| |
 |
Newsletter - Spring 2008
Simplified Approach to Research Tax Credits
Lewis Kevelson, Partner, Tax & Business Services |
|
Back in 1981, the Research Tax Credit was enacted to encourage businesses to engage in research and development (R&D) activities within the United States. Since then, businesses have been able to generate tax credits for a portion of their R&D activities. Subject to certain limitations, the tax credits can be applied dollar for dollar against a company's current tax bill. For S corporations, partnerships and LLCs, the research credits pass through to the individual owner's tax return and reduce the owner's personal income tax liability.
To qualify for the credit, a business doesn't need a laboratory of scientists or formal research department. In fact, there is no requirement that the research be innovative or ground breaking. To qualify, a company has to pursue research activities that are new to its business and meet a four-part test:
- Eliminating Uncertainty
The research activity must be intended to discover information that would eliminate technical uncertainty concerning the capability or method for developing or improving a product or process or the appropriateness of the product design.
- Process of Experimentation
The research activity must include a process of experimentation where a company evaluates and tests several alternatives.
- Technological in Nature
The research activity must fundamentally rely on one of the "hard" sciences (physical, biological, computer or engineering). The development of certain types of internal use software can also qualify.
- Permitted Purpose
The research must be undertaken for the purpose of developing a new or improved function, performance, reliability, quality or significant cost reduction.
Assuming the activities qualify, the next step is to compute the amount of the credit. The computation takes into consideration the amount of wages, supplies and contract costs that are attributable to the research activity. In general, to qualify for the credit, the total of these expenditures has to exceed a base amount.
A problem facing certain companies is that the base amount is dependent on a company's financial data going back to the years 1984-1988. The financial activity for these years is often difficult to support and the IRS often looks to modify or discredit the base amount in order to limit the availability of the credit.
To alleviate the potential audit risk and to permit more businesses to claim the credit, an alternative method of computing the credit was introduced as part of the Tax Relief and Health Care Act of 2006. The new methodology, called the alternative simplified credit method, allows a company to claim the credit without having to rely on prior years' financial data. In addition, the new methodology should help companies that don't do research every year to qualify for the credit. A downside, however, is that it generally will not produce as large a credit. Under the alternative method, a company can claim a research credit for 6% of their qualified research activities.
Companies with operations commencing after 1988 can rely on the alternative simplified credit. However, if their historical records are in good order, there could be an advantage to using one of the other computational approaches.
|
|
|
|
