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Final Regulations Issued for Election of Reduced Research Credit

The IRS released final regulations effective July 27, 2011, that simplify how taxpayers may make the election to claim the reduced research credit.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853)

Certain favorable personal tax rates enacted during the George W. Bush administration were scheduled to expire on January 1, 2011. Further, certain favorable business tax provisions, some also enacted during the Bush administration, and other provisions that existed prior to the Bush administration (e.g., the Research & Development (R&D) credit) had already expired as of 2010. The President signed into law on December 17, 2010 the "The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 Act" (or the "Act") that extends these favorable personal tax provisions, also for two additional years, generally through 2011. In particular, the R&D credit — The Act reinstates for two years (through 2011) the research credit.

Permanent research credit
On the the campaign trail, Obama pledged to make permanent the research and experimentation credit, which has been repeatedly extended. The budget makes good on that pledge and the provision is expected to cost about $74 billion over ten years.

What is the Alternative Simplified Credit (“ASC”)?
The new Alternative Simplified Credit is first available for tax years beginning in 2007. For many companies the ASC may make it easier to calculate the credit.

Taxpayers can elect the ASC for qualified research expenditures (“QREs”). The ASC equals 12 percent (ASC rate for tax years 2007 & 2008. HR 1424 increased the ASC rate to 14% effective January 1, 2009 - December 31, 2011.) of the QRE for taxable years that exceed 50% of the average QRE for the three taxable years preceding the credit determination year. If the taxpayer has no QRE in any one  of the three preceding tax years, the rate of the ASC equals 6 percent of the QRE for the credit determination year. Unlike the Regular Research Credit (“RRC”), the ASC does not have a minimum base amount equal to 50 percent of the credit determination year QRE.

With the introduction of the ASC, many taxpayers may benefit from the removal of the traditional “base Period” (generally the tax years between 1984-1988) and the research intensity approach (the relation of the QREs to gross receipts). This will allow ASC taxpayers to measure the credit solely on the calculation of incremental QREs. The new calculation method will be particularly important for taxpayers with:

• Incomplete records from the 1984-1988 base period
• Significant growth of gross receipts in recent years
• A complex history of organizational activity (mergers, acquisitions & dispositions)

Calculating and substantiating the Research Credit can be a cumbersome task. Election of the ASC, although binding, will relieve much of this administrative burden by shifting the measurement of research incrementally over the three prior years. This is a key consideration for taxpayers unable to claim the reinstated Research Credit because their current R&D intensity is lower than during the Credit’s 1984-1988 base period.

For some taxpayers, one key benefit in calculating the ASC is the removal of gross receipts from the equation, if their facts reflect a rising revenue stream. Many manufacturing and high tech companies especially will benefit from this change if their facts reflect a limitation in the amount of Credit available to them due to a shift in the relationship of QREs to gross receipts from the base period to current years. During 1984-1988, it was common for manufacturing companies, in particular taxpayers in the government contracting industry, to spend significant amounts of money on R&D in relation to sales in those same years. AS these companies have increased research expenditures through the development of more efficient, cost effective processes over the years, the relative sales may have increased faster than the increase in research spending. As a result, the ratio of QREs to gross receipts has been decreasing, effectively limiting the amount of credit available under the Research Tax Credit.