Research Tax Credit
Contract research expenditures are first amortized in the year that benefits were first realized, 26 USC §174(b)(1). For a self-employed person, "wages" is defined as the amount of earned income, 26 USC § 41(b)(2)(D); 26 USC § 401(C).
Generally, contract research results in a tax credit of 65% of the qualified research expenses,26 USC §41(b)(3)(a). Tax credit is 100% for contract research paid to an eligible small business firm for energy research, 26 USC§ 41(b)(3)(D), but for the 100% credit, the small business cannot be owned 50% or more by the taxpayer, 26 USC §41(b)(3)(D)(ii). A taxpayer is deemed to have constructive ownership of stock owned by a spouse or child, 25 USC §318(a)(1). The contract research may focus on resolution of uncertainties in the field such as development and refinement of new software.
The research results are intended to result in new software to increase revenue for the existing consulting business. For a pass-thorough tax credit from partnership or other partially-owned entity, allowed credit is limited to allocated income from the partnership, corporation, or other partially-owned entity, 26 USC§ 41(g), 26 CFR §§1.41-7(b); 1.53.-3. For applicable facts, section 41(g) limits do not apply; there is no pass-through of tax credit from a partially-owned entity. Thus, the allowed tax credit is not affected by section 41(g) limits, as shown on Form 3800, line 19a.
For research costs that are expensed, the deduction for R&D expense is reduced by 100% of the research tax credit, 26 USC §280C(c)(1). The amount capitalized is reduced by credit allowable, 26 USC § 280C(c)(2). The reduction in capitalized expenses may be avoided by claiming a reduced tax credit for the year, 26 USC 280C(c)(3).
Research credit and amortization for contract research paid in in prior years is recognized on the year when benefits were first realized. Amortization begins with the month when the taxpayer first realizes benefits from the costs, 26 USC §174(b)(1). Basis for research costs is reduced by the tax credit recognized , 26 USC §280C(c)(2).
Research expenditures recognized are depreciated over 5 years, 26 USC§ 174(b)(1),mid-year convention. Research depreciation/amortization after 12/31/86 with a life of under 10-years is not a tax preference item, due to exemption for material participation, 26 USC§ 56(b)(2)(D); 26 USC §469(h).
Research credit is 20% of the excess of qualified research expenses during the taxable year over the base amount. The base amount is a fixed base percentage times the annual gross receipts for the 4 preceding tax years. The fixed base percentage = (total research expenses 1984-1988) / (total gross receipts 1984-1988). The maximum fixed-base percentage is 16%, 26 USC§ 41(c)(3)(C). The minimum based amount is not less than 50% of the qualified research expenses, 26 USC§ 41(c)(2).
Research which Qualifies for Credit
Qualified research is research which qualifies for tax credits. Qualified research is defined as:
... research … which may be treated as expenses under section 174…which is undertaken for the purpose of discovering information…which is technological …and…intended to be useful in the development of a new or improved business component of the taxpayer, and …substantially all of the activities of which constitute… a process of experimentation…, 26 USC §41(d)(1).
Qualified research expenses include in-house research expenses plus contract research expenses, 26 USC§41(b)(1). In-house research expenses is defined as including wages for qualified services and supplies, 26 USC§ 41(b)(2). For self-employed persons, "wages" is defined as the earned income, 26 USC §441(b)(2)(D); 26 USC §401(C).
"Supplies" is defined as tangible property other than land or property subject to depreciation, 26 USC§ 41(b)(2)(C). For in-house research, use in business includes intent to use research results for future business, 26 USC§41(b)(4). Contract research is defined as amounts paid to any person other than a taxpayer employee, 26 USC§ 41(b)(3).
