Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC § 41* - Research Credit Computation
Publication Date - June, 2005
* Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the Treasury Regulations.
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
3. RESEARCH CREDIT COMPUTATION
a. In General
The research credit is an incremental credit that equals 20 percent of a taxpayer’s excess QREs (if any) for the taxable year over their base amount. The current carry-back is one year and carry-forward is 20 years (section 39). In many instances, verifying the base amount computation can have a more significant impact on audit results than the determination of allowable credit year QREs. Therefore, a review of the mechanical computation of the research credit is an essential step in the examination process, and should be performed in all examinations. All necessary documents, as determined during the pre-audit analysis, should be requested to insure that the taxpayer properly computed its research credit for all year(s) under examination.
The scope and extent of the computation review may be influenced by the following non exclusive factors:
Proper determination of gross receipts, including prior audit adjustments made to gross receipts.
A spike in the credit year’s QREs relative to the base years.
Acquisitions and/or dispositions of major portions of trades or businesses. I.R.C. § 41(f).
Changes to the fixed base percentage from prior years.
Inconsistent treatment of expenses in the base years versus the credit years (e.g., the taxpayer claims that certain costs in the credit years are QREs, but has not treated those types of costs as QREs in the base years).
In general, for tax years beginning after December 31, 1989, the base amount is computed by multiplying the taxpayer's fixed-base percentage by its average annual gross receipts for the preceding four years. I.R.C. § 41(c)(1).
A taxpayer's fixed-base percentage is the percentage determined by taking aggregate QREs of the taxpayer for taxable years beginning after December 31, 1983, and before January 1, 1989 over aggregate gross receipts of the taxpayer for the same such taxable years. I.R.C. § 41(c)(3)(A).
The maximum fixed-base percentage is 16 percent. I.R.C. § 41(c)(3)(C).
In no event may the base amount be less than 50 percent of the QREs for the credit year. I.R.C. § 41(c)(2).
Acquisition or dispositions of trades or businesses should be identified and verified (from the base years to the current year) to confirm that they are properly reflected in the computation. I.R.C. § 41(f).
The credit year’s QREs and the base years’ QREs are determined based upon application of the law in effect for the current year under examination. Consistency between the credit year’s and the base years’ QREs are required. I.R.C. § 41(c)(5). Therefore, in addition to base year workpapers, the examiner should ascertain the existence and availability of books and records from the relevant base years in order to determine consistency.
There may be instances where the calculation of the credit was not properly made. For example, taxpayers using the regular (non-AIRC) computation method who experience years of high growth in their gross receipts and flat expenditures on qualified research may find that they no longer are eligible for the research credit under the regular computation rules, because the credit year’s QREs do not exceed the base amount. The examiner should be alert to the possible inclusion of non qualified expenses as QREs.
Another aggressive strategy is for taxpayers to understate their “base amount” by understating the “fixed base percentage” and/or by understating “gross receipts” in the prior four years. The examiner should also be alert to applying the computational rules properly and verifying that all gross receipts are identified and reported.
When taxpayers can no longer maintain or increase spending on qualified research relative to gross receipts, they often transition to the Alternative Incremental Research Credit (“AIRC”).
b. The Alternative Incremental Research Credit (AIRC)
Starting with taxable years beginning after June 30, 1996, a taxpayer may elect to compute the research credit using the AIRC. I.R.C. § 41(c) (4). The election must be made on an original return and is binding on all subsequent years unless formally revoked (with the consent of the Commissioner). However new temporary regulation (TD 9205) now provides for an automatic consent to change this election, by simply completing the appropriate portion of Form 6765 on a timely filed original return for the year of the change. A taxpayer cannot elect or revoke an AIRC election on an amended return. An examiner has no authority to make this change or allow the election for the taxpayer during an examination. Treas. Reg. § 1.41-8. If properly elected, the AIRC equals the sum of: 4
2.65 percent of so much of the QREs for the taxable year as exceeds 1 percent of the taxpayer's average annual gross receipts for the preceding four years. However, this amount cannot exceed 1.5 percent of taxpayer's average annual gross receipts for the four preceding taxable years.
3.2 percent of so much of the QREs for the taxable year as exceeds 1.5 percent of taxpayer's average annual gross receipts for the preceding four years. However, this amount cannot exceed 2 percent of taxpayer's average annual gross receipts for the four preceding taxable years.
