Print this issue
 View as PDF
Send us your comments

Vol. 4 Issue 7

Many businesses incur significant costs for researching new technologies or developing new products. Both established companies and start-up ventures can realize significant tax savings, which can help offset the rising cost of research and development.

The Internal Revenue Service allows companies to take a credit directly against their regular income tax for qualified research expenditures. The credit is calculated as 20 percent of qualified research expenditures in excess of a base amount.

The base amount is a fixed percentage multiplied by the company's average revenue for the last four years. By calculating the credit in excess of a base amount, the IRS is promoting and rewarding businesses for increased research and development efforts, not for maintaining the same level of research activities from year to year. An alternative credit calculation is available that generally benefits taxpayers when sales are increasing at a faster rate than are their research expenditures.

Qualified research expenditures are also allowed to be deducted by the taxpayer either as a current period expense or as a capitalized cost to be written off over a period of not less than 60 months. However, there is an adjustment made to reduce the amounts expensed or capitalized by the credit calculated for the year. As an example, if the total qualified research expenditures are $1,000, and the base amount is $400, then the credit would be $120 ($1,000-$400=$600 X 20 percent = $120). In addition to the $120 direct offset against tax, the taxpayer would be able to deduct $880 as an expense on the tax return ($1,000 - $120 = $880).

Qualified expenditures must be incurred for carrying on an existing trade or business and must be experimental in nature (i.e.: developing a pilot model, process, formula or invention). The research must be related to physical sciences, biological sciences, engineering or computer science. The research should be related to developing a new or improved product, process, software, technique, formula or invention, whether the taxpayer is using it in the business or for license, sale or lease to others.

Costs incurred for quality control testing, acquiring a patent from others, advertising, consumer studies and other similar expenses do not qualify. Payments to acquire property or equipment do not qualify for the credit; however, the depreciation of these items is considered a qualified expenditure.

The costs for developing new or significantly improved computer software programs or routines qualify for the credit. Adapting or modifying previous programs would not qualify. The cost of software developed internally qualifies for the credit as long as it is for a qualified research or production process. However, software developed for internal administrative functions does not qualify

The type of expenditures that qualify for the credit include wages for employees involved in research activities, including their income from non-statutory stock options. The employees may include supervisory and support personnel as long as the majority of their time is spent in the department involved in the research process. Other qualified expenditures include supplies used in the research process, payments to others for the use of computer time and 65 percent of the costs paid to contractors for research activities (75 percent if the payments are to certain research consortia).

C-corporations may use the credits to offset the current year tax. For Partnerships, Limited Liability Companies (LLCs) and S-corporations, the credits flow through to the entity's owners and may be used to offset their regular income tax to the extent that the tax savings do not exceed the tax created by the entity's income for the year. Any unused amounts may be carried forward to offset future years' taxes created by the entity. Generally, the unused credits may be carried forward for 20 years.

In an effort to improve the budget, the Tax Relief Extension Act of 1999 created two "suspension periods." Credits calculated after July 1, 1999 cannot be taken on the tax return to reduce tax for each of the two suspension periods. Instead, the taxpayer must wait until after the suspension period and file an amended tax return to reflect the credit and use the new overpayment as a refund or apply it to future tax years. The full credit is allowed; however, the timing of receiving the benefit for the credit is delayed until future years.

The two suspension periods are July 1, 1999 to Sept. 30, 2000 and Oct. 1 2000 to Sept. 30, 2001. For example, a calendar year taxpayer earned a credit during 1999. The credit could not be used to offset tax on the 1999 income tax return. After Sept. 30, 2000 the taxpayer could amend the 1999 income tax return to reflect the credit and get a refund of tax. The time limit for amending tax returns is one year from the end of each suspension period.