The R&D Tax Credit Technology Companies Deserve
Additional Contributor: Corning Pearson, Senior Manager, Tax Credits & Incentives Advisory
Technology is catching up with our imaginations, making the seemingly impossible possible. Large and small companies alike continue to innovate at a high rate. Those in the technology sector have shown an increase in spending on research and development (R&D) activities while the pandemic caused a decrease in spending by U.S.-based businesses in most other areas.
The technology sector has undergone a transformation with growth in the following areas:
- Industry focus is on software as a solution (SaaS)
- The video game industry continues to grow and move into a broader range of delivery hardware
- Infrastructure, architecture, and software to deliver hosting and services via off-site server environments
- Includes the development of solutions to mitigate the effects of supply chain disruptions and inflation by supporting flexible raw material sourcing, handling, and shipping efficiencies
Data Collection, Analytics, and Customized Sales
- Emerging technologies can create a personalized purchase experience and efficiently deliver customized products
- U.S.-based manufacturers have increased their use of robotics and motion control technologies as unstable supply chains have caused companies in the industrial sector to relocate manufacturing activities from foreign countries to the U.S.
The federal government and more than 40 states encourage companies to invest in R&D in their jurisdictions through R&D credits and incentives. Proactive planning by businesses is essential to claim R&D credits so that the maximum cash benefits can be realized at the earliest point in time. Businesses are entitled to R&D Credits whether they are set up as a Subchapter C corporation for tax purposes or as a flow-though entity. For the latter, the credits follow the taxable income that is passed on to the business owners.
Funding with R&D Tax Credits
Early-stage companies in the technology sector spend their start-up years conducting massive amounts of R&D. Cash is required to pay these expenses at a time when these companies recognize little to no revenue. This disparity in the lack of ability to monetize tax credits and the need for cash runs counter to the goal of promoting an increase in US-based R&D activity. Congress addressed this disparity through legislation affecting tax years beginning in 2016.
Companies in their first five years of operations that earn less than $5 million in receipts can use Federal R&D credits, up to $250,000 per year, against their payroll tax liabilities. The measuring period for the five-year window starts with the first year the company earns sales revenue, interest, dividends, rents, royalties or other income.
Most technology start-ups do not pay income taxes in their first five years, but all have payroll tax liabilities. So, rather than wait until they are profitable, companies can claim R&D credits in the years during which the expenses are made through payroll tax offsets and realize the cash benefits starting with the first quarterly payroll tax filing. Several states have followed with payroll offsets or other immediately monetizable benefits for R&D activity conducted in their states. Claiming these state benefits is fraught with compliance complications. Cherry Bekaert knows the requirements for each of these states and can help navigate the pitfalls and filing deadlines so that your business does not miss benefits because it is unfamiliar with the required paperwork.
Companies typically seek funding for their R&D activities in the debt and equity markets. R&D credits can provide funding without the company incurring debt or diluting ownership.
Supercharged R&D Investment
R&D credits can be viewed as a supplement to a company’s R&D expenditures. The R&D credit can provide a supplement of approximately 11.06 cents for every dollar spent on R&D wages, supplies, and contractor-performed R&D in the U.S. The R&D credit is a permanent, cash tax benefit. So, any benefit realized not only provides a cash return but also has a positive impact on the company’s effective tax rate, a metric key to valuation models.
Mergers and Acquisitions
Mergers and acquisition (M&A) activity in the technology sector is taking place at an unprecedented rate. In the record-breaking year of 2021, software represented approximately 12% of U.S. Private Equity Deal Activity. Portfolio companies and industry leaders are continuously looking for businesses in which to invest or to acquire. Their analyses are becoming more sophisticated and their due diligence more thorough.
Companies claiming R&D credits are at an advantage in the M&A marketplace relative to those not claiming credits because:
- They demonstrate awareness of tax benefits that are available to their business.
- They report deferred tax assets on their balance sheets for unused R&D credit carryforwards.
- Their effective tax rates are lower.
- They have established key credit metrics and elections so that future claims will not be burdensome to calculate, substantiate, and claim.
- They have supporting documentation for the R&D activity which shows the methodology used to calculate the credits and narrative descriptions of the qualified activity.
As recognized experts regarding the R&D credit, we are often consulted during tax due diligence to determine whether companies are optimizing the R&D credits available and properly substantiating them in a manner sufficient to withstand IRS and state taxing authority examination. Businesses that maximize their R&D credits are increasingly more appealing to investors because they demonstrate an attention to all the sources of funding available to them, diligence in their financial affairs, and recognition that decreasing their effective tax rates can lead to higher valuations.
No Pain from Taxable Gain
It is increasingly common for companies to be sold prior to being tax profitable. Why claim credits after the payroll tax offsets are exhausted if a company continues to generate tax losses?
R&D credits for entities such as partnerships, LLCs, and S-Corporations are passed on to their owners on their Form K-1. If the owner is unable to use the credits because they have been allocated losses, these credits accumulate and are carried forward for 20 years. If the company is sold and the owner realizes a gain on the sale of the company, the owner can use the cumulative R&D credits against the taxes on the gain realized.
This benefit requires foresight on the part of owners and should be incorporated into exit strategies for businesses conducting R&D. Waiting to consider R&D credits until a large tax liability is imminent is not advisable.
If you have questions or want to learn more about the R&D tax credit for your technology company, consult your Cherry Bekaert advisor or contact Cherry Bekaert’s Tax Credits & Incentives Advisory group.
Want to Know More?
Join us for a Tax Credits & Incentives Virtual Conference on June 22!
This live virtual event comprised of four sessions is designed to help innovative companies take advantage of federal and state tax incentives to generate funds for capital investments.