Credit for increasing research activities in a short tax year

Editor: Anthony Bakale, CPA

Short years arise when a taxable entity is not in existence for an entire 12-month period, as may be the case in the year of formation, conversion, or acquisition. As such, many taxable entities will experience a short tax period at some point. How this short year affects the determination of the credit for increasing research activities under Sec. 41 is often an afterthought for many taxpayers and their tax advisers. Preparers may end up asking themselves: Do I annualize qualified research expenditures (QREs), or is it the base amount? Does annualization mean converting amounts to what they hypothetically would be in a full year or, rather, modifying amounts to match the portion of the year in which the entity existed?

As with most questions in tax law, the answer is: It depends. The answers to these questions vary based on whether the taxpayer is dealing with a short credit year or a short tax year preceding the credit year. Answers further vary based on whether the taxpayer is claiming the regular credit under Sec. 41(a) (1) or the alternative simplified credit under Sec. 41(c)(4). Each of these scenarios is explored below following a brief overview of the credit for increasing research activities, also referred to simply as the research credit.

Credit for increasing research activities (Sec. 41)

Regular credit: Under Sec. 41(a)(1), the regular credit is composed of 20% of each of the following three items:

• The excess of the current-period QREs over the “base amount”;
• Basic research payments determined under Subsection (e)(1)(A); and
• The amounts paid to an energy research consortium for energy research.

For purposes of this discussion, a reference to the regular credit means the first of the three components: the excess of the current-period QREs over the base amount.

QREs generally include amounts paid or incurred in the conduct of qualified research by the taxpayer during the tax year, including certain wages, supplies, and contract research expenses (subject to limitation). The base amount is defined under Sec. 41(c) as the product of the fixed-base percentage and the average annual gross receipts for the four tax years preceding the tax year for which the credit is being determined. However, in no event shall the base amount be less than 50% of the current QREs.

Alternative simplified credit: At the taxpayer’s election, the research credit may be modified to equal 14% of the amount of QREs for the tax year that exceeds 50% of the average QREs for the preceding three years. Where the taxpayer’s QREs in the preceding three years are zero, the credit is determined to be 6% of the current year’s QREs.

Short credit year

With the basics covered and terms defined, further consideration can be given to how a taxpayer’s short tax year affects the calculation of its current research credit. Under Regs. Sec. 1.41-3, the base amount, defined above, is modified by multiplying that amount by the number of months in the short tax year and dividing the result by 12. In other words, the base amount should be reduced to reflect the portion of the year for which the entity existed, and the QREs remain unchanged.

Given that the alternative credit is not a function of the base amount as defined under the regular credit, annualization for a short credit year looks slightly different. Pursuant to Regs. Sec. 1.41-9(c)(3), the average QREs for the three tax years preceding the short credit year are modified by multiplying the three-year average by the number of days in the short tax year and dividing the result by 365. Ultimately, under both the regular and alternative methods, the preceding years are prorated to be comparable to the portion of the year to which the QREs relate, and the current QREs are not modified. If a taxpayer or preparer misapplies these annualization rules by converting current short-period QREs to a full-year basis, the result would be an erroneously inflated credit, which is demonstrated as part of the example below.

Example: T Co. has been in business since Jan. 1, 2019, and is acquired by another entity on March 31, 2023, creating a short credit year. T Co.’s facts are as shown in the table “T Co.’s QREs and Gross Receipts,” below.

Under the regular credit, T Co. would compare its 2023 QREs of $500,000 with the adjusted base amount. To determine that base amount, T Co. would take the average of the gross receipts for the preceding four years, or $25 million, multiplied by the fixed-base percentage of 3% (since T Co. has fewer than five years of QREs), then multiplied by the number of months in the short credit year (3) divided by 12. The preliminary base amount comes out to $187,500. However, because this amount is less than 50% of the current-period QREs, the base amount defaults to $250,000. The regular credit is equal to T Co.’s QREs of $500,000 less the base amount of $250,000, then multiplied by 20%, yielding a credit of $50,000.

