Should a taxpayer elect the alternative incremental research credit?

• Author: Zamarra, Randy

Sometimes, a taxpayer is dearly performing qualified research, but has never claimed the Sec. 41 research credit (which terminates on Dec. 31, 2005, under Sec. 41(h)). Perhaps the taxpayer's trade or business started before 1984 and its research activity records for the base period of 1984-1988 (see Sec. 41(e) (7)(B)) are almost nonexistent. The information might be sketchy and based solely on recollection--i.e., estimations of the number of engineers who worked at that time and their salaries, and partially recalled qualified research activities and the time spent on them. Can anything be done? Can a taxpayer claim a tax benefit based on estimates?

AIRC

Sec. 41(c)(4), the election to use the alternative incremental research credit (AIRC), is a possible solution. By making an AIRC election, a taxpayer does not need to estimate activities that transpired 20 years ago; instead, it uses expenses above certain averages. At first blush, this solution appeals to many tax advisers, who are more comfortable with hard data than with estimates. However, the AIRC election should be closely considered, because AIRCs are likely to be much smaller than if actual documentation were available. If AIRCs are compared to credits from the estimated base period, the taxpayer will probably find that the latter approach produces a greater result. Further, because under Sec. 41(c)(4)(B), the AIRC election may be revoked only with IRS approval, the taxpayer is setting a precedent for reduced credits for future years.

Tax advisers familiar with the research credit generally agree that the AIRC is not as lucrative as it first seems: over the past few years, the IRS has frequently granted permission to revoke the AIRC election, which seems to be a popular letter ruling request; see, e.g., IRS Letter Rulings 200537011 (9/16/05), 200442026 (10/15/04), 200327005 (7/3/03) and 200250026 (12/12/02).

Is the Risk of Estimating Credits Acceptable?

If a taxpayer wants larger credits, it win have to settle for an estimated base period. How risky is this approach? In Cohan, 39 F2d 540 (2d Cir. 1930), the Second Circuit allowed a deduction that, in essence, amounted to a well-reasoned estimate. According to the court, "[i]t is not fatal that the result will inevitably be speculative; many important decisions must be...