental credit calculation is not based on the fixed-base-period percentage).

Base-Period Limit

The base-period percentage limits the credit for "increasing" research activities. A taxpayer must demonstrate that research expenses are increasing in relation to gross receipts to get the full credit. Eligible costs must be treated consistently; the IRS generally scrutinizes de minimis amounts that appear to manipulate the base-period percentage. A tax planning opportunity arises in years five-10 for a start up company calculating its fixed base percentage going forward.

For year 11 and all subsequent years, Sec. 41(c)(3)(B)(ii)(VII) states that the fixed-base percentage is "... the percentage which the aggregate qualified research expenses for any 5 taxable years selected by the taxpayer from among the 5th through the 10th such taxable years is of the aggregate gross receipts of the taxpayer for such selected years." This means that a start-up company can throw out the year with the greatest negative effect on its base-period calculation going forward. It also prompts the taxpayer to possibly defer the undertaking of any large R&D projects in year 10 of its calculation, because that will provide a permanent potential limit. On the other hand, it may be beneficial to accelerate the payment of R&D expenses into the "throw-out" year, once the taxpayer knows that this year will be a high base-period year. Exhibit 2 above illustrates when the base-period limit may occur.

In Exhibit 2, in each case when the Line 14 credit calculation is pulled from Line 12 instead of Line 13, there is a reduced credit. Under Sec. 41, the equation phases out the expenses eligible for the credit when the taxpayer has less than a 100% increase in research expenses over the base-period research expenses.

Reduced Credit

Occasionally, it may be beneficial to take the reduced credit, derived by multiplying the qualifying re search expenditures, Line 15, by 13%, instead of the usual 20%. The 20% credit must be added to taxable income; the 13% credit does not require this addback. The Sec. 280C "reduced credit" is beneficial only when the taxpayer is pushed into (or through) a 38% or 39% marginal tax bracket (i.e., when taxable income falls between $100,000 and $335,000 of $15 million and $18.33 million). Exhibit 3 below demonstrates the potential benefits.

In Exhibit 3, the credit is reduced by $14,000, but the tax liability is reduced by $15,600, resulting in a net gain of $1,600. A "with and without" calculation should be performed whenever a tax adviser is considering a Sec. 280C election, to ensure the maximum tax benefit.

Which to Use?

The Section B alternative incremental credit is usually less beneficial than the Section A regular credit; however, it can be claimed when the regular credit is disallowed due to the base-period limit. Lines 27-38 calculate the alternative credit, but there is a shortcut in arriving at Line 38:

1. Multiply the four-prior years' average gross receipts by 1.22%.

2. Subtract that result from the qualifying R&D expenses for the current year.

3. Multiply the result by 3.75%; this is the current-year alternative incremental research credit.

If the result is zero or less, the credit is disallowed. Basically, for every $1,000 by which the taxpayer exceeds 1.22% of the four-prior-year's gross receipts, the taxpayer receives $37.50 in research credit. Exhibit 4 on p. 592 compares the regular credit to the incremental credit.

From Exhibit 4, it is evident that the only case in which the alternative incremental credit is more beneficial occurs when the regular credit is complete]y phased out. Finally, the alternative incremental credit applies to the current tax year and all future tax years and may be revoked only with IRS consent.

All general business credits, including the credit for increasing research activities, are subject to a limit based on the current-year's tax liability. The tax liability is reduced by the greater of the tentative minimum tax or 25% of the amount by which net income tax exceeds $25,000. This equates to roughly a maximum 8.75% flat tax rate on all taxable income, assuming no alternative minimum tax limit and a limitless research credit. All unused research credits may be either carried back one year of forward 20 years. Finally, in the year following the twentieth year, the unused credit (not including the reduced research credit) reverts to a deduction.

Conclusion

This item should prompt a tax adviser to assist a client faced with personnel limits and timing decisions on large research projects. Proper tax planning and correct method selection (alternative incremental or regular) are the keys to maximizing the R&D credit.

Exhibit 1: Credit vs. deduction *

                                              Benefit of
                                              expenses as
          Total                               both a tax
          qualified               Regular     credit and
          research                credit)     deduction
          expenses    (Line 13)   (Line 16)   (35% x (A -
                      A x 50%     B x 20%     C)) + C

Example     (A)         (B)         (C)          (D)

   1       $100,000     $50,000     $10,000     $41,500
   2        $35,000     $17,500      $3,500     $14,525
   3         $8,000      $4,000        $800      $3,320

                                  % increase
          Benefit of              in tax benefit
          the expenses            as both a
          as a tax                credit and
          deduction               deduction
          A x 35%                 (D - E)/E

Example       (E)                     (F)

   1       $35,000                 18.5714%
   2       $12,250                 18.5714%
   3       $52,800                 18.5714%

* These examples assume that Line 3 is zero and that the other limits
do not apply.

Exhibit 2: Base-period limit
                                              Four-prior-year
           Total qualified      Fixed-base    average of
           research expenses    percentage    gross receipts
           (Line 8)             (Line 9)      (Line 10)

Example           (A)              (B)             (C)

1            $100,000            3%           $1,000,000
2             $50,000            3%           $1,000,000
3             $20,000            9%             $100,000
4             $20,000           15%             $100,000
5            $100,000            5%             $500,000
6            $100,000            5%           $1,200,000

                        Limited credit    Full credit,    (Line 14)
           (Line 11)    (Line 12)         no limit        Smaller of
           B x C        A - D             50% x A         E or F

Example    (D)          (E)               (F)

1          $30,000       $70,000            $50,000        $50,000
2          $30,000       $20,000            $25,000        $20,000
3           $9,000       $11,000            $10,000        $10,000
4          $15,000        $5,000            $10,000         $5,000
5          $25,000       $75,000            $50,000        $50,000
6          $60,000       $40,000            $50,000        $40,000

Exhibit 3: Reduced credit
                          With addback     Difference   Without addback

Taxable income before
  addback                 $100,000                      $100,000
R&D expenses              $200,000                      $200,000
R&D credit                 $40,000 (20%)   ($14,000)     $26,000 (13%)
Taxable income after
  addback                 $140,000                      $100,000
Tax liability             ($37,850)         $15,600     ($22,250)
Difference in tax
  credit carryforward       $2,150           $1,600       $3,750

Exhibit 4: Regular vs. Inceremental credit *

           Qualified                 Four-prior-year
           research     Fixed-base   average of
           expenses     percentage   gross receipts
           (Line 8)     (Line 9)     (Line 10)

Example    (A)          (B)          (C)

   1       $100,000      3%          $1,000,000
   2       $100,000     11%          $1,000,000
   3        $20,000      9%            $150,000
   4        $20,000      9%            $225,000
   5       $100,000      5%            $500,000
   6        $25,000      5%            $500,000

                        Alternative
                        incremental
           Regular      credit
           credit       (Line 38)
           Line (16)

Example                 (A-(C X 1.22%)) X 3.75%

   1       $10,000      $3,295
   2       N/A          $3,295
   3       $2,000         $680
   4       N/A            $645
   5       $10,000      $3,520
   6       N/A            $710

* The figure assume a Sec. 280C "reduced credit" election was not
made.

FROM KRISTOPHER HALLENGREN, CPA, ELLIN & TUCKER, CHARTERED, BALTIMORE, MD

Editor: Allen M. Beck, CPA, MST

Tax Manager

Ehrenkrantz Sterling & Co., L.L.C.

DFK International

Livingston, NJ