You CAN Afford Research and Development

By: Tatiana Gilberston
Published August 2007

Because of advances in communication, information processing and transportation technology, today’s economy is much different than our economy of a few decades ago.  These factors, and the lowering of trading barriers, have resulted in a global economy that has introduced hundreds of new competitors to the mix.  This increase in competition is one of the primary reasons that companies focused on sustaining profitability and market share continue to invest significant sums to improve their existing products and processes and/or create new products and processes.  These expenditures are generally classified as research and development (R&D) and in 2006 U.S. R&D spending was $330 billion, making us the largest R&D spenders in the world.      

For income tax purposes, these expenses may be deducted in the tax year in which they were paid and/or incurred, or amortized over a period of not less than 5 years. In addition to these deductions, Congress has encouraged investments in R&D by creating an R&D tax credit in 1981. The credit, which was established to address perceived problems in the competitive position held by US companies at that time, was initially expected to be temporary in nature, however it continues to be extended and currently is set to expire on December 31, 2007.

The nature of the activity determines whether a particular expenditure qualifies as R&D expenditure.  Qualifying research means research undertaken for the purpose of "discovering information":

• Which is technological in nature;

• Which tends to be useful in the development of a new or improved business component of the taxpayer; and

• Which constitutes elements of a process of experimentation that relates to new or improved functions, performance and/or reliability or quality.

An example of an activity that you might not ordinarily consider as qualifying would be as follows:

X, a manufacturer, wants to develop a new and more efficient process to manufacture a new widget.  X determines that it requires a specialized type of robotic equipment not commercially available, and X therefore purchases existing robotic equipment for the purpose of modifying it to meet its needs.  X's engineers identify the uncertainty that is technological in nature concerning how to modify the existing robotic equipment to meet its needs.  X develops several alternative designs, and conducts (1) experiments using modeling and simulation to modify the equipment and (2) extensive scientific and laboratory testing of design alternatives.  As a result of this process, X develops a design for the equipment that meets its needs and is able to construct and install the modified equipment in its manufacturing process.  Substantially, all of these activities qualify for the credit.

For most entities, the credit will be equal to 20% of the qualified research expenses above a base amount of such expenses for the year.   This base amount is calculated by multiplying an entity’s fixed-base percentage by the average amount of its gross receipts for the four preceding years.  For example, assume we wish to calculate the R&D credit for 2006 assuming the following amounts:

The total qualified research expenses of $390,000 for years 1-5 are divided by the total gross receipts of $4,200,000 for such years to arrive at a "fixed-base percentage" of 9.29%.  The average annual gross receipts of $925,000 for the 6th year are determined by averaging the annual gross receipts for the preceding 4 years (i.e., $3,700,000 /4).  Therefore, the current year base amount for the entity is $85,932, or 9.29% of $925,000.   In this case, the R&D credit would be $12,814, or 20% of $64,068 (which amount is calculated as $150,000 of current year qualified research expenses less the base amount of $85,932).  Keep in mind this amount is a dollar-for-dollar tax credit not a tax deduction. 

In those cases in which the base amount is lower than 50% of the current year expenditures, the taxpayer can receive a credit based upon 50% of the current year expenses.

In addition, for tax years ending in 2007, even those taxpayers that do not have revenues may be able to qualify for the credit, as they can elect to use a new "alternative simplified credit." It is calculated as 12% of the excess of qualified research expenses over 50% of the average qualified research expenses for the three tax years proceeding the tax year for which the credit is being determined.  Furthermore, if a taxpayer does not have qualified research expenses in any one of the three preceding tax years, the alternative simplified research credit is simply computed as 6% of the entity’s current year's qualified expenses.

As you can see, thanks to the generosity of our Congress, research and development expenses can be reduced significantly through proper planning and implementation.  Please feel free to contact us is you have any questions or desire additional information about this matter.

Kingery & Crouse, P.A.

About the Author
Tatiana Gilberston is a member of the Tax team at Kingery & Crouse. A graduate of the University of South Florida with an MBA degree, she has previously worked on the Audit team. Tatiana speaks English, Spanish & German fluently. Kingery & Crouse, P.A. is a full service public accounting firm with a staff of 23 dedicated professionals providing tax and accounting services, including audits of SEC companies. You may contact Tatiana at (813) 874-1280 ext #228. Find us on the web @ www.tampacpa.com.