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Research tax credits: An expired tax break worth considering

10/05/2015

Congress first approved the “temporary” research tax credit in 1981, and it’s been renewed 17 times since, often retroactively to its prior expiration. On Dec. 31, 2014, the research credit expired yet again. The congressional track record of continually renewing this credit suggests that it’ll be available again in 2015. To be prepared, manufacturers engaged in research activities should understand when and how to claim these credits. Even if the credit isn’t extended, you might be able to save tax by filing amended returns to claim the credit for recent years.

4-factor test

To be eligible for the research credit (also commonly referred to as the “research and development” or “research and experimentation” credit), a business must have engaged in “qualified” research activities. To be considered “qualified,” activities must meet the following four-factor test: 

  1. The purpose must be to create new (or improve existing) functionality, performance, reliability or quality of a product, process, technique, invention, formula or computer software that will be sold or used in your trade or business.
  2. There must be an intention to eliminate uncertainty.
  3. There must be a process of experimentation. In other words, there must be a trial and error process.
  4. The process of experimentation must fundamentally rely on principles of physical or biological science, engineering or computer science.

Among those activities specifically excluded from the credit are reverse engineering an existing product, research related to social sciences, arts or humanities, software developed for internal use, and research performed outside the United States and its territories and possessions. Research that’s funded or reimbursed by someone else via a contract, grant or other arrangement is also excluded.

Expenses that qualify for the credit include wages for time spent engaging in supporting, supervising or performing qualified research, supplies consumed in the process of experimentation, and 65% of any contracted outside research expenses.

Methods to compute your credit

There are three options for computing research credits:

Traditional Method.  Here you first compute qualified research expenses as a percentage of gross revenue for the period between 1984 through 1988. In turn, that historic fixed base percentage is multiplied by the average of the four prior years’ gross revenue to determine the current base amount. The credit equals 20% of the excess over that base amount. For example, if your current base amount is $100,000 and your qualified expenses are $150,000 for the current year, you’d be eligible for a $10,000 credit (20% of $150,000 - $100,000).

Start-up Calculation Method. This technique can be used if a company was founded after 1983 or had less than three years of activities between 1984 and 1988. It uses a historical build-up computation to establish the fixed base percentage and then, similar to the traditional method, allows a credit for 20% of the excess qualified research expenses.

Alternative Simplified Credit Method. A company uses this option when it either cannot establish its historic fixed base percentage or that percentage is so high that the credit would be limited significantly. Here the fixed base is 50% of the average research expenses incurred in the previous three years and the credit is 14% of the excess. For example, if a manufacturer averaged $100,000 per year of qualified expenses over the last three years, the credit would be $7,000 (14% of $50,000) even if its research activities didn’t increase.

Keep in mind that amended returns may be filed to claim research credits up to three years back, potentially allowing you to reap refunds from previous years.

Food for thought

Claiming research credits can be tricky. Alternative minimum tax issues could undermine your plans to use these credits. On the other hand, if your state also offers credits for research activities, the research credit may be even more significant than you initially anticipated. So discuss with your tax advisor whether it’s worth pursuing — and for the latest on whether Congress extends it again for 2015.

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