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Nov 1990

Research and experimental expenditures Sec. 174 and credit for increasing research activities Sec. 41. (Internal Revenue Code Sections 174 and 41)

by Foreman, Gerald

    Abstract- Tax deductions and credits for research and development expenditures are outlined in Section 174 and Section 41, respectively, of the Internal Revenue Code. The expenditures that qualify for deductions under Section 174 include in-house expenditures and patent expenditures. Research must meet three criteria before expenditures are eligible for a tax credit under Section 41; research must be conducted to discover technological information, must be helpful in developing a 'new or improved business component of the taxpayer,' and must have a purpose.

What is Sec. 174, Research and Experimental Expenditures?

Under Sec. 174, a taxpayer can elect to deduct research or experimental expenditures that are paid or incurred during the taxable year in connection with his or her trade or business. A taxpayer can also elect to amortize these research expenses ratably over a period of not less than 60 months, beginning with the month in which he or she first realizes benefits from such expenditures.

Research and development expenditures include all experimental and laboratory costs incidental to the development of an experimental or pilot model, plant process, product, formula, invention or similar property, or the improvement of an already existing property of like kind Regs. and Prop. Regs. Sec. 1.174-2(a)(1). The costs of developing computer software are considered Sec. 174 expenditures Rev. Proc. 69-21. Computer software includes all programs used to direct a computer to perform a task or set of tasks and the documentation to describe and maintain these programs.

Types of Research-Related Expenditures Qualifying for the Sec. 174 Research and Experimental Expenditures Deduction

Expenditures qualifying include the following:

1. In-house expenditures. This includes direct and indirect research costs. Depreciable property used in research is not deductible under Sec. 174, but is deductible under the regular depreciation, ACRS and MACRS provisions.

2. Costs of obtaining a patent. The regulation excludes the costs of acquiring someone else's patent.

3. Costs of research carried on in the taxpayer's behalf by another person or organization. This includes expenditures for depreciable property constructed by another in the taxpayer's behalf. Note that these expenditures are deductible currently by the taxpayer, whereas there would not be a current write-off if the taxpayer constructed the same depreciable property her or himself.

Activities Eligible For the Sec. 41 Tax Credit

Under Sec. 41(d)(4)(F), expenditures for research conducted outside of the U.S. are not eligible for the credit.

Research must meet three tests to be eligible for the research and development credit under the TRA 86, Sec. 41(d)(1)(B) and (C). The research must be performed for the purpose of discovering information "which is technological in nature." The application of the research must be "intended to be useful in the development of a new or improved business component of the taxpayer." Lastly, "substantially all" of the activities must "constitute elements of a process of experimentation for a purpose."

TRA 86 does not require that an improvement be "significant" to qualify, and excludes "routine" or "periodic" improvements that otherwise meet the requirements for qualified research. Under TRA 86, research relating to style, taste, cosmetic, or seasonal design factors is generally ineligible for the credit regardless of whether such research relates to product improvements or to new products.

Treatment of Computer Software--Sec. 41

TRA 86 specifies that computer software is a "business component" Sec. 41(d)(2) (B). Therefore, software development activities will generally be eligible for the credit if they meet the same tests applicable to other product or process development activities. TRA 86 included a specific exception for "internal use" software. The specifics of the exception are software used in qualified research; software developed for use in a plant process; and software developed as part of an integrated hardware-software product. Taxpayers should take an aggressive position with their development of internal use software if any of the above tests can be met.

Costs of Obtaining a Patent and Acquiring a Patented Product

It is not clear if patent perfection costs constitute eligible wage, supply, or leasing costs for the performance of qualified research services, that is, actual conduct of research, direct supervision and direct support.

Qualified Research Expenses For Purposes of the Sec. 41 Tax Credit

Qualified research expenses are defined under Sec. 41(b)(1) as the sum of individual research expenses and contract research expenses. In-house research expenses are defined under Sec. 41(b)(2) as: wages paid to an employee engaging in qualified research or engaging in the direct supervision or direct support of qualified research activities, amounts paid for supplies (any tangible property other than land or depreciable property) used in the conduct of qualified research, and amounts paid to another person for the right to use computers (after 1985) in the conduct of qualified research.

Contract research expenses are defined under Sec. 41(b)(3) as 65% of "any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research."

Under the 1983 proposed regulations, contract research expense for Sec. 41 credit purposes includes payments to another person for the performance on behalf of the taxpayer of 1) qualified research as defined in Prop. Regs. Sec. 1.44 F-4 or 2) services that would constitute qualified services within the meaning of Sec. 41(b) (2)(B) and Prop. Regs. Sec. 1.44 F-2(c).

Sec. 41 Credit Computational Rules

For 1989, the amount of the Sec. 41 tax credit is equal to 20% of the excess, if any, of 1) qualified research expenses for the taxable year over 2) the base period research expenses--Sec. 41(a). This computation is made on an aggregated basis for all taxpayers who are part of the same controlled group. The amount of credit is then allocated to specific group members.

