As more companies use technology to improve products and increase efficiencies, the importance of reviewing costs for eligibility for the Research and Development tax credit becomes more critical.
STATUS OF LEGISLATION
The R&D tax credit has been temporarily extended more than 15 times since 1981, and its expiration at the end of 2014 has necessitated the need for another extension. The Senate Finance Committee proposed legislation in June 2015 which would extend the R&D credit for two additional years. It is widely assumed that, as in the past, an extension of some sort will be approved and retroactive to January 2015.
OVERVIEW OF THE R&D CREDIT
In general, a company is able to claim the credit if it can substantiate the existence of four basic criteria related to its research expenditures and activities as follows (sometimes called the "four-part test"):
- A new or improved business component (product, process, software, technique, formula, invention).
- Technological in nature.
- Elimination of uncertainty as it relates to the product’s or process’ capability, the method to produce it, or its design.
- Process of experimentation.
CURRENT UTILIZATION OF THE R&D CREDIT
Although there has been significant growth in the usage of the R&D credit in recent years, the credit is under-utilized and taxpayers are not availing themselves of substantial opportunities. The latest data released from the IRS indicates 84% of the R&D credits being claimed currently are from businesses with gross receipts in excess of $250 million. This suggests there are untapped extensive opportunities for smaller businesses. The following chart reflects which business types take advantage of the credits:R&D Credit by Business Sector Type
- Manufacturing – 61%
- Information – 16%
- Professional Services – 10%
- Trade – 7%
- Agriculture, Mining, Utilities, Construction, Transportation, & Others – 6%
While manufacturers are generally utilizing the research credit, 75% of this figure is comprised of chemical, electronic and transportation equipment manufacturing. Thus, even within manufacturing, substantial opportunities exist for up-and-coming manufacturing sub-industries such as apparel and contract manufacturers. Further, some of the hot industries in urban areas which are seeing an uptick in research and development activity include specialty food companies, craft breweries, dental laboratories, financial services and architectural signage.
PROPOSED CHANGES TO LEGISLATION
Many of the Senate Finance Committee’s proposed changes centered on adaptations to the Credit tailored toward small businesses. As an alternative to using the Credit against an income tax liability, the proposal allows qualified small businesses to elect to use their research credits as payroll tax credits against any social security, old age, survivors and disability insurance liabilities. A qualified small business is a corporation or partnership with gross receipts of less than $5 million within the prior five years. The payroll tax Credit portion is the lessor of the calculated research tax credit or $250,000. This potential credit is particularly beneficial for small businesses, as many of them, especially start-ups, do not initially have an income tax liability against which the R&D credit can be used. The election would be made annually at the entity level in the case of S-corporations, LLC’s and partnerships.
Additionally, the proposed legislation calls for research credits for small businesses that can offset both regular tax and alternative minimum tax (AMT). Under the most recent version of the law, use of the credit against AMT was not allowed. However, the proposal includes a limitation of less than $50 million in gross receipts for the preceding three taxable years in order to qualify for use of the credit to offset AMT.
PROPOSED CHANGES TO IRS REGULATIONS
Taxpayers are not entitled to the R&D credit for the development of certain computer software for the primary purpose of internal use, unless that software meets a "high threshold of innovation" test. Proposed regulations issued on January 16, 2015 provide a narrower definition of internal use software and provide clarity about what constitutes internal use software. This narrower definition is important for taxpayers, as it means many more research-focused software projects may now qualify for the R&D credit.
Under the proposed regulations, internal use software would be defined as software developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business. On the other hand, software developed to be commercially marketed or developed to enable the taxpayer to interact with third parties is specifically excluded from the definition of internal use software. While internal use software projects are still subject to a "high threshold of innovation" test in addition to the standard four-part test, non-internal use software research projects only have to meet the standard four-part test.
There are many opportunities for businesses to take advantage of federal and state R&D credits. Marcum LLP has a team of tax professionals dedicated to R&D Credits and Incentives. We urge our clients and other readers to contact their Marcum tax advisor for a review of their entities operations to determine eligibility.