New R&D regulations provide opportunities and more flexibility for businesses

Businesses looking to utilize the research and development (R&D) credit recently got some welcome news.

On June 2, 2014, the IRS published final and temporary regulations regarding a method for R&D credit calculation. Specifically, the taxpayer-favorable regulations remove previous restrictions that prohibited taxpayers from making an alternative simplified credit (ASC) election for a tax year on an amended return, allowing businesses to now more easily maximize R&D credits in open tax years.

Background

Currently, the Internal Revenue Code provides two methods of computing the credit for increasing research activities (the R&D credit): the regular credit method and the ASC method. Each method offers its own advantages and disadvantages, and taxpayers may elect the calculation method that results in the greatest benefit on an annual basis.

Under the regular credit method, the credit is equal to 20 percent of qualified research expenses (QREs) in the current credit year that exceed the “base amount.” The base amount is computed by multiplying the fixed-base percentage (FBP) by average annual gross receipts for the preceding four years. The FBP is determined by the ratio of aggregate QREs incurred during tax years 1984-1988 to aggregate gross receipts for the same time period. Companies not in existence during the 1984-1988 time period are allowed to compute the credit under separate “start-up” rules.

The ASC method, as the name suggests, is a less complicated method for computing the credit. It involves a comparison of current credit-year QREs against QREs incurred in the prior three years. The credit under ASC is equal to 14 percent of the amount by which current credit-year QREs exceed 50 percent of the taxpayer’s average QREs for the prior three tax years.

Under the previous regulations, businesses could only make an ASC election on a timely filed (including extensions) original return. Accordingly, those seeking to amend prior-year tax returns to claim R&D credits were generally required to use the regular credit method unless a protective ASC election had been made on the originally filed tax return. While the regular credit method provides favorable results for certain taxpayers, companies who have not previously claimed the R&D credit may find computing a historical base amount, potentially back to the 1984-1988 time period, time-consuming and difficult. However, some businesses may be denied an R&D credit under the regular credit method due to a high FBP and/or rapidly increasing gross receipts relative to QREs.

Summary of the new regulations

The final regulations remove the restriction that prohibits a business from making an ASC election for a tax year on an amended return, providing opportunities to maximize R&D credits in open tax years without requiring the potentially tedious information-gathering process under the regular credit method. Further, the new rules provide businesses with more time to properly evaluate and consider, on an annual basis, the method that yields the greater benefit.

In addition to the aforementioned amendment to the ASC election rules, the new regulations also provide supplementary guidance concerning issues related to the election of the ASC. Businesses that previously claimed, on an original or amended return, an R&D credit under the regular credit method may not make an ASC election for that tax year on an amended return. And those that are part of a controlled group are not allowed to make an ASC election on an amended return if any member of the controlled group previously claimed the R&D credit for the tax year using the regular credit method (on an original or amended return).

The new regulations are effective June 2, 2014, and expire June 2, 2017. Businesses may rely on the new rules to make an ASC election on amended returns for tax years ending prior to June 2, 2014, (inclusive) as long as the statute of limitations has not expired.

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