Businesses may have more than one option when it comes to calculating the federal research and development (R&D) tax credit. Depending on the circumstances, they may be able to use either the regular research credit (RRC) method or the alternative simplified credit (ASC) method to partially offset investments that improve products, processes, software, formulas, techniques or inventions.
What is the regular research credit calculation (RRC) method for the R&D tax credit?
The RRC method allows for a credit of 20% of a company's current year qualified research expenses (QREs) over a base amount. This approach can be complicated because to calculate the credit, businesses need the average, annual gross R&D receipts over the prior four tax years and if they began operations in the 1980s or prior, they must gather data from some of those years.
What is the alternative simplified credit (ASC) method?
Unlike the RRC method, the ASC method doesn't require gross receipts as a component of the R&D tax credit calculation. Instead, it looks at QREs over the previous three-year period. This allows companies that lack the historical records necessary to document their base amount to determine their eligibility and file for the R&D tax credit. Under certain scenarios, the ASC may even allow businesses that are ineligible under the regular credit method to qualify for the R&D tax credit.
How do you calculate the R&D tax credit using the alternative simplified credit method?
As of 2009, the ASC is defined as 14% of QREs incurred in the current tax year, above 50% of the average QREs in the previous three years. If the taxpayer had no QREs during any of those three prior years, the credit is calculated as 6% of the QREs in the current tax year. Using these guidelines, the four-step simplified calculation process is as follows:
- Identify and calculate the average QREs for the prior three years
- Multiply average QREs for that three year period by 50%
- Subtract half of the three-year average (Step 2) from current year QREs
- Multiply the result of Step 3 by 14%
For example, in Step One, a company has identified the following qualified historical research expenses:
|2020 (Current Year)||$140,000|
The average QRE for the prior three-year period (2017-20109) would be $360,000/3=$120,000.
In Step Two, the company determines half of this amount or $60,000.
In Step Three, the company takes its current year QRE amount of $140,000 and subtracts the $60,000 three-year average for a total of $80,000.
In Step Four, the company calculates its ASC by multiplying $80,000 by 14%, for a credit of $11,200.
ASC Method Summary
|Three-year average QREs (2017-19)||$120,000|
|Half of the three-year average||$60,000|
|Current QRE-three-year average||$80,000|
|Credit: $80,000 x 14%||$11,200|
When should a company choose the ASC vs. the RRC R&D calculation method?
In certain circumstances, such as a decline in R&D spending, companies may no longer qualify for the R&D tax credit using the RRC method. This doesn't mean, however, that they are entirely excluded because the ASC may still be an option.
For example, if a company's R&D efforts become more efficient and, therefore, less costly, it can negatively impact the ratio of its R&D spending relative to its gross receipts. The business may then fail to meet the requirements set in the "base period" under the terms of the law and be ineligible for the credit under the regular method.
Generally, a business should consider both the RRC and ASC options and when either potentially applies, calculate the credit using each methodology to determine which is most beneficial.
How do the RRC and ASC R&D tax credit calculation methods compare?
Compared to the ASC, the RRC R&D tax credit calculation may result in a larger credit under some scenarios, particularly those where the base amount is low. Other optimal circumstances for using this method occur when the business is a startup or its R&D expenditures are relatively recent. Note, however, that the RRC calculation is more complex than the ASC and often requires a great deal of effort to gather the requisite data – a task that some businesses are unable to do.
Now, let's compare our sample ASC calculation from earlier with the RRC method calculation using the additional details below:
|Current Year QREs||$140,000|
|Fixed base percentage||3%|
|Average annual QRE gross receipts over four years||$250,000|
The base amount needed to determine the R&D tax credit is calculated by multiplying the fixed-base percentage by the average gross receipts from the previous four years. This result, in this case, is $7,500.
|Greater of base amount or 50% current QREs||$70,000|
|Excess of current QREs over minimum base amount||$70,000|
|X 20% regular credit Calculation Rate||$14,000|
Based on these figures, the RRC method vs. the ASC qualified tax credit amount would be as follows:
|RRC R&D Tax Credit Calculation||ASC R&D Tax Credit Calculation|
How can ADP help determine R&D tax credit eligibility and filing?
With an unmatched combination of tax credit experience, technology and resources, ADP makes claiming R&D tax credits as simple, streamlined and predictable as possible. We assist CPAs and their clients with financial inquiries and help them strategize the most effective ways to utilize tax credits. In addition, ADP continuously monitors for changes in legislation and compliance requirements at the federal, state and local levels that may affect tax credits.
For our payroll clients, ADP supplies the data and reporting capabilities needed to help calculate tax credits. We also provide proactive compliance insights, as well as ongoing audit support.
The article contains simplified examples for purposes of demonstrating some of the mathematical computations behind the credit. This does not account for impacts that stem from various company, business and tax factors that interplay with the R&D tax credit. Please consult an experienced tax professional to discuss the application of this information to your particular tax situation or to explore potential exceptions to this discussion that may apply.