May 9, 2016

Are You Leaving Money on the Table?

By Monte S. Colbert, Director, Tax & Business Services

Are You Leaving Money on the Table?

Innovation is critical to the growth of the U.S. economy, and to encourage innovation the Research & Development Credit (“R&D”) was introduced by the Internal Revenue Service in 1981. This credit continues to be under-utilized by most businesses, especially those within the financial services industry. There are several reasons for this, including a misunderstanding of the qualification and documentation requirements, fear of triggering an IRS audit, and the perception that the R&D credits are limited in scope and not applicable to certain industries. While there are requirements that must be met in order to qualify for the credit along with record keeping requirements, the overall benefits for taxpayers will likely exceed these burdens.

Recent legislation has been enacted to encourage taxpayers to take advantage of the R&D tax credit, both at the federal and state levels. In December 2015, President Obama signed the Protecting Americans from Tax Hikes Act of 2015 (“PATH”), also referred to as the Extender Bill. Passage of this Act combined with recent liberalization of the IRS treatment of the credit, will eliminate almost all of the concerns noted above.. The PATH Act is certainly a game changer, and many business and individual taxpayers that were not eligible in the past will now be able to take advantage of this generous credit.

Key provisions within the PATH Act related to R&D include the following:

  • The Credit is now permanent and retroactive to January 1, 2015. Taxpayers will no longer need to worry that the program will not be extended from year to year.
  • The Credit can offset the alternative minimum tax (“AMT”) for eligible small businesses and their owners, within certain limitations, effective as of January 1, 2016. Previously, the credit could not offset AMT. This is a significant change in the ability for many businesses and owners to now be able to take advantage of this credit.
  • For start-up companies, the R&D credit can now be taken in the form of a refundable credit offsetting the employer FICA payroll tax liability, also effective as of January 1, 2016.

Eligible small businesses are defined as non-public entities with average annual gross receipts not exceeding $50 million during the prior three years. The R&D tax credit for pass through entities, such as S corporations, LLCs and partnerships, in which many financial services businesses operate, will be available to the members, partners and shareholders of those entities to reduce their personal liabilities, even if they are subject to the AMT. Unused credits can be carried forward 20 years or carried back 1 year.

Owners of these flow through entities that previously opted not to explore their R&D eligibility due to the AMT, have new incentive to check with their tax advisers to determine if they may avail themselves of the credit.

Start-up companies which are considered qualified small businesses (“QSB”) can elect to utilize the R&D credit to reduce the FICA portion of employer payroll liability. This is a huge development for start-up businesses that may have a history of losses and no income tax liability. An annual election can be made to take up to a $250,000 credit against the employer’s portion of Social Security (“FICA”) for five years, essentially making the credit refundable. For these purposes, a QSB is defined as an entity which has less than $5 million of gross receipts for the taxable year and did not have gross receipts for any taxable year before the five taxable year period ending with the taxable year. The payroll tax deduction against which the credit is taken still qualifies as a deductible business expense.

This is a pro-taxpayer provision. Most start-up companies are small and do not generate income during their early years, but most do have employees, thus subjecting them to entity-level FICA that can now be offset by the credit.

In order to determine eligibility for the R&D credit, it must first be determined if the activities being performed are Qualified Research Activities (“QRA”).

What is a Qualified Research Activity (QRA)?

There are four tests an activity must meet before it qualifies for the R&D tax credit:

  • It must rely on a natural science, for example: engineering and computer science.
  • It must relate to the development of new or improved functionality, performance, or feature of the product or process.
  • There must be technological uncertainty before embarking on the project.
  • Experimentation must be conducted to eliminate the technological uncertainty.

Internal Use Software (IUS)

IUS has been defined as, software developed by the taxpayer for general and administrative functions, which are limited to human resource management, financial management, and support services. Generally, IUS is not eligible for the credit because it is not intended to be leased, licensed, or sold to a third party.

However, one of the more significant changes in the treatment of IUS provides that, software which enables the taxpayer to interact with third parties, allows third parties to initiate functions or review data on the taxpayer’s system (referred to as consumer facing software), is a QRA and eligible for the credit. For example, a customer accessing account information, initiating a trade, or utilizing research through a taxpayer’s system or utilizing a licensed program such as online accounting software are examples whereby the development of the access to those systems and the products utilized are QRA’s and are eligible for the credit. Software used in banking transactions, or to track the deliveries of goods, purchase tickets, retrieve files, or search inventories are other examples of QRA’s.

Additional criteria applied to IUS only

In addition to the four previously mentioned tests to determine if there is a QRA, there are additional criteria applied to software as follows:

  • It must be innovative and result in substantial and economically significant cost reduction or time improvement.
  • There must be significant economic risk involved.
  • It must be commercially unavailable for purchase, lease or license, and used without modifications that satisfy the first two requirements.

