A recent IRS chief counsel internal memorandum, AM 2008-002 (2/8/08), provides insight relative to electing the reduced credit available under Sec. 280C(c)(3) when claiming a research tax credit. This item considers the reasons taxpayers elect to reduce the research tax credit and the method for making this election.
The Internal Revenue Code affords many benefits to taxpayers who perform research and experimentation (R&E) activities. Such taxpayers may generally deduct R&E expenses under Sec. 174(a)(1) or alternatively may elect to capitalize R&E expenses and amortize them ratably over a period of not less than 60 months under Sec. 174(b)(1). In addition, Sec. 41 offers taxpayers a tax credit for increasing research activities. (Note: Sec. 41 is not permanent and is currently expired. Congress must act or the credit provisions will not apply to expenses incurred after December 31, 2007.) While a particular taxpayer may take advantage of both Secs. 174 and 41, limitations on these benefits are addressed in Sec. 280C.
Sec. 280C(c)(1) requires taxpayers who claim the Sec. 41 credit to reduce their deduction for research expenses allowable under Sec. 174(a)(1) by an amount equal to the credit determined under Sec. 41(a). In similar fashion, Sec. 280C(c)(2) requires taxpayers who elect to capitalize research expenses to reduce the amount chargeable to the capital account for such expenses by the amount that the research credit determined under Sec. 41(a)(1) exceeds the amount allowable as a deduction for research expenses. The legislative history of Sec. 280C(c) indicates that Congress considered the research credit the equivalent of a federal payment to the taxpayer for which it should not receive the benefit of a deduction in addition to the tax credit. Thus, under Sec. 280C(c)(1), corporate taxpayers are required to increase taxable income by the amount of the credit determined under Sec. 41(a) via an adjustment on Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More.
Reduced Credit Election
Taxpayers can avoid reducing the deduction for research expenses or the amount charged to a capital account by making an election under Sec. 280C(c)(3) to take a reduced research credit. The amount of the reduction is equal to the excess of the amount of the credit calculated under Sec. 41 over the credit amount multiplied by the maximum corporate tax rate—i.e., the credit amount is reduced by 35%. The 20% statutory credit rate that generally applies under Sec. 41(a)(1) effectively becomes 13%.
Example: A Corp. has taxable income of $20 million after deducting research expenses of $10 million in 2007 and calculates a Sec. 41 research credit of $1 million. If A makes no election under Sec. 280C(c)(3), it must add back $1 million to taxable income in 2007. A’s tax liability is $6,350,000 ($21 million × 35% – $1 million credit). However, if A elects to take a reduced credit, there is no change to taxable income and A takes a research credit of $650,000 [$1 million – ($1 million × 35%)]. Note that A’s ultimate tax liability is still $6,350,000 ($20 million × 35% – $650,000 credit).
All other factors being equal, a corporation subject to the top corporate tax rate pays the same tax whether or not it makes the election. Why then do taxpayers make the Sec. 280C election? One reason is the impact on state taxes. Since federal taxable income is the starting point for calculating taxable income for most states, adding back the credit amount to taxable income in the absence of the reduced credit election is required for most state income tax returns, but some states do not provide a credit, or at least a credit commensurate with the federal research credit (as the research activities generally must be conducted within the state). By making the Sec. 280C reduced credit election, a taxpayer generally reduces its state taxable income by the amount of the credit. Furthermore, if the taxpayer expects to amend a federal income tax return to modify its research credit amount, making the Sec. 280C election can prevent the need to amend all state income tax returns (except for those states also affected by the revised research credit).
Taxpayers subject to the federal alternative minimum tax (AMT) in the year the credit is generated may choose to elect the reduced research credit because, without the election, the income subject to the AMT is increased, while the corresponding research credit cannot be used currently and becomes a general business credit carryover. There are also other situations in which a taxpayer could not use the research credit currently where avoiding a deduction reduction could be worthwhile.
Are there reasons a taxpayer would not choose the reduced credit election? Although net tax liability is generally the same whether or not the Sec. 280C reduced credit election is made, this is generally not true for a taxpayer whose tax rate is less than the maximum corporate rate. Also, a taxpayer taking a Sec. 199 domestic production activities deduction may find the deduction amount limited by taxable income, in which case the addback to taxable income may result in an increased Sec. 199 deduction.
Making a Valid 280C Election
Sec. 280C(c)(3)(C) specifies that the reduced credit election for a tax year must be made no later than the extended due date of that year’s tax return. The election applies only for the tax year for which it is made and, once made, it is irrevocable for that tax year. Beginning in 2006, taxpayers make the election for a reduced credit by checking the appropriate box on Form 6765, Credit for Increasing Research Activities. For earlier tax years, taxpayers were required to write “Sec. 280C” on the line of the form next to the amount of the calculated reduced credit.
