Economic Growth Through Targeted Tax Credits

The federal government has a long history of using tax credits to spur growth and economic development. The 1981 Economic Recovery Tax Act (1981 ERTA) initiated the tax credit for increasing research and development/experimentation activities (R&D credit).

Since 1981, this credit has been modified and extended numerous times, stimulating experimentation and advancements in a variety of industries. In the “green energy” sector, the investment tax credit, renewable energy grant, and a host of fuel credits and other incentives have been effective in encouraging investment in this critical market.

The majority of the above incentives were due to sunset on December 31, 2010, or earlier. However, with an aim to further spur economic investments, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act) enacted on December 17, 2010, extended many provisions including the R&D credit and several key energy-related tax programs.

Extension of R&D Credit

The aforementioned extension of the R&D credit is retroactive and includes amounts paid or incurred for qualifying research activities after December 31, 2009, through December 31, 2011.

The R&D credit is designed to encourage businesses to increase research and experimental activities and is based on the company’s qualified wages, supplies and certain research contracted with third parties. To qualify, a taxpayer’s research and experimental activities must pass a four-part test related to the purpose, nature and application of the research activities.

The analysis to identify qualifying expenditures can be extremely technical in nature and vary substantially from case to case. A key to sustaining the R&D credit upon examination is often contemporaneous documentation that supports both the technical merits of the activities and the related costs.

The extension of the credit does not alter the mechanics of the calculation. Once a taxpayer determines that research expenditures qualify, the credit is generally equal to 20% of the amount by which the taxpayer’s qualified expenses exceed a defined base amount. Under this approach, the amount of the credit must be included in taxable income. Often for state planning purposes, companies may elect under Sec. 280C to receive a reduced credit of 13% whereby an increase to taxable income for the amount of the credit is not required.

Alternative Simplified Method

For taxpayers that are significantly limited by the base amount calculation, a second method, called the alternative simplified method may be elected to help maximize the credit. The alternative simplified credit is equal to 14% of the portion of qualified research expenses that exceeds 50% of the average research expenses for the three preceding tax years.

The simplified method can be a practical, tax-saving opportunity for many taxpayers, but careful consideration must be taken. For example, several special rules surround this election, including rules related to consistency, short taxable years, and controlled groups.

Regardless of the method chosen, the R&D credit is claimed on Form 6765 with a timely filed tax return. Also of note, the draft instructions of Schedule M-3 for year 2010 require the separate presentation of R&D costs as a new line item. It is anticipated that compliance with the new requirement may call for significant efforts to gather and report the appropriate information. In addition to the federal R&D Credit, many states have an R&D credit that is modeled, at least in part, after the federal approach.

Renewable Energy Credits

In recent years, renewable energy incentives have fueled the growth of the “green energy” industry. Without these incentives, investment in this area might not be economically viable. The 2010 Tax Relief Act extended numerous alternative energy related tax provisions.

Of particular interest is the extension of the cash in lieu of tax credits program (grant program) available to taxpayers who place specified energy property (e.g., a solar energy project) in service, or, where construction begins, by December 31, 2011. The grant program is in lieu of an energy investment tax credit which provides taxpayers a tax credit of 30% of the cost of installing specified energy property, thus giving taxpayers the option to receive a cash rebate of 30% of the cost of acquiring or constructing a qualifying energy property.

The program is incredibly popular, paying over $5.8 billion of cash grants through the end of 2010—significantly more than originally predicted. At a time when few companies may have been able to utilize a tax credit, the grant program helped spur over 100% growth in the solar industry in 2010. It ultimately advanced 1,100 solar projects and $18 billion in investments. The Solar Energy Industries Association expects the 2011 grant program to help create tens of thousands of new jobs in the coming years.

The 2010 Tax Relief Act also extended the nonrefundable personal income tax credit for certain energy efficient property installed in a principal residence in the United States. This credit, available at 30% in 2010, was extended at only 10% of amounts paid in 2011 for qualified improvements, plus a credit for residential energy property expenditures (e.g., $150 for qualified hot water boilers, $300 for qualified energy efficient property such as heat pumps or air conditioners). This credit is subject to a $500 lifetime limitation.

Other energy credits focus on alternative sources of fuel to replace reliance on oil. Alcohol, biodiesel and renewable fuels credits were extended to incentivize:

  1. the use of ethanol mixtures (produced from corn) by gasoline blenders;
  2. the production and use of biodiesel (produced from crops such as soybeans) to replace or supplement petroleum diesel;
  3. the production and use of alcohol blends and certain liquid fuels (produced from feedstock) as fuel; and,
  4. the installation of vehicle refueling facilities that supply alternative fuels or energy.

State Incentives and Exemptions

Just as federal energy incentives were a significant part of the 2010 Tax Relief Act, taxpayers may also benefit from significant state incentives and exemptions. Currently, 24 states offer personal income tax credits for renewable energy property, 25 offer corporate tax credits, 28 provide incentives through sales tax deductions, and most provide some form of rebate or loan program for renewable energy.

Summary

While only time will tell if the recent legislation will provide the economic growth intended, its passage illustrates the importance the federal government placed on innovation as a tool for growth and a continuing dedication to the “green energy” sector.