Taxpayers who conduct research and development (R&D) are provided with a few benefits on their tax return. These benefits include the ability to deduct R&D expenses or capitalize them over a period of time. The Internal Revenue Code even has a credit for increasing research activities.
It is worth noting that there are certain restrictions when taking advantage of both Sections 174 deduction/capitalization and Section 41, the credit for increasing research activities. These restrictions can be seen in Section 280C.
Why a Taxpayer Should Use IRC Section 280C
IRC Section 280C(c)(1) requires that the taxpayer reduce their deductible expenses by the amount of the R&D credit for the tax year(s) that the credit has been taken. In other words, Section 280C(c)(1) will require taxpayers to increase their taxable income by the amount of the credit.
The taxpayer has the option to avoid the reduction of their R&D expenses by making an election under IRC Section 280C(c)(3). By making this election, the taxpayer effectively reduces their R&D credit amount by a percentage equal to the top corporate tax rate (currently at 21%). They can claim the after-tax value of the credit without adding back in the expenses used to claim the credit.
This election may result in a similar net tax benefit as not making the election if the taxpayer is in the highest income bracket. It’s also easier to implement on the tax return. However, the election must be made on an originally filed return (including extensions). Therefore, this election is not available to those who amend the tax return to claim the credit.
Treating the R&D Credit as Taxable Income
For taxpayers who are either unable or choose not to make an election for the Reduced Credit under IRC Section 280C(c)(3), they must increase taxable income by making an adjustment to Schedule M-3 or Schedule M-1. Tax preparers and CPAs who might be new to the mechanics of the R&D tax credit as it relates to the tax return may encounter issues on how to treat the credit as taxable income.
Schedule M-1 is required for taxpayers with total receipts and total assets that are $250,000 or greater. For partnerships and S-corporations, this adjustment to taxable income is generally reported on line 4 of Schedule M-1. For corporations, this is generally adjusted on line 5 of Schedule M-1. Tax preparers should attach a statement that itemizes the type of income, the amount, and a description that states the income name for book purposes.
Schedule M-3 is required for taxpayers with total assets that equal or exceed $10 million. Partnerships and S-corporations must adjust the R&D expenses under Section 174 on line 29 of Schedule M-3. For corporations, these adjustments are made on line 35 of Schedule M-3.
A final note: Since the federal income tax rate is the starting point for many state R&D calculations, businesses that make an election for 280C can also reduce their state taxable income as well. Some states, like California, have their own version of 280C(c)(3).
Stay Up to Date with R&D Legislation
Strike stays current with shifting IRS regulations. If there’s one thing that’s constant in tax law, it’s change. The new corporate tax rates put into place after the PATH Act could affect whether a company makes a 280C election. We consider individual tax situations carefully and review your best case scenario so that you can maximize your R&D tax credits.