When reviewing the current year method used to calculate your research and development (R&D) tax credit, consider both of the methods available and choose the one that yields the best results.
There are two methods available for calculating the R&D tax credit -- the regular research credit (RRC) method and the alternative simplified credit (ASC) method. This is a year by year election.
What is the R&D tax credit?
The Research & Development (R&D) tax credit is for businesses of any size that design, develop or improve products, processes, techniques, formulas, or software. It is calculated on the basis of increases in research activities and expenditures, and is intended to reward, in general, those that pursue innovation with continually increasing investments.
Where is the R&D credit reported?
The credit is reported on IRS Form 6765 and is included with your income tax return.
How do you calculate the R&D credit?
There are two standard methods of calculating the R&D tax credit -- the regular research credit (RRC) method and the alternative simplified credit (ASC) method.
The RRC is an incremental credit that equals 20% of a taxpayer’s current-year qualified research expenses (QREs) that exceed a base amount, which is determined by applying the taxpayer’s historical percentage of gross receipts spent on QREs to the four most recent years’ average gross receipts.
The ASC equals 14% of the QREs for the taxable year that exceed 50% of the average QREs for the three taxable years preceding the credit determination year. (If the taxpayer has no QREs in any one of the three preceding tax years, the ASC rate equals 6% of the QREs for the credit determination year.)
As the ASC method is the simpler of the two calculations, it often becomes the favored method. However, as the sample below illustrates, it does not always produce the maximum benefit.
RRC Illustration (Startup - First Five Years)
Current-year QREs $125,000
Fixed-base percentage 3%
Multiplied by: Average annual gross receipts previous 4 years $600,000
Equals: Base amount $18,000
Greater of base amount or 50% current QREs $62,500
Excess of current QREs over minimum base amount $62,500
Multiplied by 20% equals credit $12,500
ASC Illustration
Current-year QREs $125,000
Less: Average QREs previous three years $100,000 x 50% $50,000
Difference $75,000
Multiplied by 14% equals credit $10,500
In general, the RRC method may be best for taxpayers with low base amounts or for new startups. The ASC method is often better suited for companies that have a high base amount or incomplete records from the base period, or those that have been complicated by mergers and acquisitions. Important to note- There is no one size fits all!
Don’t rely on same as last year
Circumstances can and do change, and both methods should be carefully evaluated annually to determine which of the two yields the best results for your business. Although R&D credits do sometimes have a reputation for adding complexity for taxpayers, the research tax credit remains a valuable source of support to businesses that conduct qualified research and development.
Additionally, a number of states also offer a research credit using their own state formulas and criteria.