Research And Development (R&D) Tax Credit: Applicability and Benefits
The research and development tax credit was created to encourage businesses to invest in creating new or improved business components in order to promote economic growth in the United States. Thousands of companies in diverse industries benefit from this tax incentive. The R&D tax credit provides over $10 billion of tax savings to U.S. businesses annually, although it is underutilized, particularly by small and medium-sized companies.
The R&D credit is a federal program and is available to businesses in most industries, including but not limited to:
- Manufacturing & Distribution
- Food & Beverage
- Consumer Products
- Software & Technology
- Financial and Professional Services
It provides significant benefits to taxpayers with qualifying expenses. Recent changes in law from the Tax Cuts and Jobs Act (TCJA) of 2017 and the 2015 Protecting Americans from Tax Hikes (PATH) Act have made the R&D credit even more lucrative by providing taxpayers potentially larger credits for tax years ending after December 31, 2017. Both acts establish the R&D credit as a very powerful tool to reduce taxpayers’ tax liabilities and increase cash flow.
SUMMARY OF TCJA IMPACT ON R&D TAX CREDIT OPPORTUNITY
The TCJA did not directly impact or change the qualification requirements. However, the TCJA expanded the availability of the R&D tax credit to certain taxpayers by eliminating the alternative minimum tax (AMT) for corporate tax payers. These recent law changes removed hurdles that previously prevented some corporate taxpayers from utilizing credits.
However, all taxpayers (corporate and personal) are subject to a minimum tax requirement specifying that a credit cannot exceed the excess of the taxpayer’s net income tax over 25% of the taxpayer’s net regular tax liability above $25,000.
TCJA AND R&D EXPENSE PLANNING
The current method for accounting for the R&D credit remains the same for tax years beginning before January 1, 2022. Thereafter, the TCJA eliminates the option to deduct R&D expenditures and will require taxpayers to capitalize and amortize R&D expenses over five tax years.
PAYROLL TAX RELIEF
The PATH Act of 2015 allowed the R&D credit to be applied against the employer OASDI (Social Security) portion of payroll taxes for qualified small businesses. A qualified small business is defined as one with less than $5 million in revenue in the current tax year and no gross receipts for any tax year prior to the 5- year period ending with the tax year.
The payroll credit is limited to $250,000 per year for up to five years, and any unused portion can be carried forward to future years. The tax credit may also be claimed if the business uses a Certified Professional Employer Organization (PEO). This provision allows qualified small businesses the ability to utilize the R&D credit against payroll taxes and obtain an immediate cash savings in a loss year rather than carrying forward a credit.
ALTERNATIVE MINIMUM TAX RELIEF
Another benefit under the PATH Act of 2015is the ability to utilize the R&D tax credit to offset AMT (Alternative Minimum Tax) for taxpayers with $50 million or less in average annual gross receipts in the three preceding tax years.
The R&D credit is calculated by determining the amount of QREs for the company’s current and prior years. The QREs include wages, supplies used in the R&D development, and a percentage of fees paid to third party contractors. In order to meet the definition of qualifying research expenditures, research activities performed in the United States need to satisfy a four-part test:
- The work is being performed to develop new or improved business component (product, process, technique, formula, invention, or computer software component).
- The activities are performed to discover information that is technological in nature. The activities involve physical, biological, engineering, or computer sciences.
- The research is performed to eliminate technical uncertainty, determine if a desired result could be achieved, how to achieve it, or determine the specific design of a product.
- The activities will include a process of experimentation involving identification of the technical uncertainties, alternatives to consider in eliminating the uncertainties and a process for evaluating alternatives.
The TCJA and PATH Acts have significantly increased the value of R&D development activities and the potential opportunity to leverage the R&D tax credit as a part of a taxpayer’s year-end tax planning. In addition to the federal credit, many states have their own Research & Development credits.
Effectively using this credit will help increase a company’s cash flow by reducing tax liability and the amount of quarterly tax estimates due. In addition, businesses might be eligible to claim the credit retroactively by amending returns prior year returns.
Contact your Marcum tax professional in order to determine if your business qualifies for this benefit.