An R&D Credit Not Earning Its Keep

Business doesn't like much about the President's tax plan, but one tasty carrot appeals to executives: the idea of extending indefinitely a widely used credit for research and engineering innovation.

Next year companies will knock $8 billion off their tax bills using the credit according to Congress' Joint Committee on Taxation, up from $5.5 billion in 2003. The provision, typically called the R&D tax credit, has existed since 1981, but only as a temporary break, which has required periodic legislative renewal. Now the Obama Administration has proposed making it permanent.

Like most parts of the tax code, this one comes with complications. The well-intentioned credit has been subject to alleged abuse by some companies, according to the IRS.

The IRS has denied claims, for example, concerning software of dubious value developed for internal corporate use. Currently, FedEx is objecting in court to the government's denying it $11.6 million in credits for the delivery company's development of package-tracking software that FedEx ultimately abandoned.

Even when used properly, the R&D credit may not do much good. In an analysis prepared last year, the Congressional Research Service concluded that from 1997 to 2005, "the credit delivered no more than a modest stimulus to domestic business R&D investment." Examining the growth of domestic private-sector research and development and the size of the credit itself, the legislative service found the credit may have raised business R&D spending by at most 3.3% over that time. Advocates of the credit argue that its impact has been limited by its size and that the U.S. has fallen behind other countries with more generous research tax breaks.

Cottage IndustrySo enticing is the R&D credit even as currently structured, however, that an entire cottage industry has developed to advise companies on how to benefit. Alliantgroup of Houston has built a nearly $60 million-a-year business largely on this narrow specialty.

In its seven years of operation, Alliantgroup says it has obtained refunds and credits worth $500 million for its corporate clients, most of them small and midsize companies that don't have sophisticated in-house tax departments. They include food packagers, winemakers, architects, and the more obvious categories like software outfits and chemicals manufacturers.

"Fortune 1,000 companies are able to shelter quite a bit of income, but these smaller companies are by and large not taking the same credits," says Dhaval R. Jadav, a tax attorney who co-founded Alliantgroup. "Some amount of R&D goes into everything you touch. But most small and midsize companies will say: 'I'm just doing my job. This qualifies me for a tax credit?'" Jadav's answer: "Yes, absolutely."

The notion that practically any business can find some kind of advance for which it might seek a tax credit has contributed to the increase in the number of companies filing claims: more than 17,000 in 2006, up from 10,244 two years before. And the expanding popularity of the credit worries tax authorities responsible for seeing that the U.S. Treasury receives its due.

Cheryl Claybough, an IRS official, says the agency's concern relates in part to a flood of historical claims, some of which refer to innovations that date back a decade. Many of these claims rely on prepackaged submissions and offer little proof of R&D spending, Claybough says, adding: "We aren't relaxing our approach to the research credit."

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