Under the alternative credit, T Co. would modify the preceding three-year average of QREs to reflect the portion of the year in existence as a function of days. The unadjusted three-year average is $741,667, which is multiplied by 90 days, then divided by 365, resulting in an annualized prior QRE average of approximately $182,877. To determine the credit under the alternative method, T Co. would subtract 50% of the annualized prior three-year average, or $91,439, from the current-period QREs of $500,000 and multiply that by 14%, yielding a credit of $57,199.

To demonstrate the importance of correctly applying these rules, let us look at what the resulting credit would be if the rules under the regular credit were misapplied. Using the same facts above, assume T Co. incorrectly annualized the QREs to be comparable to the full-year periods in the base amount. To make the short-period 2023 QREs of $500,000 represent a full year of activity, T Co. multiplied the QREs by a factor of 4, yielding an “annualized” amount of $2 million. The base amount is the greater of 50% of $2 million or 3% of the four-year average ($25 million). Thus, the base amount is $1 million, and the credit would be 20% × ($2 million – $1 million). The result is an erroneous $200,000 credit. Comparing the correct credit of $50,000 in the earlier example above to the incorrect credit of $200,000 shows that misunderstanding the term “annualization” will yield a falsely inflated research credit for the short period.

Short tax year preceding the credit year

In the event a taxpayer has a short tax year preceding the credit year, the base amount will again be adjusted to reflect comparable periods. Under the regular credit, if one or more of the four preceding tax years is a short year, then the gross receipts for that year are deemed to be equal to the gross receipts actually derived in the period multiplied by 12 and divided by the number of months in that year.

For instance, assume the same facts about T Co. as above, but instead of being in business as of Jan. 1, 2019, assume T Co. was incorporated and began operations on Sept. 30, 2019. In order to determine a research credit for tax years 2020 through 2023, the gross receipts from 2019 need to be modified to reflect what the receipts would have been if T Co. were operating for a full 12 months. In other words, when determining the base amount for credit years after 2019, the gross receipts of $15 million would be multiplied by 12 and divided by 3, which is the number of months T Co. was operating in 2019. The actual gross receipts of $15 million received in the short year would equate to $60 million on a full-year basis. This $60 million would then be averaged with the other three preceding tax years to determine the base amount for a 2023 research credit.

When determining the alternative simplified credit for which a preceding year was a short period, the methodology for annualizing the QREs is similar to that of annualizing the gross receipts under the regular credit calculation. Pursuant to Regs. Sec. 1.41-9(c)(3), if one or more of the three tax years preceding the credit year is a short tax year, then the QREs for the short year are deemed to be equal to the actual QREs incurred, multiplied by 365 and divided by the number of days in the short year.

Again, assume the original facts detailed above, but this time independently assume T Co. did not begin operations until July 1, 2020. In determining the prior three-year average of QREs under the alternative simplified credit method, T Co. must annualize the 2020 QREs by multiplying the $650,000 of expenses by 365 and dividing by 184 days. In doing so, the 2020 full-year QRE equivalent is $1,289,402.

The aforementioned result also highlights a key difference in annualization between the regular and alternative methods: months versus days. It is important to note that while regular credit modifications are done using months, the alternative credit modifications use days. In the example above, the by-days analysis yields nearly $10,600 less of annualized QREs than the by-months calculation would. Though the difference may initially seem negligible, it can quickly amplify and may ultimately affect the determination of the credit amount.

Although the term “annualization” may seem straightforward enough, careful consideration should be given to the context in which amounts are being modified, as well as the nuances in the application of those modifications. As demonstrated herein, annualization can take on more than one meaning, and the amounts being annualized may not be the same, depending on the research credit method the taxpayer uses. A thorough understanding of the rules for determining a research credit when short tax years are involved will enable the taxpayer to obtain the most benefit from the credit while immensely reducing the risk of inadvertently overstating or understating the credit amount.

Editor Notes

Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Bakale at tbakale@cohencpa.com. Contributors are members of or associated with Cohen & Company Ltd.