Recent Guidance Affecting Research Credit Carryforwards From Closed Years

Editor: Mindy Tyson Weber, CPA, M.Tax.

Corporations that erroneously failed to claim general business credits, including the research credit, have long known it was possible to claim unused credits on a carryforward basis. However, the application of that approach to flowthrough entities remained unclear until recently. The IRS in November 2015 issued a private letter ruling confirming that passthrough entities may claim unused credits on a carryforward basis. However, the IRS also recently promulgated final regulations that prohibit a taxpayer from increasing research credit carryforwards from closed years by electing the alternative simplified credit (ASC) method.

Adjusting General Business Credits

Generally, Sec. 6511(a) limits taxpayers to filing a claim for refund within the later of three years from the time the return was filed or two years from the time the tax was paid. As a result, a taxpayer generally loses the opportunity to claim a credit once the Sec. 6511(a) limitation period closes. However, with the issuance of Rev. Rul. 82-49, the IRS provided taxpayers with an avenue to claim a credit beyond the Sec. 6511 limitation period.

In Rev. Rul. 82-49, the taxpayer was a corporation founded in 1976. That year, it placed in service certain property that qualified for the former investment tax credit. However, the taxpayer erroneously failed to claim the tax credit. Additionally, the taxpayer could not use the entire investment credit generated in the initial year, and if the credit had been properly claimed, the taxpayer would have used the credit over the next three tax years. The taxpayer’s failure to claim the credit continued for the next three tax years.

In reaching its decision in Rev. Rul. 82-49, the IRS relied primarily on Rev. Rul. 69-543, Rev. Rul. 81-88, and Mennuto, 56 T.C. 910 (1971). In Rev. Rul. 69-543, the taxpayer claimed the investment credit and carried forward a portion of the unused credit into three subsequent tax years. The IRS examined the taxpayer’s subsequent returns after the assessment period for the initial year closed and determined that the taxpayer improperly claimed the investment credit in the closed year. The ruling stated that the IRS could disallow the investment credit carryovers to the open years and assess deficiencies even though the claim originated on a return from a closed year. In Mennuto,the Tax Court affirmed Rev. Rul. 69-543 and stated that “the critical element is that the deficiency being determined is for a year on which the period of limitations has not run.”

In Rev. Rul. 81-88, the taxpayer failed to take a deduction in closed years in which the taxpayer had taxable income. While the taxpayer was barred from receiving a refund, the IRS held the taxpayer could use the barred deduction to generate a net operating loss (NOL) carryover.

In the analysis for Rev. Rul. 82-49, the IRS determined that the rules for carryovers of NOLs and the investment tax credit operate in a similar manner. As a result, although Sec. 6511 bars a refund for years in which the statute of limitation for claiming the credit has expired, it does not prohibit a taxpayer from claiming the refund as a carryforward of its unused investment credit in an open year. A taxpayer need not have claimed the investment credit on its return in the same year as when the investment credit property was placed into service before the credit can be carried forward to an open year.

In Rev. Rul. 82-49, the taxpayer was allowed to carry the investment tax credit back three tax years and forward 15 tax years, under then-Sec. 46(a). Currently, Sec. 39 allows a taxpayer to carry forward Sec. 38 general business credits for 20 tax years. General business credits include, for example, the investment credit now under Sec. 46, the employer Social Security credit (Sec. 45B), and the research credit (Sec. 41). Therefore, it is reasonable for a taxpayer to apply Rev. Rul. 82-49 and carry forward unused general business credits from a closed year to an open tax year without claiming the credit on an original filed tax return (see, e.g., Letter Ruling 201548006). This common practice has been applied by taxpayers to research tax credits for many years without IRS challenge.

Letter Ruling 201548006

Although Rev. Rul. 82-49 does not specifically refer to partnerships or S corporations, the IRS in Letter Ruling 201548006 stated that it is reasonable to apply the same analysis described in Rev. Rul. 82-49 to flowthrough entities. While the letter ruling provides welcome clarity, it is directed only to the taxpayer that requested it and cannot be relied upon by any other taxpayer. The letter ruling involved a nonpassive owner of various flowthrough entities, including partnerships and S corporations, in the business of operating restaurants. For tax years 1998 through 2012, these entities generated Sec. 45B credits claimed in lieu of deducting Social Security and Medicare taxes paid on certain employee tips. Subsequently, the taxpayer represented that the flowthrough entities had incorrectly computed the credit amounts. However, at the time the errors were discovered, the statute of limitation had expired for 2009 and the earlier tax years. The flowthrough entities amended the tax returns for the open years, 2010 through 2012, to correctly reflect the recalculated Sec. 45B credits. The tax year 2013 return was filed with the correct Sec. 45B credits.

