The phrase “research and development” (“R&D”) frequently appears in American business and political discourse, particularly in tax policy debates. The “Protecting Americans from Tax Hikes” (PATH) Act of 2015 was the most recent manifestation of the importance that business and political leaders place on R&D, and particularly the federal income tax credit for R&D activities that is intended to support investments in technical innovation and workforce expansion. This credit offsets taxes on a dollar-for-dollar basis at the rate of five to seven cents for each dollar of R&D expense incurred. However, many taxpayers still do not know which expenses they incur during the course of the tax year constitute R&D expenses that may qualify for the R&D tax credit (“Credit”).
White Lab Coats – or Not?
Taxpayers too often associate R&D with “white lab coat” activities. Unless they view their research activities through the lens of the tax code, which defines R&D more expansively than most taxpayers realize, they likely are understating their Credit. Taxpayers should recognize three key principles in relation to their research activities:
- Process development qualifies, not just product development;
- Qualifying development activities may be evolutionary, and do not need to be revolutionary; and
- Qualifying development activities need only be new to the taxpayer, and do not have to be new to the taxpayer’s industry.
Which Costs Qualify as “Research and Development?”
Because many taxpayers continuously analyze their existing processes and product components in order to improve their function, performance, quality, or reliability, they incur expenditures that largely can qualify for the Credit. The following qualified activities are often overlooked when computing the Credit:
- Alternative material analysis;
- Customization of machinery for specific design requirements;
- Design and development of tooling, dies, fixtures, molds, etc.;
- Design and integration of new machinery operations;
- Process automation development;
- Process improvements to increase throughput;
- Process improvements to increase material yield/reduce waste; and
- Process improvements to reduce cycle time.
Proposed Regulations Expand Software Development Opportunities
The scope of qualified research activities in the software development industry has expanded. The Department of the Treasury released proposed regulations in January 2015 that clarified the distinction between internal use software and non-internal use software. This has made it easier for some software innovators to claim the Credit.
While a discussion of the new proposed software regulations is beyond the scope of this article, taxpayers should be aware that the proposed regulations have created new Credit opportunities. Previously, unless taxpayers sold, leased, or licensed developed software, the software was presumed to be for internal use. The proposed regulations eliminate this presumption. Moreover, they provide that software that enables third parties to interact with its functionality constitutes software that does not solely benefit the taxpayer, and thus is not internal use. Consequently, many taxpayers whose software development may have previously been considered for internal use can now pursue the Credit without having to satisfy the more onerous internal-use software qualification criteria.
Expanded Credit Utilization under the PATH Act
The PATH Act made three important changes to the tax code:
- The Credit is now permanent, whereas in the past it had been temporary and was renewed 16 times before the Act;
- Eligible small businesses can use the Credit to offset the Alternative Minimum Tax (“AMT”;) and
- Qualified small businesses can use the Credit against payroll taxes.
Permanency Aids Planning
The permanency of the Credit creates certainty for taxpayers from the tax and financial perspectives. Taxpayers can now evaluate the costs and benefits of working with a consultant to identify and calculate the projected Credit during the course of the tax year, without the fear of incurring costs for a Credit that may become obsolete if not renewed. They can also reliably factor the Credit into their financial planning and their federal income tax projections.
The AMT and payroll tax offset provisions create new opportunities for taxpayers that incur R&D expenditures but do not have a significant “regular” tax liability to absorb the Credit. Therefore, many taxpayers that may not have claimed the Credit in prior years should revisit the opportunity.
The Credit and the AMT
An eligible small business is a corporation the stock of which is not publicly traded, or a partnership or sole proprietorship, which has average gross receipts for the three tax years preceding the tax year of $50M or less. Many corporations in this revenue range may pay income taxes under the AMT regime. Similarly, business owners or partners in pass-through entities may find themselves in AMT positions. Prior to the PATH Act, these taxpayers’ AMT positions would have eliminated the ability to utilize the Credit. However, these taxpayers can use the Credit determined in tax years beginning after December 31, 2015 against AMT, so long as they meet the gross receipts test (applicable at the shareholder and partner levels).
Although the PATH Act did not include a special carryback provision (as provided in the 2010 Small Business Jobs Act), taxpayers may have an opportunity to carry back a Credit determined in the first tax year beginning after December 31, 2015 for use against the prior tax year’s AMT. This could provide a significant opportunity to taxpayers who were in an AMT position for the 2015 tax year. As a result, the Credit now can provide immediate value to taxpayers in an AMT position.
The Credit and Payroll Taxes
A qualified small business is a corporation, partnership, or person with current tax year gross receipts of less than $5M, and no gross receipts for any taxable year preceding the five-taxable-year period ending in the applicable tax year. For tax years beginning after December 31, 2015, a taxpayer that meets this definition will be able to elect to utilize the Credit against its (employer) portion of payroll (FICA) taxes, up to an annual limit of $250,000. Consequently, start-up companies, which often incur significant R&D expenditures before they generate revenue, will be able to utilize the Credit to reduce their non-income-tax burden and invest the savings into the growth of their business.
The Bottom Line
The R&D tax credit landscape has evolved favorably for taxpayers in the past couple of years. Case law, treasury regulations, and Congressional action have created new credit utilization opportunities. Taxpayers should revisit this important tax incentive and benefit from the tax savings.
To learn more about the R&D tax credit and how it may enhance your cash flows, please contact the author of this article,Daniel Laughlin.
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