Initially created by the Economic Recovery Tax Act of 1981, the federal research credit was intended to expire after four years. And it did, but only temporarily.
Since 1981, the credit has expired and been revived, often retroactively, more than a dozen times.
Introduction to the Federal Research Credit
Designed to encourage investments in U.S.-based research and experimentation, the federal research credit can be claimed by individuals, C corporations and S corporations, partnerships, trusts and estates.
It is available to companies in such diverse sectors as software and information technology, energy, electronics and telecommunications, biotech and medical technology, aerospace, automotive, tool and die, manufacturing, food processing, construction and engineering, pharmaceuticals and chemicals, and agriculture.
Importantly, this research credit is not a tax deduction—which only reduces a company’s taxable income—but rather a dollar-for-dollar reduction in its federal income tax liability.
Over the last thirty years, the credit has proven to be a valuable source of innovation and well-paying jobs for companies investing in U.S.-based research and experimentation. Unfortunately, its effectiveness has been hampered by complexity and a lack of predictability. As a result, many companies eligible for the research credit have not elected to claim it. In fact, nearly 80 percent of the more than seven billion dollars in research credit tax benefits each year goes to a small number of the country’s largest companies.
To simplify the calculations and documentation required to claim the credit, Congress created an alternative approach—the alternative simplified credit, sometimes referred to as the reduced research credit. Recently, the IRS issued final regulations governing its use.
Although President Obama and members of Congress have expressed a preference for making the credit permanent, the credit is currently set to expire at the end of this year and research expenditures paid or incurred after December 31, 2011 will not be eligible.
Calculating the Amount of the Federal Credit
The federal research credit is a credit against a company’s federal income tax based on a percentage of qualified research and experimentation expenditures.
The credit is subject to the limitations of the general business credit. If, as a result, you cannot use the full amount of the research credit in the current year or the immediate prior year, you can carry it forward for 20 years.
The total amount of your research credit for any taxable year is calculated based on research and experimentation expenditures attributable to qualified research undertaken as part of your trade or business, including wages for in-house labor, supplies, computer time-sharing costs, and a percentage of contract research payments to contractors in the U.S.
If any of your basic research is done by a university or tax exempt research organization, or you have energy research done by an energy research consortium, a portion of these expenditures may also be factored into the amount of your credit.
There are two basic methods for calculating a company’s credit based on its own research and experimentation expenditures: regular and alternative simplified. The details of the calculation are complex, but the basics are as follows:
Regular Research Credit
Under this method, the credit is calculated as 20 percent of the amount of qualified research expenses for the year that exceed a specified base amount. The calculation is designed to incentivize increasing investments in research and experimentation, not consistent levels of investment.
Alternative Simplified Credit
As an alternative to the regular method, a business can claim a credit of 14 percent of the amount by which its qualified research expenses for the year exceed 50% of its average qualified research expenses for the preceding three tax years.
Further, a business that did not have qualified investments in any of the preceding three tax years can claim a credit equal to 6 percent of its qualified expenses during the current tax year.
As a result, under this alternative method, a business with consistent or even declining investments in research and experimentation may be eligible for a research credit.
Note that, even without the credit, the research and experimental expenses you incur in connection with your trade or business can be deducted from taxable income each year—or deferred and amortized over a period of not less than 60 months. However, you cannot claim the deduction and tax credit for the same expenses.
Qualified Research or Experimental Expenditures for the Federal Credit
Generally, qualified research or experimental expenditures for purposes of the research credit are amounts paid or incurred during the year for U.S.-based in-house and contract research. They are technological in nature and relate to new or improved business components, such as processes, products, software, techniques or formulas.
Expenditures for research in the social sciences, arts, or humanities are ineligible for the credit, as are expenditures for research conducted outside of the U.S. or research funded by another entity or person.
Also generally ineligible for the credit are the following: research performed after the start of commercial production, surveys and studies, research funded by a governmental entity or another person or organization, research adapting a product or process to suit a specific customer, duplication of an existing product or process, and research related to certain internal-use software.
To identify research and experimental expenditures for purposes of the federal tax credit, businesses often start with research and development expenses as classified in their financial accounting systems. If you claim any research and experimental expenditures that are not classified R&D for financial statement purposes, the IRS will likely require additional justification.
The IRS also requires that your approach to classifying research and experimental expenditures is consistent among all base years and the current tax year, since the amount of the credit is generally determined relative to base-year expenditures.
Documenting Qualifying Expenditures
To be eligible for the credit, you’re required to retain sufficient paper and/or electronic documentation to substantiate your expenditures, including contemporaneous records from project accounting and timekeeping systems.
If you choose to use the alternative simplified method, the method applies to all future tax years unless you revoke the election on an original (not amended) tax return that is timely filed.
Washington State R&D Tax Incentives
Washington State currently offers a variety of tax incentives for technology businesses in the fields of advanced computing, advanced materials, biotechnology, electronic device technology and environmental technology.
The Washington State Department of Revenue website publishes information on the full range of incentive programs offered to businesses in Washington State.
High Technology B&O Credit for R&D Spending
This Washington State tax incentive applies to businesses conducting research and development within Washington State in the fields of advanced computing, advanced materials, biotechnology, electronic device technology and environmental technology.
Qualifying expenditures consist of “operating expenses, including wages, compensation of a proprietor or a partner in a partnership, benefits, supplies and computer expenses, directly incurred in qualified research and development.” They do not include “capital costs and overhead, such as expenses for land, structures and depreciable property.”
Generally, the amount of the credit is 1.5 percent of qualified research and development expenditures after subtracting a portion of taxable income related to such expenditures-although the exact calculation includes additional complexities.
This Washington State B&O tax credit expires January 1, 2015.
High Technology Sales and Use Tax Deferral / Waiver
This Washington State tax incentive applies to businesses in the fields of advanced computing, advanced materials, biotechnology, electronic device technology and environmental technology that “start new research and development or pilot scale manufacturing operations, or expand or diversify a current operation by expanding, renovating or equipping an existing facility anywhere in Washington.”
Sales and use taxes are deferred “during the year in which the investment is certified as operationally complete” and for the next seven calendar years. One-eighth of the deferred tax is waived for each year that the investment remains eligible and the required annual survey is filed with the state.
The deferral requires that an application be filed with the Washington State Department of Revenue before either a building permit is issued or the business takes possession of equipment.
This Washington State tax incentive expires January 1, 2015.
Biotechnology and Medical Device Manufacturing Sales and Use Tax Deferral / Waiver
This tax deferral is available to biotechnology businesses in the fields of biology, microbiology, molecular biology, cellular biology, biochemistry and biophysics-including recombinant DNA techniques, genetics and genetic engineering, cell fusion techniques and new bioprocesses using living organisms or parts of organisms. It is also available to manufacturers of certain qualifying medical devices.
The deferral is available to the lessor or owners “for investments in construction or renovation of structures or machinery and equipment used for biotechnology product or medical device manufacturing.” Eligible investments include new construction and expansion or renovation of qualified buildings—such as plant offices, commercial laboratories, quality assurance/control facilities and warehouses—and qualified machinery and equipment. They also include labor and services rendered in the planning, installation, and construction of the project.
Sales and use taxes are deferred during the year in which the investment is made and for the next seven calendar years, as long as the investment remains eligible. One-eighth of the deferred tax is waived for each year that the investment remains eligible and the required annual survey is filed with the state.
The deferral requires that an application be filed and approved with the Washington State Department of Revenue before construction is started.
This Washington State tax incentive expires January 1, 2017.
If you need help accounting for, or maximizing the tax benefits from, your investments in research and experimentation, give us a call.