Prepaid amounts are deductible in the year paid, even if the research is conducted in a later year, 26 USC§ 41(b)(3)(B). For contract research, the qualified expense is 65% of the amount paid, 26 USC§ 41(b)(3)(A). This 65% is increased to 100% for amounts paid to an eligible small business for energy research, 26 USC §41(b)(3)(D). An eligible small business is defined as a business with under 500 employees, and which is owned not over 50% by the taxpayer,26 USC §41(b)(3)(D).
The research credit, 26 USC §41, is for "research which is undertake for the purpose of discovering information which is technological in nature and …is intended to be useful in the development of a new or improved business component of the taxpayer," General Explanation, 1998, Nov. 24, 1998, page 236.
By definition, development of new computer software is technological in nature and requires experimentation for development. The software developed is intended to be useful for improved business operations of the taxpayer. Computer software development costs, for developing new or significantly improved programs, are qualified research costs, General Explanation of the 1981 Act, p. 124. Tax credit is not allowed for research after commercial production, adaptation to customer requirements, duplication or reproduction of existing components, routine data collection, or routine computer software primarily for internal use, 26 USC §41(d)(4)(E). Tax credit is allowed for development of new software for a new or improved business component of the taxpayer, 26 USC §41(d)(4)(E)(i).
Qualifying research expenditures includes the cost of supplies involved in experimental development of computer software for sale. A qualifying development program may be based on computer science technology, using experimental methods and evaluation of alternative approaches.
Qualified research is undertaken to discover technological information intended to be useful for development of a new or improved business component of the taxpayer, 26 USC§41(d)(1). Qualified research includes wages and supplies.
Supplies are defined as any tangible property, other than property of a character subject to depreciation, used in the conduct of qualified research, 26 USC §41(b)(2)(C). Computer software development costs are allowed, Gen. Expl.,1981, p.124; 1986, p. 128-140. Expense must be paid or incurred in carrying on the business at the time that the expenses is paid or incurred, 26 CFR §1.41-2(a), 26 USC §162. Expenses for expansion of an existing business are qualified, but expenses prior to starting a new business are not qualified, 26 CFR§ 1.41-2(b). For in-house expenses qualified research also includes expenses with the principal purpose to use the results for active conduct of taxpayer's future business, 26 USC §41(b)(4).
The deduction for research expenses is reduced by the tax credit amount, 26 USC §280C(c)(2). Thus, the total cost for research expenses, less the tax credit amount, equals the deductible research cost. However, the full amount of the deduction for research expenses is authorized if the tax credit amount is reduced, 26 USC §280(c)(3).
The research tax credit is 20% of the excess over a base amount, 26 USC §41(a). The Base Amount is a percentage of gross receipts for the past four years, but not less than 50% of the current year R&D expense, 26 USC§ 41(c)(1). The percentage of base is calculated for the tax years 1984 through 1988, and this base cannot exceed 16%.
Expense vs. Amortization of Research Costs
The taxpayer has the option to expense research outlays in a single year, 26 USC§174(a). Alternatively, the taxpayer may amortize the expenditures over a period of not less than 60 months, 26 USC §174(b). The amortization deduction begins with the month that the taxpayer first realizes benefits from the costs, 26 USC §174(b)(1).
Software research costs may be deducted over 1 year, 26 USC §174(a), or 36 months, 26 USC §167(f)(1), or 60 months, 26 USC 174(b). Although amortization of research expenditures over less than 10 years is a preference under alternative minimum tax, this preference does not apply for expenditures incurred after 1990 for a taxpayer that materially participates, 26 USC §56(b)(2)(D); 26 USC §469(h). Research costs are expensed or capitalized on a project basis. Commissioner consent for expense or capitalization is not required because research cost treatment is defined in the first year, 26 CRF §1.174-3(b)(1).
Joint owners may elect to deduct all of the cost of section 179 property placed in service in 2018, 26 USC §179(f). Depreciation is 2.564% per year for the 39-year life, a short-term rental is classified as a non-residential building. Employees are deemed engaged in the conduct of their business of employment, 26 CFR §1.179-2(c)(6)(iv).