Research and Development: Tax Credit Benefits and Capitalization Considerations
By Nicholas Thomas, Partner, Tax & Business Services
The Federal Research and Development (R&D) tax credit is available for companies that incur qualified research expenditures (QREs) to develop new or improved products, processes, or software in the United States. The Economic Recovery Tax Act of 1981 (ERTA) originally introduced the R&D tax credit, also known as the research and experimentation (R&E) tax credit, on a temporary basis to incentivize R&D spending in the United States. Since its inception, this incentive has been extended numerous times but became permanent as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015.
The credit, though often underutilized, is a powerful tax-savings tool. Many companies underestimate their R&D tax credits or wrongly believe they do not qualify. In actuality, the R&D tax credit represents a dollar-for-dollar reduction in income tax liability. Companies should carefully consider eligibility for R&D tax credits because these incentives may:
- Significantly reduce federal tax liability and may be carried forward, if unused, for 20 years,
- Be utilized up to $500,000 to offset employer-paid FICA and Medicare taxes beginning with 2023 income tax return filing for qualified small businesses or
- Provide generous state credit tax incentives
Industries where R&D-qualified expenses often occur include, but are not limited to:
- Manufacturing & Distribution
- Software & Technology
- Food & Beverage
- Consumer Products
Federal R&D Credit Calculation
The Federal R&D credit is calculated by determining the amount of QREs for the company’s current year over a base. QREs comprise wages, supplies used or consumed in the R&D development process, and 65% of third-party contract research expenditures.
The base is calculated using either the regular or alternative simplified credit (ASC) method. The regular credit computes the base using factors, including historical QREs, historical gross receipts, and when the Company began operations. The ASC calculates the base using QREs in the three immediately preceding tax years. Assessment of each base computation is paramount for a Company to optimize its tax credit.
To meet the definition of qualifying research expenditures, research activities are required to be performed in the United States and must satisfy the Internal Revenue Service’s (IRS) “Four Part Test”:
- The work is being performed to develop a 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 and determine if a desired result could be achieved, how to achieve it, or the specific product design.
- The activities will include a process of experimentation involving identifying the technical uncertainties, alternatives to consider in eliminating the uncertainties, and a process for evaluating alternatives.
Changes under recent legislation have made the R&D tax credit more beneficial but have also added complexity to the tax deductibility of R&D expenditures and documentation to support R&D credit claims.
2015 PATH Act, expanded by the 2022 Inflation Reduction Act
The PATH Act allows the R&D income tax credit to be applied against an employer’s 6.2% portion of Social Security payroll taxes for “qualified small businesses.” A qualified small business is defined as one with less than $5 million of gross receipts for the tax year and no gross receipts for any tax year before the 5-tax-year period ending with the tax year. Gross receipts are determined under Internal Revenue Code (IRC) Sections 448(c)(3)(B), (C), and (D).
As originally enacted by the PATH Act, 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 Inflation Reduction Act has extended the benefit of the R&D tax credit to tax years beginning on or after January 1, 2023. This expansion allows for an increase in the annual payroll offset, enabling employers to offset their 1.45% portion of Medicare tax, resulting in a total offset of 7.65%. The Inflation Reduction Act also expanded the maximum credit amount allowable to offset payroll tax from $250,000 to $500,000.
2017 Tax Cuts and Jobs Act (TJCA)
A. R&D Expense Capitalization
For tax years beginning on or after January 1, 2022, the TCJA eliminated the option to deduct R&D expenditures in the current tax year under IRC Section 174. The change in treatment requires taxpayers to charge such expenses to a capital account and be allowed to amortize R&D expenditures over five years (or 15 years for amounts attributable to foreign research) beginning with the midpoint of the taxable year in which such expenditures are paid or incurred.
The TCJA also changed the formal language from “research or experimental expenditures” to “specified research or experimental expenditures (SREE)” and added the requirement that any amount paid or incurred in connection with the development of software is treated as a “specified research or experimental expenditure.” This may restrict the ability to deduct software development expenditures for tax years beginning on or after January 1, 2022.
The IRC Section 174 capitalization requirement is distinct from the R&D tax credit. While R&D credit-eligible expenditures are associated with direct costs relating to the research and development, such as wages, materials and supplies used in the conduct of research, and third-party contract research amounts, the IRC Section 174 expenditures subject to capitalization is more expansive than the R&D tax credit eligible expenditures. The broader IRC Section 174 definition focuses on R&D expenditures that include direct and indirect costs, such as legal and overhead. These indirect costs are not eligible for R&D tax credit treatment.
Taxpayers should note that if they are incurring expenditures that meet the definition of research and experimental expenditures, they are required to capitalize and amortize such expenditures over the applicable amortization period regardless of whether they claim the R&D tax credit. The IRS can re-classify expenditures as capitalizable under IRC Section 174, thus increasing taxable income. The R&D tax credit may help to mitigate the increased tax liability caused by IRC Section 174 capitalization. Although there have been three proposals to rescind the Section 174 capitalization requirement in 2023, as of this publishing date, Section 174 has not been revoked. Please consult your tax advisor regarding the 2023 impact of Section 174 capitalization.
