Managing new schedule M-3 disclosures.

• Author: Hennig, Cherie J.

Schedule M-3, Net Income (Loss) Reconciliation, is required for returns of corporate and partnership entities that report assets of $10 million or more on their Schedule L balance sheet, to reconcile taxable in-come or loss with financial statement income or loss.The IRS introduced Schedule M-3 effective for tax years beginning after December 31, 2004. Since then, numerous changes to the form have expanded its reporting requirements. The most recent change, for 2010 and following tax years, requires new disclosures of research and development (R&D) costs and Sec. 118 exclusions from income of nonshareholder contributions to capital for corporate filers including S corporations. (1) Entities taxed as partnerships (2) must also disclose R&D costs but have no reporting requirement for the Sec. 118 exclusion, since they are not entitled to it. In addition, certain Form 1065 filers with assets less than $10 million are required to complete Schedule M-3 if an alternative computation of gross assets meets the $10 million threshold or if a corporate partner is required to file the Schedule M-3.

[ILLUSTRATION OMITTED]

The reporting requirement for R&D costs creates a new level of transparency for Sec. 174 research and experimental (R&E) expenses, including those claimed as qualified research expenses and basic research payments for the Sec. 41 credit for increasing research activities. Although a supporting attachment for R&D costs will not be required for 2010 and 2011 tax years,3 their amount must still be reported. Furthermore, specifics of exclusion from income of nonshare-holder contributions to capital must be disclosed in an attachment even if there is no book-tax difference. Since the Sec. 41 credit and the Sec. 118 exclusion are Tier I audit issues, taxpayers availing themselves of these tax benefits should ensure that there is adequate documentation to defend the tax treatment of these items. This article discusses the likely tax compliance and tax reporting issues that Schedule M-3 filers face when completing these new lines on their 2010 and following Schedules M-3.

R&D Expenses Reportable on Schedule M-3

Corporate taxpayers should budget for the additional time that will likely he required to accurately compute and report the related book-tax permanent and timing differences associated with these expenditures. Mapping and classification issues may arise when attempting to obtain the required information from the company's accounting information system. The new disclosures may have reporting implications for taxpayers that apportion R&D expenses under cost-sharing arrangements.(4) Also, there may be an effect on the amount of expenses that qualify for the credit for increasing research activities.(5)

Sec. 174: R&E Expenses

Reportable R&D expenses include R&E expenses under Sec. 174 that arc paid or incurred by the taxpayer in connection with the taxpayer's trade or business that are reasonable in amount under the circumstances.(6) They include the cost of obtaining a patent, such as attorneys' fees for making and perfecting a patent application for a discovery made by the taxpayer. Amounts the taxpayer pays or incurs for research or experimentation carried on in the taxpayer's behalf by another person or organization also qualify as R&E expenditures.(7)

The costs must be incurred in the "experimental or laboratory sense," (8) arising from activities intended to discover information to eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer before undertaking the research does not establish either (1) the capability or method for developing or improving the product or (2) the appropriate design of the product. The nature of the activity determines whether the costs qualify, not the nature of the product or improvement or the level of technological advancement brought about by it. (9)

Expenditures for the following types of activities do not qualify:

* Ordinary testing or inspection of ma terial for quality control, manage ment studies, advertising or promo tions, consumer surveys, or efficiency surveys; (10)

* Obtaining another person's patent, model, production, or process; (11)

* Research in connection with literary, historical, or similar projects; (12)

* Acquiring or improving land used in connection with research and experimentation; (13)

* Acquiring or improving property sub ject to an allowance for depreciation or depletion that is used in connection with research and experimentation; (14) and

* Ascertaining the existence, location, extent, or quality of mineral deposits, including oil and gas. (15)

The Code provides three methods for deducting RScE costs. First, the taxpayer may deduct the expenses in the year paid or incurred. (16) Second, the taxpayer may elect to amortize the expenses over a period selected by the taxpayer of not less than 60 months. (17) Only expenses that would be chargeable to a capital account in the absence of Sec. 174 (except for expenditures chargeable to property that is depreciable or depletable) qualify for the 60-month amortization method. The amortization period under this method begins with the month the taxpayer first realizes benefits from the expenditures. A benefit is first realized in the first month that the process, formula, invention, or similar property is put to an income-producing use. ls Third, the taxpayer may amortize the expenditures over a 10-year period beginning in the year they are paid or incurred.19 R&E expenses not accounted for using one of these three methods must be capitalized.20 The way a taxpayer treats R&E expenses for financial accounting purposes does not affect their tax treatment.21

The future results and benefits of R&E undertaken by a taxpayer are generally uncertain. If a research project is abandoned without realizing any benefits and the taxpayer has elected to amortize the expenditures using the second or third method or capitalizes the expenses, the expenditures may be recovered in full as a loss, (22) The same rule would apply for any unrecovered cost if a project initially thought to be successful is abandoned after cost recovery has begun.

R&E expenditures are not subject to recapture as ordinary income upon the sale of the technology to which the deduction relates. Therefore, if the capital gain requirements are otherwise satisfied upon the sale of the technology, the entire gain may be treated as a capital gain despite the prior tax benefit received by offsetting R&E expenditures against ordinary income. (23)

The Sec. 174 deduction for R&E expenditures must be reduced by the amount of the Sec. 41 incremental research credit for the year. (24) If the taxpayer capitalizes the research expenditures instead of immediately taking a deduction for them, the amount capitalized must also be reduced by the amount of the research credit. (25) The taxpayer can make an annual irrevocable election to take a reduced research credit instead of reducing the research expense deduction or capitalized research costs (Sec. 280C election). (26) The effect of the election is to reduce the amount of the research credit by the amount of tax saved (using the highest corporate tax rate) by not making a reduction of the Sec. 174 deduction.

Sec. 41: Incremental Research Credit

The Economic Recovery Tax Act of 1981 (27) added a nonrefundable income tax credit for certain qualified research expenses paid or incurred in carrying on an active trade or business. The Sec. 41 credit for increasing research activities currently provides two methods for determining the amount of credit. Under the "regular" method, the credit is equal to the sum of (1) 20% of the qualified research expenditures in a tax year over a base amount, plus (2) 20% of "basic research payments" to qualified organizations over a "qualified organization base period amount," plus (3) 20% of any amounts paid or incurred by the taxpayer to an energy consortium for energy research in connection with carrying on the taxpayer's trade or business. (28)

Qualified research expenses consist of three categories of in-house research expenses and contract research expenses paid to third parties. (29) In-house research includes (1) wages for employees engaged in the research activity, (2) cost of supplies used in the research, and (3) amounts paid or incurred to a third party for the right to use computers in conducting the research.30 Contract research services are amounts paid by the taxpayer to a third person (other than an employee of the taxpayer) for research.31 Only 65% of the amount paid for the contract research services is taken into account in computing the research credit. However, the amount is increased to 75% for amounts paid to a qualified research consortium for qualified research on behalf of the taxpayer and one or more unrelated taxpayers (32) and to 100% for amounts paid for qualified energy research to an eligible small business, an institution of higher education, or a federal laboratory.33

The qualified research expense base amount is computed by multiplying the "fixed-base percentage" by the taxpayer's average annual gross receipts for the four preceding years. (34) However, the base amount may not be less than 50% of the qualified research expenses for the year.( 35) The...