Tax Advantage of R&D Tax Credit to Minimize Your Tax Liability
For many organizations, taking the research and development (R&D) tax credit means identifying a hidden source of cash in addition to minimizing their tax liability. If you reviewed the R&D tax credit in the past and determined you would not receive benefit, it is time to take another look.
It has been a little over a year since Congress passed the Protecting Americans from Tax Hikes (PATH) Act of 2015 and Former President Obama signed it into law—and it contains many provisions for individual and business taxpayers. Some of the most significant improvements relate to the R&D tax credit. Not only did the law make the credit permanent, but it greatly enhanced the credit and made it available to more taxpayers.
Understanding the Research and Development Tax Credit
One of the common misunderstandings about the R&D tax credit is that it’s a deduction on the company’s tax return. In fact, it’s actually a dollar-for-dollar credit against what the company owes in state and federal taxes paid in a particular calendar year. In other words, it’s a direct reduction of the taxpayer’s tax liability. In the case of a C corporation, the credit is claimed on the entity tax return. S corporation shareholders and partners claim the credit on their individual tax returns. The credits may carry forward 20 years and, in addition to the federal tax credit, some states may offer an R&D tax credit as well. Companies can take the credit for all open tax years which usually equates to the previous three or four years plus the current year.
You Probably Do More R&D than You Think
It’s not uncommon for business leaders to believe that the functions they perform on a day-to-day basis would not be considered research and development qualifying activities. Yet many are surprised when they take a closer look at those specific activities. While the definition of R&D for purposes of the tax credit is very broad, many activities related to the following may qualify for the credit:
- Developing a product that is new to the company
- Designing and testing of product prototypes
- Conducting certain types of research
- Experimenting or eliminating ideas through a trial and error process
- Improving or modifying existing products
- Improving or modifying production techniques and processes
The following may also qualify for the R&D tax credit:
- The wages of employees who carry out the R&D activity
- A portion of contractor expenditures for R&D activity
- Expenditures for supplies consumed during the R&D process
Research and Development Tax Credit for Eligible Small Businesses
Generally, the amount of the R&D credit allowed is limited to the excess of the regular tax liability over the tentative minimum tax. If a taxpayer’s tentative minimum tax exceeds the regular tax, no R&D tax credit is allowed for that year and the credit is carried back one year and forward up to 20 years. In addition, non-active shareholders and partners of flow through entities are required to treat their share of R&D expenditures as an addback to alternative minimum taxable income. This often results in a tentative minimum tax that exceeds the regular tax thereby increasing the tax liability without the ability to use the tax credit.
Under the new law, for R&D credits generated in tax years beginning after December 31, 2015, the taxpayer’s minimum tax for the year is treated as zero if the credit is generated by an eligible small business. An eligible small business is defined as a privately held corporation, partnership, or sole proprietorship whose average annual gross receipts for the prior three years does not exceed $50,000,000.
For S corporations and partnerships, the gross receipts test must be met at both the entity and the individual taxpayer level. This is a great win for taxpayers who have been limited in their ability to utilize R&D credits due to the alternative minimum tax limitation.
Apply the Research and Development Tax Credit as a Payroll Tax Credit
The new legislation also provides a great opportunity for taxpayers to treat a portion of their R&D credit for the year as a payroll tax credit. This credit is available to qualified small businesses (QSB) for tax years beginning after December 31, 2015. Two tests must be met to be a QSB. First, the business (including a sole proprietorship) must have less than $5,000,000 in current year gross receipts. Second, the business cannot have any gross receipts in any tax year preceding the five tax year period that ends with the current tax year. In the case of a sole proprietor, gross receipts from all trades or businesses of the taxpayer are aggregated to determine if the $5,000,000 gross receipts test is met.
This new twist on the R&D credit allows start-up companies without a current income tax liability, or whose R&D credit exceeds their current tax liability, the ability to maximize their current benefit from the R&D credit.
Taxpayers must elect to apply the payroll credit rules to their R&D credit. The election must be made by the due date of the return and can be elected for five tax years. The election must specify the amount of the R&D credit to which the election applies. The amount allowed in the election is limited to the lesser of:
- The amount of the R&D credit generated in the current tax year,
- $250,000, or
- for a QSB that is not a partnership or S Corporation, the amount of the business credit carryforward under IRC Sec 39 from the current tax year, without regard to the election.
The payroll tax credit is allowed as a credit against the taxpayer’s social security portion of the FICA tax for the first calendar quarter that begins after the date on which the taxpayer files the tax return containing the payroll credit election.
For example, a calendar year S corporation files its extended 2016 tax return containing the Payroll tax credit election on May 31, 2017. The credit is allowed for the calendar quarter beginning July 1, 2017. If the amount of the election exceeds the applicable tax on the wages for that quarter, the unused portion is carried forward and used as a credit in succeeding calendar quarters. The credit does not reduce the taxpayer’s deduction for the related payroll tax.
These major changes to the R&D tax credit will provide many taxpayers increased cash flow as the result of reduced tax liabilities.