2023 Update: Calculating the Federal R&D Credit

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For Los Angeles and Orange County companies engaged in product or process improvement, few other tax benefits reap the substantial tax saving rewards of the Research & Development tax credit. Available at the federal level and in most states, including California and Texas, the R&D tax credit helps to spur investments in innovation for startups, small businesses, and corporations alike. Many understand that the credit amount is often significant, creating a compelling reason to examine the opportunity. However, numerous companies are still missing the valuable tax savings available due to common misconceptions about eligibility thinking they do not qualify or won’t benefit from the R&D tax credit.

Knowing the credit is valuable is not the same as knowing how to calculate the potential savings opportunity. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details of the federal R&D Credit calculations and the requirements that must be met under §41(c) of the Internal Revenue Code (IRC) below.

Federal R&D Credit Overview: The IRS offers two methods to determine credit value, including the Regular Research Credit and Alternative Simplified Credit (ASC). Under each computation method, companies must establish a historical base amount that must be exceeded to claim any current year credits. Both methods require a look back period comprised of multiple years to establish a historical base amount that is then compared to the research expenses and activities in the current taxable year.

In general, one could use different types of data for the multi-year look-back to calculate the base amount, such as:

  • Federal Form Box 1 W-2 Wages
  • Employee Job Titles
  • General Ledgers
  • Financial Statements
  • Tax Returns
JLKR Insight

One woman and three men are discussing research and development details around a table.Consistency is Key: In determining the base amount, it is important to make sure you are including similar types of research expenses in the base years as the current year. For instance, if you are taking employee wages and supply and contractor costs for a tax year, then you need to include any similar type of expenses for the look back years. You can still include all the expenses in the current year’s calculations if you did not have similar types of costs in the base period. The key is that you need to be consistent in your analysis of research activities and expenses year to year. For example, if you include certain activities for employees for one year, then the same types of activities must be evaluated for the base years. In addition, prior year inclusions or exclusions do not limit what you can claim in the current tax year. If you discover additional research costs that you had not previously claimed, you can still include them for the current year so long as you factor them in the lookback period for the purposes of the calculation.

How Do I Calculate the Federal Regular Research Credit?

The Regular Research Credit allows for 20 percent of current year (CY) qualified research expenses (QREs) greater than a base amount, which is the greater of 50 percent of current year research costs or a product of a fixed-base percentage (FB%) and the average gross receipts (AGR) of the prior four years. These steps are broken out below.

Step One: Calculate CY QREs.

Step Two: Determine the base period that applies to your business and calculate the Base Amount, including the QREs for the look back years.

The relevant base period is the greater amount of the following:

  • Option One: FB% multiplied by the AGR of the four previous tax years
  • Option Two: 50% of the CY QREs

This means if 50% of the CY QREs is 250,000 and the result under Option One is 400,000; the Base Amount would be 400,000.

Calculating the FB%:

There are two ways to calculate the FB%, commonly referred to as 1980s or startup that depends on when your business first started research activities and had gross receipts. For instance, if your business was incorporated in 2000, but you did not have R&D expenses until 2008, the first year for determining the base would be 2008. The maximum FB is also capped at 16 percent. This means that if the calculations for the tax year result in a FB% of 30 percent, you would be allowed to use 16 percent to determine the base amount.

The 1980s Methodology: If your business had gross receipts and QREs for at least three years between 1984 and 1989, then you would fall under the 1980s method and the FB% would be determined by taking the aggregate of QREs over the gross receipts for the same years within this period.

The Startup Methodology: If you do not meet the requirements of a 1980s base, then you would use the guidance set forth in IRC §41(c)(3)(B) to determine the FB% under the startup method. Under this approach, the first year is 1994 if you had QREs prior to 1994; otherwise, it is the first year your business had QREs. Determining the FB% hinges on which year your business started ranging from year one to eleven. After year eleven, you are locked into the FB% for future years. In general, the FB% under this method is computed by taking a specified percentage of the total of the aggregate QREs over the gross receipts for the same years. To determine the FB% for year 6 for example, you would take 1/6th of the aggregate QREs over gross receipts for the preceding two years. The exception is that for years one through five, the fixed-base percentage is set at 3 percent.

Step Three: Calculate the gross Regular Credit by multiplying 20% against the CY QREs divided by the Base Amount.

How Do I Calculate the Federal Credit Under the ASC Method?

The ASC method produces a smaller R&D credit rate compared to the Regular Credit but allows more companies to participate by substantially reducing the difficulty of calculating the base amount as the look back period is the three years preceding the current tax year. In addition, if you do not have QREs for all three prior years, you can still calculate the credit by taking six percent of the CY QREs. The ASC computation method steps are detailed out below:

Step One: Determine the QREs for the three prior tax years.

Step Two: Total the QREs from the three prior tax years and divide this amount by three.

Step Three: Take one-half of the average prior three-year QREs to determine the Base Amount.

Step Four: Reduce the CY QREs by the Base Amount.

Step Five: Multiply the remainder by 14 percent to calculate the gross credit amount.

Which Calculation Method Should I Use?

Deciding which calculation method to use depends on the circumstances. All else being equal, there are a couple of scenarios where it might make sense to use one method over the other. For example, if QREs decline significantly, the alternative method may be more appropriate. However, if the traditional method is available, it is recommended to figure the calculation both ways to see which produces the most benefit.

Should I Elect 280c?

Consider electing 280c to reduce the gross credit amount. For tax years beginning after 12/31/17, this is currently set at 79 percent. This means that you can reduce the gross credit amount by 21 percent. Your tax professional will be able to do an analysis based on your tax situation to determine which scenario will benefit you more. With current requirements for amortizing research expenses, it is very important to do an analysis of the benefits with and without the election.

JLKR Insight – 280c Protective Elections: If you think you may amend a tax return in the future to claim the R&D tax credit, consider filing protection elections on originally filed tax return. This means that if you amend to claim the R&D tax credit, you will be able to avoid adding the credit amount back into taxable income by automatically reducing the gross credit. You are able to go back three years to claim a R&D refund but you will need to provide a little more information with an amended versus an originally filed return due to new requirements.

What Do I Include With My Amended Return?

Starting in tax years after 12/31/21, taxpayers claiming a refund for eligible research expenses have a new process to follow. The five pieces of essential information, which must be submitted along with the tax return consists of:

  • Identifying all the business components for which a claim is being made.
  • For each business component, identifying all research activities performed.
  • Name the individuals or the individual’s job title/position who performed each research activity.
  • List the information that each person or grouping of individuals in the same position sought to discover.
  • Provide the total qualified expenses for employee wages, supplies, and any third-party contracts. This can be done by using Form 6765.

For personal returns, it may be beneficial to include a statement that describes the purpose for the amendment and reconciles the amount claimed with amended K-1. It may also be helpful to include copies of Form 6765 and amended K-1 with the statement. You can also submit a report or documentation so long as each of the five requirements is clearly flagged and indicated on the relevant pages.

We’re Here to Help:

Calculating the Research & Development tax credit is a complex process that most often requires the assistance of a specialized tax consultant. The details of each calculation method illustrate just how challenging the process can be. If you have questions about the credit or calculation methods or are interested in finding out if your organization qualifies for these credits, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.