Reconsider electing reduced R & D credit.

• Author: Turk, Raymond L.
• Position: Research and development

Under Sec. 280C(c), taxpayers may either (1) claim a full research and development (R&D) credit under Sec. 41 and reduce their current deduction for research and experimentation expenditures by the credit amount or (2) elect to reduce their R&D credit by 35% and claim a full deduction for such expenditures.

As a result of the Revenue Reconciliation Act of 1993 (RRA), which extended the R&D credit until June 30, 1995 for all taxpayers (and increased individual tax rates), taxpayers should now reconsider whether to elect the reduced R&D credit. For individuals who are owners of passthrough entities, election of the reduced credit now generally reduces Federal and state taxes. For C corporations, election of the reduced credit generally produces state tax benefits, although there may be Federal tax detriments in some situations.

Passthrough entities

For passthrough entities such as partnerships or S corporations, an election to claim the reduced R&D credit is made at the entity level (rather than at the owner level). A passthrough entity claiming the full credit must increase its taxable income by the credit amount, which correspondingly increases the amount of income passed through to its owners. Since most states use Federal adjusted gross income (AGI) as a starting point in calculating state taxable income for an individual, the entity's election of the full credit increases the state taxable income and state tax of its owners.

Under pre-RRA law, for Federal tax purposes, it typically was more advantageous for a passthrough entity to claim the full R&D credit even if its individual owners were in the top marginal tax bracket (31%); the entity's owners would otherwise have to reduce their R&D credit by 34% (the prior mandated credit-reduction rate), more costly than the 31% tax benefit from deducting the credit amount. After 1992, however, the reduced-credit election becomes advantageous from a Federal standpoint because the mandated credit-reduction rate is 35% and the individual top marginal rate is 39.6% (40.79%, if the 3% itemized deduction limitation is considered).

Electing the reduced credit may provide an additional state tax benefit. Most "Federal conformity" states, while not allowing any R&D credit, do not provide a subtraction from Federal AGI for the R&D credit amount included in Federal AGI when the full R&D credit is claimed.

Example: An individual in the 31% marginal Federal bracket (31.93% after considering the 3%...