Fourth Circuit Affirms Tax Court in IRC Secs. 41 and 45C Dispute

The Fourth Circuit, on June 24, 2024, affirmed a 2023 Tax Court decision holding that a company improperly excluded certain expenses under IRC Sec. 45C in claiming the orphan drug credit. The case highlights the interplay between the research tax credit and orphan drug credit for certain research activities. 

IRC Sec. 41 Explained

The credit for increasing research activities under IRC Sec. 41 provides businesses with a federal income tax (or payroll tax for certain businesses) credit of up to 20% over a base amount for certain research and development activities. The credit is commonly referred to as the “R&D credit” or “research credit.” 

Taxpayers can claim the credit for two types of activities:

1. Qualified research activities or qualified research expenses (“QREs”), and
2. Basic research payments.

There are two different methods for calculating the R&D credit: The regular method and the alternative simplified method. Both credit calculations are current year QRE over a base amount. The regular method uses a higher statutory credit rate of 20%, with the base amount a function of the taxpayer’s average prior four-year gross receipts and a statutorily based fixed base percentage of QREs. The taxpayer is allowed a credit of 20% against the lesser of either incremental QRE or 50% of current year QRE. The full calculation of the regular method is extremely complex and outside the scope of this article.

The alternative simplified method (“ASC”) has a lower statutory rate of 14%. Under this method, the base amount is equal to half of the average of the taxpayer’s prior three-year QREs. The incremental QRE (current year over base amount) is then multiplied by the rate of 14% to determine the credit. For companies with no QRE in any one of the prior three-year tax periods, a 6% credit rate is applied against current year QRE to determine the credit.

IRC Sec. 45C Explained

IRC Sec. 45C is a relatively overlooked section of the tax code that gives companies an increased credit for clinical testing expenses for developing treatments for rare diseases or conditions. This credit is often referred to as the “orphan drug credit.” Under this section, businesses can claim a credit equal to up to 25% of qualified clinical testing expenses. This credit is intended to incentivize companies to develop treatments that are so rare that there would otherwise be no financial incentive for companies to develop them. 

IRC Sec. 45C(c) sets forth the coordination between the IRC Sec. 45C credit and the IRC Sec. 41 credit for increasing research expenditures. Under IRC 45C(c)(1), any qualified clinical testing expenses in a tax year for which the IRC Sec. 45C credit applies are not taken into account for purposes of determining the research credit for that tax year, unless IRC Sec. 45C(c)(2) applies. However, under IRC Sec. 45C(c)(2), the qualified clinical testing expenses which are also qualified research expenses under IRC Sec. 41(b) are taken into account for determining base period research expenses in applying IRC Sec. 41 to subsequent tax years.

United Therapeutics Corp. v. Commissioner

United Therapeutics develops pharmaceuticals to assist patients with chronic and/or life-threatening conditions who may not always receive treatment. For the tax years in question, 2011-2014, the company claimed the research credit under IRC Sec. 41 as well as the orphan drug credit under IRC Sec. 45C. When calculating its credit under IRC Sec. 41, the company did not follow the coordination rule under IRC Sec. 45(c)(2) and did not include qualified clinical testing expenses in its base amount. 

The IRS audited the return and claimed United Therapeutics had improperly disregarded the coordination rule, resulting in a lower tax bill of nearly $1 million. On appeal, the company argued that IRC Sec. 45(c)(2) was “implicitly” repealed in 1989 under legislation and therefore was no longer a requirement. 

The court thoroughly rejected this argument. The court looked to the plain meaning of the statute and concluded that “base period research expenses” as used in IRC Sec. 45C(c)(2) includes “overlapping expenses during the three-year period” under IRC Sec. 41.

This case highlights how important it is for companies to calculate these credits correctly. In the case of United Therapeutics, incorrectly excluding research expenses from their base amount not only led to an income tax adjustment, but also to hefty penalties and interest as well. Taxpayers who wish to claim the R&D credit should engage with a trusted tax advisor to navigate the particular intricacies of IRC Sec. 41.