Increase research credit by excluding certain gross receipts
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Gross receipts from asset sales or exchanges not in the ordinary course of business are excludable from the research tax credit “base amount” calculation, thereby increasing the incremental spending eligible for the research tax credit when using the regular credit method. The federal research credit for “increasing research activity” requires the calculation of a “base amount.” The current tax year’s incremental qualified research spending in excess of the base amount is eligible for the credit. The credit amount is determined by multiplying the incremental qualified research spending by the credit rate.1 Under the regular credit method, the base amount is a function of the interplay between the prior four years of gross receipts and research expenditures. Excluding certain gross receipts can lower the base amount, thereby resulting in a larger increment and, thus, a larger research credit. In order to maximize the research credit, taxpayers need to carefully scrutinize all components of the research credit, specifically analyzing gross receipts as well as research expenditures.
The regulations authorize certain exclusions from the definition of gross receipts, including “receipts from a sale or exchange not in the ordinary course of business.” Excluding these types of receipts when multiplying the fixed-base percentage by the prior four years of gross receipts will decrease the base amount, thereby increasing the amount eligible for the credit. The consistency rule also requires the same treatment (exclusion) when utilizing gross receipts for the base years.2
For example, assume the following facts:
- Current year qualified research expenses of $2 million
- A fixed base percentage of 4 percent
- Average annual gross receipts for the prior four years of $40 million
- $10 million of the $40 million represents receipts from the sale of a division
The unadjusted base amount is $1.6 million (4 percent fixed-base percentage * $40 million in average annual gross receipts), resulting in a net credit of $52,000. By excluding $10 million from gross receipts, the base amount is $1.2 million, resulting in a net credit of $104,000− double the unadjusted result.
As this example shows, taxpayers need to carefully analyze gross receipts as well as qualifying research expenditures in order to maximize the research credit. Typically, taxpayers focus almost exclusively on maximizing qualified research expenditures and overlook performing a rigorous gross receipts analysis, possibly overcalculating the base amount and underclaiming the allowable amount of the research expenditures eligible for the research credit. In this example, in order to obtain the larger research credit of $104,000 without adjusting the gross receipts, the taxpayer would have needed to increase qualified research expenditures by $400,000, or 20 percent.
1 Congress only wanted to reward firms for increasing research activity in excess of what they would normally spend on research–the “base amount” and assumed that companies in private industry establish a research budget as a function of gross receipts. Congress therefore established that a firm’s base amount would change as the firm’s gross receipts changed. Thus, the base amount changes and is updated as gross receipts change. The excess of current-year spending over the base amount is credit eligible.
2 The base years are either 1984 through 1988, assuming the firm had both gross receipts and qualified research expenditures in three of these five years, or actual post-1988 years when the firm had both gross receipts and qualified research expenditures. The relationship between gross receipts and qualified research expenditures in the base years establishes the fixed-base percentage. The fixed-base percentage multiplied by the average gross receipts for the prior four years equates to the base amount. To the extent the current year’s qualified research spending exceeds the base amount, the firm is eligible for the research credit.
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