Newly Released Drafts Help Businesses Prepare for Revamped R&D Credit
Qualifying businesses can now use the research and development (“R&D”) tax credit to offset up to $250,000 of the Social Security portion of their payroll taxes, thanks to the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”). The PATH Act not only made the R&D credit permanent and retroactive to January 1, 2015 – it also expanded the credit so that qualified small businesses (typically start-ups) can reduce their payroll taxes by taking advantage of the R&D credit. The PATH Act also makes it possible for eligible small businesses to offset their entire Alternative Minimum Tax (“AMT”) liabilities with the credit.
And now, the Internal Revenue Service (“IRS”) has taken the next step by releasing new drafts of Form 941 (Employer’s Quarterly Federal Tax Return) and Form 6765 (Credit for Increasing Research Activities). These drafts reveal the line item changes that the IRS is considering in order to accommodate the PATH Act. The drafts will give businesses some idea of what to expect when they claim the R&D credit to reduce their payroll or AMT liabilities.
What’s new with these forms – and what should business entities be looking for as they review these drafts?
Reminder: These drafts of Forms 941 and 6765 aren’t meant to be used for filing purposes. The IRS will release final versions of the forms later in the year. But these drafts can signal some important changes down the road.
Background – What and Who Qualifies for the R&D Credit?
The R&D credit includes a broad definition of what qualifies as an R&D activity. Businesses don’t have to reinvent the wheel to qualify. Sometimes, something as simple as working to improve existing products in an effort to make them better can be enough to qualify your business for the credit.
Engaging in any of the following activities could make you eligible for some R&D credit incentives:
- Developing or testing new products and materials
- Developing new or enhanced formulations or combinations of existing products
- Testing new concepts
- Improving existing products
- Conducting trial and error experiments
- Designing tools, jigs, molds or dies
- Developing or improving production or manufacturing processes
- Developing, implementing or upgrading systems and/or software
The PATH Act makes four important changes to the R&D credit. It:
- Retroactively reinstates the credit to January 1, 2015.
- Makes the R&D credit permanent.
- Allows eligible small businesses to use the R&D credit to offset AMT liabilities.
- Lets eligible startup companies begin to use the R&D credit to offset payroll taxes.
Whether your business is considered an “eligible small business” or a “qualified small business” (and yes, they are two separate things) will determine how you can potentially apply the R&D credit.
The PATH Act adopts the definition of an “eligible small business” found in IRC § 38(c)(5)(C). This definition includes corporations (not publically traded), partnerships, and sole proprietorships with average annual gross receipts for the three preceding taxable years of $50 million or less. In the case of a partnership or S corporation, the gross receipts test is applied at the individual owner level.
The PATH Act and IRC § 41(h)(3) define a “qualified small business” as a corporation, partnership, or individual that has less than $5 million in gross receipts during the current taxable year in which the R&D credit is determined. The business also has to have $0 in gross receipts in all taxable years preceding the five-year period that ends with the current “credit” year (a five-year look-back). In other words, if your first sales occurred less than five years before the beginning of the taxable year, your business may qualify. For individuals, the five-year period considers all of the trades or businesses of the individual rather than just the business generating the credit.
Two New Ways to Apply the R&D Credit
Qualified small businesses, which are usually start-ups, can use this credit to offset up to $250,000 of the Social Security portion of payroll taxes for taxable years starting in 2016. If you’re not generating a lot of income yet as a newer business, this tax incentive could be critical as you establish yourself. However, the credit must be claimed on an original income tax form or information return that is filed on time. The credit can also only be used for five years.
The employer’s portion of Social Security, or old age, survivors and disability insurance (“OASDI”), is what qualified small businesses can offset with the R&D credit. OASDI generally equals 6.2% of wages up to a limit that changes annually. For 2016, this limit is $118,500. 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. The credit may not exceed the OASDI liability for the quarter. Excess credits may generally be carried forward.
For eligible small businesses, the PATH Act lets you choose to use the R&D credit to offset AMT liability during taxable years beginning after December 31, 2015. Unused R&D credits of an eligible small business may be carried back one year and carried forward 20 years to offset any AMT liabilities in those years under the general business credit rules of IRC §§ 38 and 39.
What Are the Changes?
The changes in the drafts of Forms 941 and 6765 focus mainly on where to report R&D credit offsets. Changes to the draft Form 941 highlight the opportunity for qualified small businesses to offset their payroll tax liabilities. Changes to the draft Form 6765 highlight the opportunity for eligible small businesses to offset their AMT liabilities.
The 2016 draft of Form 941, Part I lists 13 line items to help calculate deposits and balance due or overpayment. The new draft Form 941 for 2017 includes two new line items:
- Line 11, “Qualified small business payroll tax credit for increasing research activities,” is specifically for entering R&D credit information. Line 11 requires Form 8974, which has yet to be created, to be attached.
- Line 12, “Total taxes after adjustments and credits,” guides users through tallying the total deposits.
Part II has been amended to include Line 12’s calculation for determining whether an employer is a monthly or semiweekly schedule depositor.
In the previous version of Form 941, the subtotal calculations (i.e., total taxes after adjustments) did not include any credits to reduce an employer’s possible quarterly tax liability.
The 2015 Form 6765 ends with Section C—Summary, which guides users through the final calculations based on which entity type they fall under: estates and trusts, partnerships and S corporations, and all others.
On the draft 2016 Form 6765, Section C is broken down a little differently. Section C, now called “Current Year Credit,” lists a fourth group under Lines 38 and 40: eligible small businesses. The new Line 38 guides the taxpayer to report the credit on Form 3800, “General Business Credit”, Part III, line 4i. The new Line 38 also tells taxpayers to refer to the instructions to find the definition of “eligible small businesses.” A draft of the instructions has not been released. However, one can assume with some certainty that the definition will likely match the definitions already put forth in the PATH Act and IRC § 38(c)(5)(C). These changes to the form are directly related to the ability of users to claim the R&D credit to offset AMT liabilities.
Another important item the draft form points out on the new Line 38 is that qualified small business filers, other than partnerships and S corporations, that elect to offset payroll tax liabilities must complete Form 3800 before completing the newly added Section D (Lines 41-44), “Qualified Small Business Payroll Tax Election and Payroll Tax Credit.”
New Line 41 contains a box to check if you are making the election to offset payroll taxes, while the remaining lines are used to report how much of the R&D credit will be used to offset payroll.
All the changes found in these drafts indicate how the IRS is planning to accommodate legislative changes in its forms. The good news is that these changes benefit businesses, so business entities will want to be prepared.
Be on the lookout for the updates to Forms 941 and 6765 to be finalized towards the end of 2016 or the early part of 2017 at the beginning of filing season.
For businesses that aren’t sure if the money they’re putting into R&D initiatives qualifies for the R&D credit, commissioning an R&D study can help bring to light incentives which you’re entitled to – incentives that can reduce your tax liability substantially. A thorough, well-done study examines both direct and indirect costs related to your activities.
And, there’s a bonus! Many states offer their own R&D credits or incentives that can often be claimed for the same expenditures that qualify for the federal credit.
Are there processes or materials you’re trying to create or improve? The R&D credit is quite broad and could apply to something you’re doing in your business right now.
As you’re looking through the drafts and thinking about whether or not your business could benefit from an R&D study, feel free to contact Cherry Bekaert’s Credits/Accounting Methods team. They’re a great starting point for your R&D questions.
Or reach out to a local member of our client service team so they can guide you through this analysis.