Base Period Research Expenses--1989

Base period research expenses are the average of Sec. 41(b) qualified research expenses for each year of the three base period years immediately preceding the taxable year for which the credit determination (year) is being made Sec. 41(c)(2)(A). In any particular determination year, base period research expenses cannot be less than 50% of the qualified research expenses for the determination year. The credit cannot be obtained on increases in Sec. 41 expenditures in the determination year to the extent this incremental increase exceeds 100% of the qualified research expenses over the three base period years. For short determination or base period years, see Prop. Regs. Sec. 1.44 F- 3(d)(1), 1.44 F-3(d)(3), and 1.44 F-3(b)(1).

Allocation of Credit Through Pass-through Entities

S Corporation. The amount of credit computed for the corporation for any taxable year is apportioned pro rata, on a per share, per-day basis, among the shareholders of the corporation during the corporation's taxable year Secs. 1366 and 1377.

Estate or Trust. The amount of credit computed for the taxable year is apportioned between the estate or trust and the beneficiaries on the basis of the income of the estate or trust allocable to each Prop. Reg. Sec. 1.44 F-7(a)(2).

Partnerships. The credit is computed at the partnership level and is apportioned among the partners during the taxable year in accordance with Sec. 704 and applicable regulations Prop. Regs. Sec. 1.44 F-7(a) (3)(i).

Credit Carrybacks and Carryovers. The credit can be carried back to each of the three taxable years preceding the unused credit year and forward to each of the 15 years following the unused credit year Sec. 39(a). For years after 1985, the carryback and carryforward apply under the general business credit provisions Sec. 39(d)(3).

Basic Research Credit

Sec. 41(a)(2), as modified by the TRA 86, provides a 20% credit for the incremental payments made to qualified organizations for basic research. Separate formulas must be used for the determination of "basic research payments" and "qualified research expenses," and for the computation of their respective incremental amounts. The qualified research credit and the basic research credit should be considered as distinct.

Basic research is "any original investigation for the advancement of scientific knowledge not having a specific commercial objective" Sec. 41(e)(7)(A).

Computational of the Basic Research Credit

The basic research credit is given for the excess of research payments or expenses for the relevant taxable year over a base period amount. A basic research payment is defined in Sec. 41(e)(2)(A) as any cash payment made during a taxable year by a corporation to a qualified organization pursuant to a written agreement. The credit is only available to corporations. The term "corporations" does not include S corporations, personal holding companies under Sec. 542, or personal service organizations under Sec. 414(m)(3) Sec.41(e) (7)(E). Cash payments are restricted to amounts paid, not amounts accrued.

Qualified Organization Base Period Amount

The qualified organization base period amount is the sum of the "minimum basic research amount" and the "maintenance-of-effort amount" Secs. 41(e)(4)(A), 41(e) (7)(B), and 41(e)(4)(B).

Relationship Between the Basic and Qualified Research Provisions

If payments do not qualify under the basic research rules, the taxpayer should determine if such payments qualify as contract research expenses.

It is to a taxpayer's advantage to treat payments as basic research payments rather than contract research expenses, because only 65% of the contract research payments are eligible for the credit. For an organization that has been in existence for at least one year prior to its taxable year beginning in 1983, there is no minimum 50% base period requirement under the basic research rules. The rules under the general qualified research credit require that the base period amount be at least 50% of the qualified expenses.

OBRA 89 Extends Credit

OBRA 89 extends the credit through 1990. However, for any tax year that begins before October 1, 1990, and ends after September 30, 1990, a special rule limits the expenses to which the credit applies to the portion of the total of such expenses for the year that the days in the tax year before October 1, 1990, bear to the total days in that year. For a 1990 calendar tax year, only 273/365 of the total qualified research expenses for the year would qualify for purposes of computing the credit. The "base amount" for determining whether there has been an increase in such expenditures is similarly prorated.

The university basic research credit component of the credit for increasing research activities is extended to amounts paid or incurred before 1991. Expenses through December 31, 1990, should qualify for this credit.

Effective for tax years beginning after December 31, 1989 there is a change in the manner of computing the credit for increasing qualified research expenditures. The credit is 20% of the excess of a taxpayer's qualified research expenditures for the current tax year over its "base amount" for that year. "Base amount" is the product of 1) the taxpayer's "fixed-base" percentage and 2) the average annual gross receipts of the taxpayer for the four years preceding the credit year. The base amount may not be less than 50% of the qualified research expenses for the credit year Sec. 7110 amending Code Sec. 28(b)(1)(D), 41(a), (b), (c), (e), (f), and (h), 196(d) and 280C(c) and adding Sec. 174(e).

Effective for tax years beginning after December 31, 1988, the election not to claim the credit for increasing research activities for a tax year is repealed. This election enabled taxpayers to avoid the required reduction of the Sec. 174 deduction by 50% of the credit. A new election permits a taxpayer to avoid reducing the deduction (under the new rules by 100% of the credit) by electing to reduce its Sec. 41 research credit by the product of 1) 50% of the credit and 2) maximum corporate tax rate, as imposed by Sec. 11(b)(1) Act Sec. 7814(e)(2)(A)- (E), repealing Sec. 41(h) and redesignating Sec. 41(i) as Sec. 41(h), and amending Sec. 196(c)(4), 280C(c) and 6501(n).

Gerald Foreman, CPA, Own Account

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