The taxpayer stated that, had the Sec. 45B credits been calculated correctly in the closed tax years, the individual partners and S corporation shareholders would have been entitled to larger credit amounts than those claimed on their originally filed returns. If the maximum allowable credits had been used in those years, claiming the additional credits would have had the effect of increasing taxable income, as the amount of allowable deductions would be required to be reduced by the amount of credits claimed, and additional credit amounts would have been carried forward to subsequent years. The taxpayer therefore requested that it be allowed to adjust and increase the Sec. 45B credit carryforwards to the 2014 tax year when credits that were originally calculated incorrectly originated in years closed under the statute of limitation.

In addition to applying Rev. Rul. 82-49, the IRS relied upon statutory and judicial authority related to the treatment of general business credits in reaching its conclusion. The Sec. 45B Social Security credit is included within the definition of general business credits under Sec. 38 (Sec. 38(b)(11)). Therefore, the rules that govern the treatment of Sec. 38 general business credits also govern the treatment of Sec. 45B credits. Thus, Sec. 45B credits are subject to the general business credit rules, such as (1) limitations based on amount of tax, (2) the carryback and carryforward rules, and (3) the period of limitation on filing claims, as specified in Secs. 38(c), 39(a), and 6511(a), respectively.

The letter ruling also referred to relevant case law in making the determination, citing Mennuto and Hill, 95 T.C. 437 (1990). In both cases, the Tax Court affirmed the IRS’s right to recompute an incorrect credit carryforward originating from a closed year.

Letter Ruling 201548006 has direct application to the Sec. 41 research credit. Similar to the Sec. 45B credit, the research credit is explicitly included within the list of general business credits under Sec. 38 (Sec. 38(b)(4)). It would follow that the research credit would be subject to the same rules outlined in the letter ruling and that the IRS’s analysis would be identical. A research credit originating from closed years and being carried into an open year in arriving at tax due can be adjusted to correct computational errors (Rev. Rul. 82-49). However, based upon the rationale in the letter ruling, it is apparent that the adjustment to correct for computational errors, or a failure to properly claim a credit, can be applied not only to C corporations, but also to partnerships and S corporations.

Final Alternative Simplified Credit Regulations

In T.D. 9712, the IRS issued new guidance allowing a taxpayer to elect and claim the ASC method on amended returns (Regs. Sec. 1.41-9(b)(2)). A taxpayer’s ASC election is accomplished by completing Section B of Form 6765, Credit for Increasing Research Activities. The new guidance is effective for tax years ending on or after Feb. 27, 2015. The final regulations may also be relied upon to elect the ASC method on amended returns for all tax years open under the statute of limitation. However, the guidance is subject to certain restrictions. For example, if the taxpayer claimed the credit using the regular credit method on the original or a previously amended return for the tax year, the ASC method cannot be elected.

Additionally, if the taxpayer is a member of a controlled group of corporations under Sec. 41(f)(1), and a member of the group previously claimed the regular credit for the year, then the ASC method cannot be elected. Most importantly, as related to the application of Rev. Rul. 82-49, the preamble to the final regulations states that a taxpayer may not adjust credit carryforwards for prior-year ASC elections. The rationale for the prohibition is that allowing adjustments of credit carryforwards for prior-year ASC elections for tax years in which the period of limitation for assessment of tax has expired would have the practical effect of permitting a taxpayer to make an ASC election on a return that cannot be amended.

As a practical matter, regardless of whether a taxpayer elects the regular credit method or the ASC method, it may elect the Sec. 280C(c)(3) reduced credit, which has the effect of allowing the taxpayer to maintain its research and development expense deduction under Sec. 174 without any reduction by the amount of the research credit it earns in that year. This election must be made on an original timely filed return, not an amended return. However, making a Sec. 280C(c)(3) election by checking the box on line 17 of Form 6765 for a particular tax year does not, in and of itself, constitute electing the regular credit method and, accordingly, does not prevent the taxpayer from electing the ASC method on an amended return for that tax year. Therefore, making the reduced credit election but leaving the remaining section of the form blank preserves the reduced credit election but leaves open the option of electing either the regular method or the ASC method on an amended return. Similarly, making a Sec. 280C(c)(3) election in Section B of Form 6765, line 34, and leaving the remaining section of the form blank should have a similar effect.

Thus, existing authority, coupled with the clarity provided by Letter Ruling 201548006, establishes that a research credit originating from a closed year and being carried into an open year can be adjusted by both C corporations and flowthrough entities. However, the preamble to the final ASC regulations prohibits taxpayers from adjusting credit carryforwards under Rev. Rul. 82-49 for prior-year ASC elections, as that can only be accomplished via an amended return.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.