Once it is determined that you are involved in a QRA, you then gather the quantitative information, the Qualified Research Expenditures (“QRE’s”) to calculate the credit. Examples of QRE’s are as follows:

Qualified Research Expenditures (QREs)

  • Wages paid to employees for providing qualified services.
  • Expenses for materials used in the R&D process.
  • Expenses incurred for contract research performed by someone other than the employee of the taxpayer so long as the research is performed in the U.S.
  • Payments made to qualified education institutions and scientific research organizations.

Qualifying R&D Activities in the Financial Services Industry

Financial service companies, including investment management firms, broker/dealers, banks, financial institutions, fund administrators and independent valuation specialists’ qualifying R&D activities typically fall into four general categories:

  • New product development, for example the design or development of new technology for sale, lease or license.
  • Incremental product development, for example modifying existing software that significantly enhances performance, functionality, or quality.
  • New process development, for example designing database management systems.
  • Incremental process improvement, for example optimizing data access patterns.

Examples of specific qualified activities that are common within the financial services industries and qualifying for the credit include:

  • Development of software utilized by customers or clients to access the company’s computer or software technology.
  • Development of new or improved proprietary trading systems and valuation models.
  • Modification or development of algorithms for investment funds.
  • Advanced mathematical modeling.
  • Optimizing data access patterns.
  • Development of financial analytics engines to improve forecast quality and coverage.
  • Optimization of code and programming software source code for product performance, new features, or integration with new platforms or operating systems.
  • Modifications or improvements to an existing software or technology platform that enhances performance, functionality, reliability, or quality.
  • Development of new communications and security protocols.
  • New architecture design and research to improve scalability, functionality, or improved performance.
  • Design of database management systems and database back-end systems.
  • Beta-testing-logic, data integrity, performance, regression, integration, or compatibility testing.
  • Software development to improve system reliability, up-time, and computer efficiency.
  • Integrating legacy applications across virtual environments.
  • Software design to work with different databases.
  • Design and development of any new software or technology products for commercial sale, lease, or license.
  • Development of new online and mobile banking functionality.
  • Research of specifications and requirements, domain, software elements including definition of scope, and feasibility analysis for functional enhancements.
  • Research for development of applications for technology patents.

Other Recent Developments in R&D Credit Tax Provision

New modifications and taxpayer-friendly regulations have recently been put into place to make the R&D credit less onerous and more appealing to taxpayers. Legislation includes:

  • The American Taxpayer Relief Act of 2012 (Act) made a revision which allows taxpayers that acquire a trade or business to prorate the acquired entity’s QRE gross receipt and related base-period effect based on the number of days from the date of acquisition through the end of the controlled group’s tax year.
  • The Act also revised how the R&D credit is allocated to members of a controlled group. The R&D credit that is allocable is the proportionate basis to its share of the aggregate of the QRE, regardless of the amount of the group credit as compared to the sum of the standalone credits.
  • The IRS is proposing under Section 174 that expenses qualifying as R&D expenditure during development can be taken as a credit regardless of whether the product is used by the taxpayer or ultimately sold.
  • The IRS has modified its position on the level of audit treatment related to potential tax audits involving a credit review. The IRS will no longer consider R&D credits as being a Tier 1 audit issue. A Tier 1 issue was generally reviewed by an agent with the highest level of detail.

Calculating the R&D Credit

There are two standard methods of calculating the R&D credit, namely, the traditional “Regular Credit” method and the Alternative Simplified Credit method (ASC). Under the traditional method, the credit is 20% of the amount by which current year QRE exceeds a base amount computed on a moving average of gross receipts and historical expenses. In the ASC method, the credit is 14% of the amount that current year QRE exceeds 50% of the average QRE for the three tax years preceding the current tax year. The ASC method is ideal for companies that do not have, or are unable to determine the historical QRE used for calculating the base amount.

Traditional method = 20% of the smaller of ((current QRE base period amount) or (50% of current QRE)) +20% (current payments to universities-base period amount)

ASC method = (current year QRE – (average of pervious 3 years QRE x 50%)) x 14%


To maintain their advantage in a highly competitive industry, financial services companies have increased their spending to all-time highs on research and development. As part of public policy encouraging this type of spending, the IRS has taken steps to provide additional benefits to those companies that are involved in that initiative, as the credit can now provide a refundable credit to companies even if they are operating at a loss. The credit can now also be utilized by certain taxpayers that are subject to the Alternative Minimum Tax. The R&D credit may be carried back one year and forward up to 20 years, thereby lowering the effective tax rate in more profitable years.

Many states offer similar research credits that are either based on or follow the federal credit. In addition, there are other credits and incentives at the federal, state and local levels, such as investment tax credits and emerging technology credits, which are also applicable to financial services companies. Overall, these credits can add significant value to the organization by increasing cash flow, lowering overall tax liability, lowering effective tax rates, and by creating deferred tax assets that can be used as a negotiating tool for businesses that may be for sale now or in the future.

Please contact a Marcum Research & Development Tax Specialist to discuss how this program may provide benefit tailored to your specific business.

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