Don’t Miss Out on a Credit Opportunity
We have good news for innovators! Your company’s research and development efforts may also reduce your income tax liability. The recently enacted Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”) includes the following important changes to the Research & Development (“R&D”) credit:
- The credit was retroactively reinstated effective January 1, 2015;
- The credit was made permanent;
- The credit can now be used by eligible small businesses to offset Alternative Minimum Tax (“AMT”) liabilities; and
- The credit can now be used by eligible start-up companies to offset payroll taxes.
Read on for a closer look at what these changes may mean to you and your business.
Permanence as of January 1, 2015
Until the enactment of the PATH Act, the R&D credit was maintained as a temporary tax incentive, leading to uncertainty in planning and reluctance by many eligible entities and industries to utilize it. This reluctance was due to lack of understanding and an accompanying fear of audit, which entities often chose not to face because of the fact that the credit was only temporary in nature. Now that the R&D credit has been made permanent, you will leave an even more valuable opportunity (and money) on the table if you don’t gain an understanding of it.
The R&D credit may be a lucrative incentive for companies that:
- Develop or test new products and materials;
- Develop new or enhanced formulations;
- Test new concepts;
- Improve existing products;
- Conduct trial and error experimentation;
- Design tools, jigs, molds or dies;
- Develop or improve production or manufacturing processes; and/or
- Develop, implement or upgrade systems and/or software.
Since the PATH Act made the R&D credit retroactive to January 1, 2015, taxpayers who previously filed a return may now have an opportunity to file an amended return and claim an increased credit attributable to costs incurred during 2015 that may not have been considered on the originally filed return.
AMT Offset for Small Businesses
If your business is an “eligible small business”, the PATH Act affords you an additional opportunity to utilize the R&D credit during taxable years beginning after December 31, 2015, by allowing you to offset the credit against any AMT liability.
If you are not sure if you are entitled to this treatment, an “eligible small business” is generally defined in Internal Revenue Code (“IRC”) §38(c)(5)(C) as a business with average annual gross receipts of $50 million or less for the three preceding taxable years. In the case of a partnership or S corporation, the gross receipts test is applied at the individual owner level. Further, unused R&D credits of an eligible small business may be carried back one year and forward 20 years to offset any AMT liabilities in those years, under the general business credit rules of IRC §§38 and 39.
Payroll Tax Offset for Start-ups
If your business is in a start-up phase, you can use R&D credits to offset up to $250,000 of payroll tax liabilities with R&D credits, effective for taxable years starting in 2016. This can be a pivotal tax incentive if you have a smaller company that does not yet generate income tax liabilities that would typically be offset by the R&D credit, but must be elected on a timely filed original income tax or information return and can only be used for five taxable years.
The portion of payroll tax that can be offset is the employer’s portion of Social Security or old age, survivors and disability insurance (“OASDI”), which generally equals 6.2% of wages up to a limit that changes annually. The allowed offset does not apply to the Medicare portion of payroll tax that is imposed at 1.45%. The R&D credit is applied to the quarterly payroll tax return for the quarter beginning after the filing of the income tax return that includes the election, and may not exceed the OASDI liability for the quarter. Excess credits may generally be carried forward.
Start-ups or “qualified small businesses” are defined in IRC §41(h)(3) as corporations, partnerships or individuals with less than $5 million in gross receipts during the taxable year and no gross receipts at any time preceding the five taxable years preceding the current “credit” year. For individuals, the five-year period considers all of the trades or businesses of the individual, rather than just the business generating the credit.
Qualified Research and Development Expenses
You may have qualified research and development expenses without realizing it, because the definition of qualified research is broader than expected and does not exclusively apply to technology companies, or involve scientists. Qualified research generally includes activities to develop new or improved products, processes, and techniques, unless the activity specifically concerns matters of style, taste, and cosmetic or seasonal design factors. If your company develops new or enhanced formulations; tests new concepts; develops new products; conducts trial and error experimentation; develops or improves systems and software; and/or creates or improves production or manufacturing processes, it is likely conducting qualified research and may benefit from R&D credits.
Expenditures eligible for the R&D credit include wages, costs of supplies used, and 65% of contract research expenses incurred in relation to qualified research, which is most research that satisfies the following four requirements:
- The research expenses must be eligible for treatment as research or experimental expenses under IRC §174;
- The research must be undertaken for the purpose of discovering information that is technological in nature;
- The application of the discovered information must be intended to be useful in the development of a new or improved business component of the taxpayer; and
- Substantially all of the research activities must constitute elements of a process of experimentation.
Thanks to the PATH Act, innovative and progressive companies have been provided more tax savings opportunities and planning. In addition, many states offer their own R&D credits that can often be claimed for the same expenditures that qualify for the federal credit. Do not leave money on the table by ignoring this opportunity. If you have any questions, please contact your Cherry Bekaert Tax professional or a member of Cherry Bekaert’s Credits/Accounting Methods team for guidance.