Alternative Incremental Research Credit
Internal Revenue Code (I.R.C.) § 41 provides taxpayers with a tax credit for increasing research activities. The alternative incremental research credit (“AIRC”) was one of the tax credits that make up the research tax credit. The AIRC was phased out for tax years beginning after December 31, 2008. For tax years in which the AIRC was available, it provided taxpayers with a streamlined computation when compared to the regular research tax credit.
Computing the Alternative Incremental Research Credit
For the years that it was available, the AIRC was equal to the percent of the taxpayer’s qualified research expenses (“QREs”) in excess of the taxpayer’s average annual gross receipts for the previous four tax years (“AAGR”). The percentage is equal to:
- 3% of QREs above 1% but less than 1.5% of AAGR
- 4% of QREs above 1.5% but less than 2.0% of AAGR
- 5% of QREs greater than 2% of AAGR
Qualified Research Expenses
Qualified research expenses for the AIRC are the same as those for the regular research tax credit. These expenses can include wage costs, supply costs, contractor costs and certain computer rental expenses that the taxpayer paid or incurred for qualified services in carrying on the taxpayer’s trade or business. The two key terms are “qualified services” and “qualified research.”
The term “qualified services” refers to directly engaging in qualified research or engaging in the direct supervision or direct support of research activities that constitute qualified research. The term “direct supervision” means the immediate supervision of qualified research and the term “direct support” means services in the direct support of either persons engaging in actual conduct of qualified research or persons who are directly supervising persons engaging in the actual conduct of qualified research.
The term “qualified research” is also the same for purposes of the AIRC and the regular research tax credit. Qualified research includes activities:
- with respect to which expenditures may be treated as expenses under I.R.C. § 174;
- which is undertaken for the purpose of discovering information that is technological in nature and the application of which is 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 elements of a process of experimentation for the purpose of achieving a new or improved function, performance, or reliability or quality.
To be eligible for expense treatment pursuant to I.R.C. § 174, the expenses must be related to developing a concept, plan, or design for a product; be paid or incurred in connection with a trade or business; and be reasonable under the circumstances. Expenses for the acquisition or improvement of land or depreciable property are not eligible for expense treatment pursuant to I.R.C. § 174.
Research is undertaken for the purpose of discovering information that is “technological in nature” if a process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A “process of experimentation” is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities. Research is not conducted for a qualified purpose if it relates to style, taste, cosmetic, or seasonal design factors.
The term “business component” refers to any product, process, computer software, technique, formula, or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer. A business component, such as a product, may consist of several subcomponents. Where the product does not meet the conditions of qualified research, it may be necessary to consider the subcomponents as separate business components to determine if the subcomponents meet the conditions of qualified research.
Section 41(d)(4) says that the following activities are not considered to be research:
- research conducted after the beginning of commercial production of the business component;
- research related to the adaptation of an existing business component to a particular customer’s requirement or need;
- research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component;
- surveys or studies, including efficiency surveys; activities relating to management functions or techniques; market research, testing, or development (including advertising or promotions); routine data collection; and routine or ordinary testing or inspection for quality control;
- research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States;
- research in the social sciences, arts, or humanities;
- research to the extent funded by any grant, contract, or otherwise by another person or governmental entity; or
- research related to certain types of software and computer lease payments.
Reporting the Research Tax Credit
The taxpayer must elect to take the AIRC in lieu of the regular research tax credit on an original and timely filed tax return. The AIRC is reported on Form 6765, which is to be submitted with the taxpayer’s tax return. Taxpayers often make this election where they will not be able to immediately reap the full benefits of the regular research tax credit, such as when the taxpayer has an alternative minimum tax issue or a situation involving a net operating loss.
If the taxpayer elects to file an alternative incremental research credit rather than the regular research tax credit, it generally must continue to do so in future tax years unless it obtains the government’s permission to claim the regular research tax credit. The taxpayer can request government permission by submitting a private letter ruling request to the IRS.