R&D: don't overlook it.

• Author: Oettinger, David, Jr.
• Position: Research and development tax credit

As a result of the newly enacted tax bill, the research and development (R&D) credit is alive and well, having been extended for three years (during the period July 1, 1992 through June 30, 1995). This credit, and the expensing election, make R&D attractive for business.

R&D involves two tax issues. Before 1939, it was unclear whether R&D costs were a capital or deductible item. The Internal Revenue Code of 1939 held that R&D expenses were deductible if they were an "ordinary and necessary" business expense. In 1954, Sec. 174 was added to the Code to provide that R&D costs may be deducted currently or amortized over a period of 60 months or more. The Economic Recovery Act of 1981 added the second tax issue--the R&D credit now found in Sec. 41.

With the possibility of deductions and credits taxpayers may attempt to include many different items as R&D. With this in mind, the Code has limited the items eligible for the Sec. 174 election and the Sec. 41 credit. R&D must be incurred in connection with a trade or business. It must be technological in nature. It must be useful in developing new or improved business components or products. The item developed must be improved in function and not a mere design change; routine design changes do not constitute R&D for purposes of the credit. Further, the method of reaching the result must not be ascertainable at the onset. The taxpayer must bear the risk of failure. The expenses cannot be part of the manufacturing process, nor may any depreciable items qualify for the credit.

The 1989 proposed regulations tried to limit the use of R&D expensing, by applying a "timeline" approach. Expenditures incurred after meeting the basic design specifications could have been deducted only for significant cost reductions or higher performance levels. The Treasury withdrew these proposals in 1993 and replaced them with proposed regulations that involve a different approach. The Treasury conceded that progress in R&D is often achieved only in small, incremental steps and that it would be difficult to determine when a basic design specification has been met and whether subsequent changes are significant.

As noted, one major tax benefit of R&D is the credit availability. Under Sec. 41, taxpayers are entitled to a tax credit for incremental "qualified research expenditures" paid or incurred. This credit equals 20% of the amount by which expenses exceed a base amount. The base is the taxpayer's fixed base percentage...