R&D Tax Credits for COVID-19 Activities
Businesses that are pivoting their operations and reinventing products and services, even to a small degree, during the COVID-19 pandemic may be eligible for Research and Development (“R&D”) tax credits. Companies should review their research and development initiatives as part of year-end tax planning to determine if these activities qualify the companies to receive significant cash benefits.
The federal R&D tax credit, the credit for increasing research activities, is a dollar-for-dollar offset of an income tax liability and is generally claimed by businesses developing or improving products, processes or software. The credit often represents 7 to 20 percent of R&D expenditures, such as wages, supplies and payments to third-party contractors.
While many large enterprises are familiar with the R&D tax credit and capture it annually, the COVID-19 crisis could lead more small- and medium-sized companies, including service-oriented businesses, to qualify for the first time.
COVID-19 R&D Opportunities
The following are examples of situations triggered by COVID-19 that could lead to research and development expenditures eligible for the R&D tax credit.
Development of eCommerce tools
Restaurants, retailers and service providers are rushing to develop or improve their eCommerce platforms to service customers who are no longer making in-person purchases. Functionalities need to be developed to support new delivery or pick-up options. Online transaction applications need to be revamped and improved to withstand increased volumes of eCommerce sales.
Financial institutions are developing new features to enhance online banking. Medical offices are launching enhanced telemedicine applications for remote consultations. All along the supply chain, businesses are seeking to improve the performance and resiliency of their systems. These projects are likely to include activities and expenditures that qualify for the R&D tax credit.
The rapid move toward working from home and the drastic reduction in travel caused by COVID-19 is triggering new software R&D projects. The development of scalable and secure remote working solutions, for instance, could lead to software-oriented R&D projects.
Cybersecurity is a critical concern for most companies during this surge of online business operations. Protecting employee and customer data is particularly complex as large portions of the workforce work remotely. Accordingly, the integration of legacy platforms with modern virtual collaboration tools such as Zoom and Microsoft Teams has led to complex software development projects that could include creditable activities and expenses.
Manufacturing of PPE and household goods
Many manufacturers across the country are scrambling to transform standard operations to manufacture personal protective equipment and sanitary equipment. Others are implementing new or improved processes to ramp up the production of high-demand household consumables. The development or improvement of these manufacturing processes often requires experiments as well as a series of costly trials to reach product specifications. Issues with the supply chain are also leading many manufacturers to experiment with alternative raw materials and redesign certain products.
Pharmaceutical and biotech companies, including startups, are racing to develop new drugs and therapeutics to fight COVID-19. Drug development projects are costly and inherently risky. These projects are generally eligible for significant R&D tax credits.
Benefits for Startup Companies
Certain startups with less than $5 million in annual revenue can use the R&D tax credit to offset payroll taxes up to $250,000. This is a significant opportunity for startups that are not yet taxable from an income standpoint. The utilization of the R&D tax credit against payroll taxes can generate immediate cash flow and should not be overlooked, especially during uncertain economic times when shoring up cash flow is critical to future business success.
Post-Election and Potential Impact of R&D Tax Legislation
COVID-19 likely will have an impact on future R&D tax legislation.
The idea of deglobalizing the supply chain and repatriating the development and manufacture of critical drugs and essential goods is emerging from the pandemic and would require significant investments in innovation and R&D by U.S. companies.
The federal government is expected to pass additional stimulus and relief legislation in the near future. Currently, in Congress, the idea of repealing the Tax Cuts & Jobs Act (“TCJA”) provision requiring businesses to start capitalizing R&D costs in 2022 and amortizing these costs over a five-year period, as opposed to the current immediate expensing treatment, is gaining bi-partisan traction.
Also, ideas raised in recent years to boost research and development in the U.S. include increasing the credit percentage amount, enhancing the R&D payroll credit by allowing more businesses to qualify, and relaxing the restrictions on contract research organizations (“CROs”) performing R&D on behalf of another taxpayer. This last measure would have broad application in the pharmaceutical and biotechnology industry, given that clinical trials are often conducted in collaboration with CROs.
Lastly, the idea of an enhanced R&D tax credit for organizations developing products that will then be manufactured exclusively in the U.S. could be used to incentivize domestic manufacturing.
This year, more businesses than ever may qualify for federal R&D tax credits. The challenge is identifying and correctly applying these tax credits to new or revamped operations, products or services. Companies should consult with credits and accounting professionals for guidance during year-end tax planning to ensure they are taking advantage of these cash incentives.