3.75 percent of so much of the taxpayer's QREs as exceeds 2 percent of such taxpayer's average annual gross receipts for the four preceding taxable years.
c. Start-Up Companies
A “start-up company” is generally defined as a company that did not have both gross receipts and QREs in at least three of the base period years, or the first taxable year in which there were both QREs and gross receipts began after December 31, 1983. (The second provision did not take effect until July 1, 1996). For a start-up company, I.R.C. § 41(c)(3)(B) assigns a fixed-base percentage of 3 percent. The 3 percent start-up rate continues each of the first five years beginning after 1993. In years 6 through 9, a statutory fraction of the ratio between aggregate QREs and aggregate gross receipts is used to determine the start-up’s fixed-base percentage. Only years in which the taxpayer has QREs are counted in this computation. See I.R.C. § 41(c)(3)(B)(ii) to determine the start-up’s fixed base percentage after its initial 5-year period.
Spun-off companies may or may not be considered start-up companies for purposes of computing the base amount. Their base year activities carry over with them. A taxpayer that is created as a result of a spin-off may refer to themselves as a start-up, but if it had the relevant base year QREs and gross receipts, then it will not be treated as a start-up company.
d. Gross Receipts
Section 41(c)(6) does not provide a definition of the term “gross receipts”, other than to provide that gross receipts for any taxable year are reduced by returns and allowances made during the taxable year. In the case of a foreign corporation, only gross receipts effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico (for amounts incurred after June 30, 1999), or any possession of the United States (same) are taken into account. As a result, a taxpayer may have included in gross receipts only the figure on Form 1120, line 1c. Treasury Regulation section 1.41-3(c)(1) provides that for purposes of section 41, gross receipts means the total amount, as determined under the taxpayer's method of accounting, derived by the taxpayer from all its activities and from all sources (e.g., revenues derived from the sale of inventory before reduction for cost of goods sold) with the exception of the following items that are specifically excluded by Treasury Regulation section 1.41-3(c)(2):
Returns or allowances.
Receipts from the sale or exchange of capital assets, defined under section 1221.
Repayments of loans or similar instruments.
Receipts from a sale or exchange not in the ordinary course of business, such as the sale of an entire trade or business or the sale of property used in a trade or business as defined under section 1221(2).
Amounts received with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the goods or service, and the taxpayer merely collects and remits the tax to the taxing authority.
Amounts received by a taxpayer in a taxable year that precedes the first taxable year in which the taxpayer derives more than $25,000 in gross receipts other than investment income.
Selected issues include:
A foreign branch of a United States company should have its receipts included as part of the gross receipts computation.
Gross receipts of the entities required to aggregate their expenditures under section 41(f)(1)(A) and (B) should be included regardless of whether the entity companies have QREs.
Gross Receipts should not be reduced by cost of goods sold.
Tax exempt interest and other tax exempt income should be included in the gross receipts computation.
The examiner should secure information to determine the taxpayer's average annual gross receipts for the preceding 4 years as well as the gross receipts relevant to the fixed-base percentage. A good starting point to verify income is line 11 of Form 1120, page 1, adding back the cost of goods sold. The amount on line 11 should be reduced for capital gain, sales taxes, and other excluded amounts per Treasury Regulation section 1.41-3(c)(2) reported in the line 11 amount. Verify that the correct definition of gross receipts was used, and applied consistently for the prior 4 years and the base years. Confirm incorporation of any prior audit adjustments to gross receipts, when applicable.
e. Special Rules
The Research Credit Technical Advisor Team has identified the following recurring computational issues:
(1) Aggregation Rules of Section 41(f)
The examiner should take steps to insure that the taxpayer has included all relevant members in its research credit computation. Section 41(f)(1) requires that all members of the same controlled group (greater than 50 percent control), and all trades or businesses under common control, be treated as a single taxpayer. Care should be taken to ensure that all members have been included, as the section 41 definition of control is broader than the definition for consolidated return groups.
In May 2005, the IRS issued new temporary and proposed regulations (TD 9205 and REG-134030-04) under section 41(f)(1). These regulations retain the computation of the group credit from the July 2003 proposed regulations (REG-133791-02) except for a slight modification of the start-up company rules. However, these temporary regulations make significant changes to the allocation of the group credit to the members of the group. The July 2003 proposed regulations replaced proposed regulations issued in January 2000.