IRS scrutiny of Sec. 280C elections has increased in recent years. In a Large and Mid-Sized Business (LMSB) Directive first issued in 2004, the IRS made clear its position that a Sec. 280C election initially made on an amended return after the return’s timely due date is invalid. The Service instructed examiners to refer practitioners who assist taxpayers in making such late elections and who refuse to correct them to the IRS Office of Professional Responsibility (LMSB Directive, “Amended Returns/Refund Claims Containing Invalid I.R.C. §280C(c)(3) Elections” (7/16/04)).
A June 2005 internal IRS publication, Audit Technique Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) (6/1/05), provided guidance to examiners to the effect that taxpayers cannot make a valid Sec. 280C election without actually claiming a credit on the original timely filed return. The guide indicates that a taxpayer who (1) filed a timely Form 6765 with a credit claim of zero, (2) clearly complied with the directions for electing a reduced credit (i.e., by checking the box), and (3) later filed an amended return showing a reduced credit and no deduction reduction has made an invalid election that the IRS should return to the taxpayer to correct.
More recently, IRS scrutiny of research credit claims has intensified. Research credit claims were designated an LMSB Tier 1 issue in April 2007, virtually guaranteeing that every return with an amended research credit amount would be examined in accordance with certain mandatory examination procedures (LMSB Industry Director Directive #1, LMSB-04-0307-025). Some IRS examiners took the position that even a nominal amount of research credit claimed on the Form 6765 filed with an original, timely filed return, purporting to make a Sec. 280C election, would not validate the election, suggesting that the law requires that the taxpayer must claim at least a reasonable estimate of the credit on the original return.
For many companies, filing an amended return to claim the research credit has been a practical necessity. The complex documentation and calculations required to compute the credit accurately are time consuming and different from those typically needed to compute taxable income. Further, given the frequent expiration and late extensions of the research credit, it has been impractical for many taxpayers to invest in an information-gathering process to support the research credit on a contemporaneous basis. Therefore, filing an amended return with the initial credit amount has been more efficient for many taxpayers than filing a Form 6765 with an estimate and later filing a “trued-up” credit amount. The IRS LMSB position about Sec. 280C elections raised questions about practical tax compliance.
However, internal memorandum AM 2008-002 concluded that the LMSB positions requiring a stated credit amount to make a valid Sec. 280C election were not correct. The memorandum concluded that “a taxpayer should be treated as having made a valid reduced credit election under Sec. 280C(c)(3) if it clearly indicates its intent to claim the reduced credit on its timely filed original return for the taxable year.” Thus, in the IRS chief counsel’s opinion, if a taxpayer files a Form 6765 with an original, timely filed return and properly indicates that it is electing to use the reduced research credit, the taxpayer has properly elected to use the reduced credit, even though Form 6765 does not indicate any credit amount or state a nominal amount.
The memorandum also states that protective elections, where a taxpayer indicates on its originally filed Form 1120, U.S. Corporation Income Tax Return, or on an attached statement that it is reserving the right to make a Sec. 280C election on a future amended return, are not valid. It suggests that any contingency in the taxpayer’s intent to make the Sec. 280C election on the original timely filed return, and to have the election apply only in the event that a research credit is in fact claimed on an amended return or other research credit claim, would render the election invalid.
The IRS has indicated that internal memoranda such as AM 2008-002 are generic, nontaxpayer-specific legal advice issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. As such, the memorandum cannot be relied on or cited as precedent in a dispute over a valid Sec. 280C election.
However, AM 2008-002 does establish that the IRS Chief Counsel’s Office has considered the issue and concluded, in general, that an election made on an original return should be considered valid, as a matter of law, even if the taxpayer provides a nominal credit amount or no credit amount. A taxpayer with facts similar to those described in the memorandum who sought its own private letter ruling from the IRS chief counsel may receive the same treatment.
Taxpayers who are unable to determine the exact amount of a credit to be claimed on a tax return but who desire to make a Sec. 280C election on an amended return in the future should be advised to indicate the reduced credit election by checking the appropriate box on Form 6765. This action may constitute a valid Sec. 280C election in accordance with recent IRS guidance. In addition, taxpayers should be advised to attach a statement indicating why the correct amount is not indicated on the return and that the taxpayer intends to file an amended return when an allowable credit amount has been determined.
Mary Van Leuven ia a Senior Manager at Washington National Tax KPMG LLP in Washington, DC
The information contained in this Tax Clinic is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser. The views and opinions expressed are those of the authors and do not necessarily represent the views and opinions of KPMG LLP.
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If you would like additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or email@example.com.