The research and development (R&D) credit provides an incentive for companies to invest in innovation in the US. The R&D credit is available to companies in any industry that develop new products or processes or improve upon existing products or processes. Companies that qualify can claim wages, supplies, and contract research costs associated with R&D projects and activities.
On Dec. 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015, which included the following important changes to the R&D credit.
- Made permanent the R&D credit
- Allows businesses with less than $50 million in gross receipts to offset the R&D credit against alternative minimum tax (AMT)
- Allows certain small businesses with less than $5 million in gross receipts to offset the R&D credit against payroll taxes
These changes positively affect businesses of all sizes that invest in R&D projects and activities in the US.
Permanent R&D credit
Congress originally enacted the R&D credit in 1981 as a temporary credit that was set to expire in 1985. Since 1985, the R&D credit was extended 15 times, often at the end of the calendar year, or retroactively in the following calendar year, with a one- or two-year extension. This uncertainty limited the overall effectiveness of the R&D credit by making it difficult for businesses to consider the credit in strategic planning for R&D investments.
The PATH Act eliminates the uncertainty surrounding the availability of the R&D credit by making it permanent. With a permanent R&D credit, taxpayers can more effectively plan and commit to long-term investments in R&D and innovation.
Offset against AMT
Under prior law, taxpayers in AMT received no immediate benefit from the R&D credit since it could not be used to offset AMT. However, for tax years beginning after Dec. 31, 2015, “eligible small businesses” (ESBs) will be able to claim the R&D credit against its AMT liability. The ability to offset the credit against AMT removes a major obstacle associated with utilization of R&D credits, particularly for owners or members of pass-through entities.
An ESB is a sole proprietorship, partnership, or non-publicly traded corporation with average annual gross receipts for the prior three taxable years that do not exceed $50 million. Partners of a partnership and shareholders of an S corporation must separately meet the gross receipts requirement to use the R&D credit against their individual AMT liability.
The IRS has yet to issue guidance with respect to how taxpayers will apply the AMT offset.
Offset against payroll tax liability
The PATH Act also presents a significant cash flow opportunity for certain small start-up businesses that will now be able to realize the tax advantages associated with R&D expenditures. Specifically, under the PATH Act, a “qualified small business” (QSB) can make an election under section 41(h) to apply its R&D credit against payroll tax instead of income tax. As the R&D tax credit is non-refundable, this change in the law provides a significant cash flow opportunity for start-ups that do not have tax liability to otherwise offset the credit. This election is effective for tax years beginning after Dec. 31, 2015.
What is a QSB?
A QSB is a corporation (including an S corporation) or partnership that meets both of the following tests:
- Has gross receipts of less than $5 million for the taxable year, and
- Did not have gross receipts in more than four taxable years preceding the taxable year.
For purposes of applying the rules of this section, all members of the same controlled group of corporations and trades or businesses under common control are treated as a single entity.
How to convert the R&D tax credit to a payroll tax credit
To take advantage of this opportunity, a taxpayer that is a QSB must make an election under section 41(h) for the taxable year to convert a certain amount of its R&D credit to a payroll tax credit. The election must be made on a timely filed income tax or informational return, including extensions. In the case of a QSB, which is a partnership or S corporation, the election must be made at the entity level.
Additionally, the taxpayer must specify the amount of the R&D credit to be used as a payroll tax credit. The payroll tax credit portion for any taxable year is the least of:
- The amount specified by the taxpayer (not to exceed $250,000)
- The R&D credit determined for the taxable year, or
- In the case of a QSB other than a partnership or S corporation, the amount of the business credit carryforward from the taxable year under section 39 (determined before the application of this provision to the taxable year).
Using the converted tax credit
The payroll tax credit portion of the R&D credit specified by the QSB may be applied against its employer old-age, survivors, and disability insurance (OASDI) taxes beginning in the first calendar quarter following the date on which the taxpayer files the return. If the payroll tax credit portion of the R&D credit exceeds the QSB’s tax liability for any calendar quarter, the excess is carried to the next calendar quarter and allowed as credit for that quarter.
Taxpayers are prohibited from making the payroll tax election for more than five taxable years. Also, once made, the election may only be revoked with the consent of the IRS.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
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