The computation of the aggregate group research credit under these new temporary regulations is computed by treating all of the members of the group as a single taxpayer. The group credit is computed under either the regular method or the AIRC method, whichever method produces the greater group credit. The temporary regulations provide that the decision to use one method or the other will be made by the designated member or the group. The designated member is the member of the group that is allocated the greatest amount of the group credit. If the group, as a whole, meets the start-up company provisions of section 41(c)(3)(b), then the group is considered a start-up company. However, if any one member had gross receipts prior to December 31, 1983 and another member had QREs prior to December 31, 1983, then the group as a whole does not qualify for start-up company status. The group credit is then allocated to the individual members of the group, using whatever method yields that member the greatest credit, regardless of whether or not they use the same method used to compute the group credit. However, the allocation to the individual members cannot exceed 100% of the group credit.
These new temporary regulations are effective for taxable years ending on or after May 24, 2005. However, the temporary regulations also provides that for taxable years ending on or after December 29, 1999, taxpayers can use any reasonable method of computing and allocating the group credit, provided that the members of the group do not claim more than 100 percent of the group credit.
(2) Short Years
a) Short Credit Year
If a credit year is a short taxable year, then the average annual gross receipts of the taxpayer for the 4 prior taxable years used in determining the base amount under section 41(c)(1) must be modified by multiplying that amount by the number of months in the short taxable year and dividing the result by 12. Treas. Reg. § 1.41-3(b).
b) Short Taxable Year Preceding the Credit Year
If one or more of the four taxable years preceding the credit year is a short taxable year, then the gross receipts for such year are deemed to be equal to the gross receipts actually derived in that year multiplied by 12 and divided by the number of months in that year.
c) Short Taxable Year in Determining Fixed-Base Percentage
No adjustment is made on account of a short taxable year to the computation of a taxpayer’s fixed-base percentage.
Section 41(f)(3) generally requires an adjustment to be made to the base amount in the case of the acquisition or disposition of a major portion of a trade or business. Therefore, the examiner must ascertain whether the taxpayer made any acquisitions or dispositions that could affect the research credit computation. Compare the prior years and question any large discrepancies.
Change in ownership of a business is discussed under section 41(f)(3). Acquisition of the stock of another company, or disposition of stock, standing alone, does not trigger application of section 41(f)(3). See I.R.C. § 41(f)(1).
(4) Partnership Issue
Section 41 requires that a taxpayer incur credit-eligible research expenditures "in carrying on" any "trade or business“. Thus, two conditions must be satisfied to qualify for the credit. First, as under section 174, there must be a qualifying trade or business. Second, the expense must be incurred in carrying on that trade or business.
The "in carrying on" and "trade or business" tests for the research credit generally are the same as the test for the purposes of section 162. The expenses must relate to a particular trade or business of the taxpayer that is being carried on at the time the expenses are paid or incurred. Thus, expenses paid or incurred in connection with a trade or business within the meaning of section 174 are not necessarily paid or incurred in carrying on a trade or business for purposes of section 41.
As is the case with section 174, when a taxpayer contracts out research and intends to sell or license the results thereof, the section 41 trade or business requirement is not satisfied if the activity is merely a financing arrangement.
a) Application of Test at Partnership Level
Under section 162, it is well established that the determination of the existence of a trade or business with respect to a partnership must be made at the partnership level, without regard to the existing businesses of the corporate or individual partners. The research credit regulations generally follow the section 162 approach to the application of the trade or business requirement to a partnership. Thus, if a newly formed research partnership initially has no active trade or business, the "in carrying on" requirement generally bars eligibility for the research credit.
b) Special Exception for Qualifying Joint Ventures
The research credit regulations provide that an in-house research expense or contract research expense paid or incurred by a partnership other than in carrying on a trade or business of the partnership is eligible for the credit if certain conditions are met. The regulations do not require that all partners meet the "in carrying on" test, but do contain limits similar to those in section 168(h)(6) (relating to tax-exempt use property).
c) Expenditures Relating to a Startup Business
Special rules for startup ventures in applying the trade or business requirement are set forth in section 41(b)(4).
4 The Tax Relief Extension Act of 1999 amended section 41(c)(4)(A) by striking 1.65 percent and inserting 2.65 percent, by striking 2.2 percent and inserting 3.2 percent, and by striking 2.75 percent and inserting 3.75 percent. This change applies to taxable years beginning after June 30, 1999.