B. R&D Credit and IRC Section 280C
The TCJA changed the expense adjustment relating to the R&D credit. For tax years beginning before January 1, 2022, this code section disallowed a deduction for the portion of Qualified Research Expenses (eligible for the credit) equal to the amount of research credit claimed. The code section allowed a taxpayer to elect to reduce the credit (by 21%) in lieu of reducing the deduction.
For tax years beginning on or after January 1, 2022, revised IRC Section 280C(c) provides that if the R&D credit exceeds the amount allowable as a deduction for qualified research expenses or basic research expenses, the amount chargeable to capital account (as IRC Section 174 SREE) shall be reduced by the amount of such excess.
There is ambiguity in the revisions to IRC Section 280C in that it does not address the need to make any adjustment to expense (or, under current law, the amount chargeable to the capital account) where the credit does not exceed the amount allowable as a deduction. Additionally, where a reduction is required, the amount of the reduction is not necessarily the entire amount of the credit but only the excess of the credit over the amount allowed as a deduction.
Further complicating the revisions to IRC Section 280C under TCJA is that the IRS may disagree with the revision. The most recently published instructions for Form 6765 (Credit for Increasing Research Activities), Line 17, dated January 2023, provides that if a taxpayer does not elect the reduced credit under IRC Section 280C, it must reduce its otherwise allowable deduction of qualified research expenses by the amount of the credit. The instructions further provide that if the credit exceeds the amount allowable as a deduction for the tax year, then the excess reduces the amount chargeable to the capital account for the year.
The Form 6765 instruction does not appear to follow the statutory language within IRC Section 280C, as revised by TCJA. Taxpayers should consult with their tax service providers regarding any legislative updates regarding IRC Section 280C and advisement regarding the tax effect and tax risks associated with the IRC Section 280C election until further guidance is released.
Other IRS Releases
A. Chief Counsel Memorandum (CCM) Impact on Amended Returns
On October 15, 2021, the IRS issued CCM 20214101F, providing new guidelines that clarify procedural instructions for eligible taxpayers to claim the R&D tax credit while reducing the number of disputes over such claims.
The CCM identifies the information a taxpayer must include in an administrative claim for refund of credit (“refund claim”) for the refund claim to be valid under IRC Treasury Regulation Section 301.6402-2(b)(1).
The IRS has provided a transition period through January 10, 2024, giving taxpayers 45 days to “perfect” an insufficient claim before the IRS makes a final determination if all the requested information has been provided. A valid claim only means a taxpayer provided the requested documents in the CCM. The validity of a claim does not preclude the IRS from denying the request or auditing the credit claim.
B. Notice 2023-63
On September 8, 2023, the IRS released interim guidance and signaled its intention to issue proposed regulations to clarify IRC Section 174 capitalization. Taxpayers are not required to apply the rules in Notice 2023-63 immediately but may use them for tax years beginning after September 8, 2023, provided they rely on all the rules and apply them consistently.
The interim guidance within Notice 2023-63 covers uncertainties that Taxpayers were facing in addressing the IRC Section 174 capitalization, including:
- Capitalization and Amortization of SRE Expenditures
- Scope of Section 174
- Software Development
- Research Performed Under Contract
- Disposition, Retirement, or Abandonment of Property
- Long-Term Contracts Under Section 460
- Cost Sharing Regulations at IRC Treasury Regulation section 1.482.7
The IRS has requested feedback on the interim guidance and any issues needing further consideration for proposed regulations.
C. Proposed Changes to Form 6765
On September 15, 2023, the IRS released a preview of proposed changes to certain sections of Form 6765 for claiming the R&D credit. The proposed changes aim to provide taxpayers with consistent and predefined formats for tax reporting and improve the information received for tax administration, building on ongoing efforts to manage issues and resources regarding research credit claim matters.
The IRS is considering making the changes effective beginning with tax year 2024. The proposed additional sections would require taxpayers to provide more expansive information associated with their research credit claim, including additional information related to the identification of officers’ wages claimed for the credit, additional information defining a business as a member of a controlled group and expanding information requirements associated with a Taxpayer’s business components for which research expenditures are being claimed for credit.
Beyond Federal Credits
In addition to the Federal credit, many states offer R&D tax credits. Effectively using both Federal and state credits can help small and mid-sized companies increase cash flow during their early growth years.
The Federal Research and Development (R&D) tax credit is valuable for companies to reduce tax liabilities and incentivize R&D spending in the United States. Despite being underutilized, the R&D tax credit offers significant benefits. However, recent legislation has added complexity to the tax deductibility of R&D expenditures, including the requirement to capitalize and amortize such expenses over several years. It is essential for companies to carefully consider their eligibility for R&D tax credits and consult with their Marcum advisor to optimize their tax savings.