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R&D: don't overlook it.

As a result of the newly enacted tax bill, the research and development (R&D) credit is alive and well, having been extended for three years (during the period July 1, 1992 through June 30, 1995). This credit, and the expensing election, make R&D attractive for business.

R&D involves two tax issues. Before 1939, it was unclear whether R&D costs were a capital or deductible item. The Internal Revenue Code of 1939 held that R&D expenses were deductible if they were an "ordinary and necessary" business expense. In 1954, Sec. 174 was added to the Code to provide that R&D costs may be deducted currently or amortized over a period of 60 months or more. The Economic Recovery Act of 1981 added the second tax issue--the R&D credit now found in Sec. 41.

With the possibility of deductions and credits taxpayers may attempt to include many different items as R&D. With this in mind, the Code has limited the items eligible for the Sec. 174 election and the Sec. 41 credit. R&D must be incurred in connection with a trade or business. It must be technological in nature. It must be useful in developing new or improved business components or products. The item developed must be improved in function and not a mere design change; routine design changes do not constitute R&D for purposes of the credit. Further, the method of reaching the result must not be ascertainable at the onset. The taxpayer must bear the risk of failure. The expenses cannot be part of the manufacturing process, nor may any depreciable items qualify for the credit.

The 1989 proposed regulations tried to limit the use of R&D expensing, by applying a "timeline" approach. Expenditures incurred after meeting the basic design specifications could have been deducted only for significant cost reductions or higher performance levels. The Treasury withdrew these proposals in 1993 and replaced them with proposed regulations that involve a different approach. The Treasury conceded that progress in R&D is often achieved only in small, incremental steps and that it would be difficult to determine when a basic design specification has been met and whether subsequent changes are significant.

As noted, one major tax benefit of R&D is the credit availability. Under Sec. 41, taxpayers are entitled to a tax credit for incremental "qualified research expenditures" paid or incurred. This credit equals 20% of the amount by which expenses exceed a base amount. The base is the taxpayer's fixed base percentage multiplied by the average of the taxpayer's gross receipts for the four years preceding the credit year. The taxpayer's fixed base percentage (which cannot exceed 16%) is computed by dividing the qualified research expenses during the 1984-1988 base period by gross receipts for the same period; this base amount cannot be less than 50% of the current year qualified expenditures. For start-up companies with fewer than three years during the base period, Sec. 41(c)(3)(b) sets the percentage at 3%. Under the new law, this fixed-base percentage will only apply for the first five years. After that the start-up company's percentage will be determined by a ratio of qualified research expenses to gross receipts.

Sec. 41(b) provides that qualified research expenditures may be incurred in connection with in-house expenses as well as contract research. The four basic expense categories are (1) wages for employees involved in research, (2) supplies used in research, (3) payments for the use of computer time for qualified research and (4) 65% of costs of contracting with another party to conduct research on the taxpayer's behalf.

Under Sec. 2800(c)(1), the amount of any otherwise allowable deduction for research expenses must be reduced by 100% of the amount of the research credit determined for that year. Taxpayers who elect to capitalize such expenditures must also reduce the amount capitalized by the amount of the credit. A taxpayer may elect, however, to claim a reduced Sec. 41 credit rather than reducing the Sec. 174 deduction or the amount capitalized. The reduction is equal to the credit multiplied by the maximum corporate tax rate.

The second tax benefit is the write-off or amortization of R&D. Sec. 174 provides that R&D costs may be deducted currently or amortized over a period of 60 months or more. Either the current expense or amortization method may be adopted without IRS consent if the taxpayer adopts this method for the first tax year in which R&D costs are incurred. The current expense method is adopted by claiming a deduction for the R&D costs on the tax return. (It is preferable that the expenses be included as a separate line item.) The deferred method may be adopted by attaching a statement to the return as well as amortizing the expense.

In order to change to a different method of deducting R&D expenses, an application for permission to change methods must be made in writing to the IRS and filed no later than the last day of the first tax year for which the change in method is to apply.

The Sec. 174(a) deduction is an adjustment in computing the alternative minimum tax (AMT). Sec. 56(b)(2)(a)(ii) provides that all R&D amounts paid or incurred after 1986 must be capitalized for AMT purposes and amortized over a 10-year period. There is an exception to this rule for tax years beginning after Dec. 31, 1990 for taxpayers who materially participate in the activity to which the research deduction relates (Sec. 56(b)(2)(d)). From David Oettinger, Jr., J.D., LL.M., CPA, and Vidette Rouse, C, CPA, Rocky Mount, N. C.
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Title Annotation:research and development tax credit
Author:Rouse, Vidette
Publication:The Tax Adviser
Date:Sep 1, 1993
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