When to elect the reduced R & D credit (under sec. 280C).

Taxpayers eligible for the research and development (R&D) credit can elect to take either:

1. a 20% credit and add the credit amount back to taxable income; or

2. a 13% credit without any addback (Sec. 280C(c)(3)).

This is an irrevocable election that can only be made on the original tax return filed for the tax year.

Although some states have R&D credits, they usually do not resemble the Federal credit. However, since Federal taxable income is the starting point for computing state or local taxable income, in nearly every state the deduction added back when a full Federal credit is taken will likewise be added back for state and local purposes.

Take full credit when in 15% or 25% corporate tax bracket

A corporation will generally benefit by taking the full 20% credit (choice #1) when it is in a tax bracket lower than 34%; the tax effect of the addback will not be an additional 7% of taxes (the difference between 20% and 13% by electing the reduced credit).

Example 1: For a corporate taxpayer in the 25% Federal bracket, with an effective state and local tax rate (net of Federal benefit) of 6%:

Creditable base           $50,000
Full credit             x      20%
Credit                     10,000
Federal effect
 of $10,000
 lost deduction
 ($10,000 x 25%)           (2,500)
State effect
 of $10,000
 lost deduction
 ($10,000 x 6%)              (600)
Net benefit
 of a full credit           6,900
Creditable base            50,000
Reduced credit          x      13%
Federal benefit
 of a reduced
 credit                     6,500
Total tax savings
 by taking full
 credit                   $   400

However, if the corporation does substantial business in the Northeast states, where an effective state and local tax rate of 9% or higher is not unusual, the tax savings from taking the full credit might be mitigated or eliminated.

Take reduced credit when in 34% or higher corporate tax bracket

For Federal purposes, it generally makes no difference whether a corporation elects the full 20% credit or the 13% reduced credit when it is in the 34% or 35% bracket; the effect of the addback would approximate 7% (35% x 20%). However, taking a reduced credit would result in a state tax savings.

Example 2: For a corporate taxpayer in the 35% bracket, with an effective state and local tax rate (net of Federal benefit) of 6%:

Creditable base           $50,000
Full credit             x      20%
Credit                     10,000
Federal effect
 of $10,000
 lost deduction
 ($10,000 x 35%)           (3,500)
State effect
 of $10,000
 lost deduction
 ($10,000 x 6%)              (600)
Net benefit
 of a full credit           5,900
Federal benefit
 of reduced credit
 ($50,000 x 13%)            6,500
Total tax savings
 by taking reduced
 credit                   $   600

The benefit of the reduced credit will be from the state and local tax savings obtained. Taxable income for Federal, state and local tax purposes will be $10,000 higher if the full credit is elected. Therefore, sufficient state and local taxes would be saved to make electing the reduced credit worthwhile since there would be no addback.

Take reduced credit when partners or shareholders of entity are in 36% or

higher tax brackets

If the entity that incurs the R&D expenditures is a flowthrough entity (partnership, S corporation, etc.), the tax bracket of the shareholder or partner, as well as the state and local consequences of the lost deduction, will determine whether the entity should make the election of the full or reduced credit. If all partners or shareholders are individuals in either the 36% or 39.6% tax bracket, the partnership or S corporation should virtually always elect the reduced credit.

Example 3: An S corporation with all shareholders in the 39.6% bracket and paying state and local individual taxes at an effective rate of 6% (net of Federal benefit):

Creditable base           $50,000
Full credit             x      20%
Credit                     10,000
Federal effect
 of a $10,000
 lost deduction
 ($10,000 x 39.6%)         (3,960)
State effect
 of a $10,000
 lost deduction
 ($10,000 x 6%)              (600)
Net benefit
 of full credit             5,440
Federal benefit
 of reduced credit
 ($50,000 x 13%)            6,500
Total tax savings
 by taking
 the reduced credit       $ 1,060

These savings from the reduced credit may be further increased if the S corporation or partnership is subject to tax at the entity level (e.g., in New York State, New York City, Californa, Massachusetts, New Jersey, Connecticut).

From Steven Touger, CPA, New York, N.Y.