by Valerie Fedie and Chris Blaylock

Businesses have been eligible for a federal tax credit on increases in qualified research spending since 1981.  Over the past 25 years, there have been a number of changes in how the credit is calculated and which activities qualify for the credit.  In addition, the credit expired and was re-enacted 11 times.   

On December 20, 2006, The Tax Relief and Healthcare Act of 2006 (“2006 Act”) was signed into law.  The 2006 Act retroactively extends the credit for the 2006 and 2007 calendar years.  In addition, it introduces a valuable new calculation method which may make it easier for companies to qualify for the credit. 

Under prior law, taxpayers were allowed to use either of two calculation methods:  (1) the regular credit or (2) the incremental credit (AIRC). 

Regular credit

Under the regular credit calculation method, a taxpayer had to first determine the base amount.  To calculate this amount, the taxpayer multiplied the base period percentage by the taxpayer’s average annual gross receipts for the prior four years.

If the taxpayer was in business during the 1984 through 1988 tax years and had qualified research expenditures and gross receipts for at least three of those years, this five-year time period was used to determine the base period percentage.  If they did not meet this requirement (i.e., have both gross receipts and qualified research expenditures during each of at least three tax years beginning after 1983 and before 1989), then the base period percentage was 3% for the first five years and then an increasing percentage in years 6 through 10.

For the 11th and later tax years, the base period percentage is its actual ratio for any five tax years selected by the taxpayer from its 5th through 10th tax years.  However, in all events, the base period percentage cannot exceed a maximum of 16%.

The taxpayer then was eligible to claim a credit of 20% of the lesser of the current year qualifying research expenditures in excess of the base amount or one-half of the total qualifying research expenditures. 

Incremental credit (AIRC)

Under the AIRC, a tiered approach was used.  Companies were eligible to claim the credit when their qualifying research expenditures exceed 1% of their average annual gross receipts for the prior four years.  However, the maximum credit under this method was 3.75%.

Typically, this method was used when the base period percentage could not be determined or the base amount was too high so the taxpayer does not have a sufficient increase in qualified expenditures to qualify under the first method.

Once the AIRC method is elected, taxpayers must continue to use the method unless they receive permission from the IRS to change. 

The 2006 Act retains the same calculation methods for both the regular credit and the AIRC.  Moreover, under the AIRC, the maximum tax rate has been increased to 5%.

Simplified credit

More importantly, the 2006 Act added a third calculation method for tax years ending after December 31, 2006, called the alternative simplified credit (“simplified credit”).

By using the new simplified credit calculation method, companies now will be able to claim a credit equal to 12% of qualifying research expenditures in excess of 50% of the average qualifying research expenditures for the three tax years preceding the tax year for which the credit is being determined.

If a company has no qualifying research expenditures in any one of the three previous tax years, a credit of 6% of the current year’s qualified research expenditures may be claimed. It is important to note that, in this case, the credit is based on 100% of the current year’s qualifying research expenditures and not on an increase in qualifying research expenditures.

If a company elects to use the alternative simplified credit, it must continue to use this method until permission is received from the IRS to change methods.

Example 1:

ABC Co. incurs $500,000, $700,000, $600,000, and $800,000 of qualified research expenditures in its 2004 – 2007 tax years, respectively.  A research credit of $60,000 may be claimed by ABC Co. on its 2007 tax return calculated as follows:  12% x [$800,000 – (50% x (($500,000 + $700,000 + $600,000)/3))= $60,000. 

Example 2: 

XYZ Co. sporadically develops new products and incurs $1,000,000 of qualified research expenditures in its 2007 tax year.  XYZ Co., incurred no qualified research expenditures in its 2004-2006 tax years. Since XYZ Co. does not have any qualifying research expenditures in any one of the three previous tax years, its research credit is limited to 6% of its current year qualified research expenditures, or $60,000, calculated as follows:  6% x $1,000,000. 

Which companies will benefit from the new simplified method?

Companies whose own circumstances match up to any of the following five situations will benefit from the new calculation method.

Companies whose qualified research expenditures are low and gross receipts are high. 
Companies whose qualified research expenditures are increasing. 
Companies using the regular credit method that are limited by more than the minimum base amount. 
Companies using the regular credit that do not have documentation supporting their base year calculations (i.e., 1984-1988).
Companies using the AIRC whose credit is limited because their qualified research expenditures do not exceed the 1% of gross receipts needed to claim the AIRC. 

Should all companies elect the alternative simplified credit method?

Companies should continue to calculate all three calculation methods to determine which method will provide the most beneficial credit, not only in 2007 but in future years as well.

Companies will need to forecast their gross receipts and R&E expenditures to ensure the R&E credit is maximized over the long-term because once an election is made to use the new simplified method; it cannot be revoked without first obtaining permission from the IRS.

Under an extremely beneficial provision of the new law, a taxpayer may switch from the AIRC to the new simplified credit without first getting IRS permission as long as the switch is made in the tax year that includes January 1, 2007. 

Which companies can benefit from the R&D credit?

Almost every manufacturer incurs some type of research expenditures that qualifies for the increasing research credit.

Under the regular credit and the AIRC, a threshold based on sales needs to be exceeded before the company qualifies for a research credit.  However, under the new simplified method, all companies with increasing qualified research expenditures will qualify for a credit, regardless of sales.

In addition to manufacturing companies, a large number of other types of companies also qualify for the research credit.  Companies that develop new products, develop prototypes or models, automate processes, develop certain types of highly specialized software, design tools, jigs or fixtures, conduct testing of new equipment and techniques, develop or improve formulas, or develop or improve manufacturing processes may also qualify for the research credit under existing Treasury regulations.

Valerie Fedie, a Wipfli tax manager based in Eau Claire, is an expert in tax consulting issues related to the R&D tax credit. She can be reached at 715.858.6654 or vfedie@wipfli.com.

Chris Blaylock is a senior accountant based in Wipfli’s La Crosse office. Please call Chris at 608.784.7300 or e-mail him at cblaylock@wipfli.com.