Don’t Leave R&D Tax Credit Benefits on the Table

With 2024 barreling forward and the passage of critical pro-business legislation at an impasse in the Senate, it is important that taxpayers taking advantage of the Credit for Increasing Researching Activities (the “R&D Tax Credit”) be cognizant of the interplay between the required capitalization and amortization of research and experimental expenses under Internal Revenue Code (“IRC”) Section 174 and the decision whether or not to elect a reduced R&D tax credit under Section 280C of the IRC.

Historically, many taxpayers elected to take a reduced R&D tax credit in order to remove the requirement to add the credit quantified back to federal taxable income (“FTI”) when a gross R&D tax credit is claimed. The net credit under 280C is determined by reducing the gross R&D tax credit by the federal tax rate of 21%. The primary motivation for doing so was to reduce the starting point for state taxable income calculations, given that FTI is the starting point for state taxable income in many states.

The landscape has changed

The passage of the Tax Cuts and Jobs Act changed the decision-making process around taking the gross vs. net R&D tax credit by revising 280C such that the previously required addback of the gross credit to FTI is only relevant in cases where the gross credit quantified exceeds the deduction allowed for the IRC §41 qualified research expenses (“QREs”) to which the credit relates.

The amount of the deduction is determined through the required capitalization and amortization of research and experimental expenses under IRC §174, the amortization of which is determined utilizing a five-year period with a midpoint convention applying. Note that by definition all QREs are IRC §174 expenses, but that for purposes of determining any addback it is the QRE component of IRC §174 expenses that controls.

The verbosity of the rules outlined above can be boiled down to a simple rule of thumb for taxpayers. If the ratio of the gross R&D tax credit quantified is less than 10% of the current year QREs on which the credit is determined, an election to reduce the credit under 280C should not be made.

Consider the following simplified example:

• IRC §41 qualifying research expenses:   $2,250,000
• Gross R&D tax credit calculated:            $200,000

In this example, because the ratio of the gross R&D tax credit claimed of $200,000 to the total QREs of $2,250,000 is less than 10%, no addback to FTI is required. With no addback in play, the gross credit should be claimed by the taxpayer.

Practical Takeaways

For the vast majority of taxpayers, the facts will play out similar to the above example and the election to reduce the R&D tax credit under 280C will not be warranted. There are isolated cases where dramatic increases in current year R&D spend may result in credits that exceed 10% of current year QREs. Regardless of the facts and circumstances, taxpayers should bear in mind the rules outlined above in seeking to maximize their return on investment in research and development activity.

Related: Tax Credits and Incentives

Smith + Howard: Expert Guidance to Maximize Your R&D Tax Credits

It is important to work with an experienced tax advisor to ensure you are maximizing credit opportunities while complying with tax law.  The specialty tax team at Smith + Howard can advise and work closely with you and your team to maximize the R&D credit savings available to your company.

Please contact Brad Pittman at [email protected] or complete the brief form.