In 2010, U.S. businesses reported research and development tax credits exceeding $8.5 billion. Therefore, it’s not surprising that a recent survey found that “Tech CFOs Anticipate Boost in Revenue This Year,” 19 percent of CFOs in the technology sector were most apprehensive about the expiration of tax incentives like the R&D tax credit. What do CFOs, particularly CFOs of high-growth companies, need to know about the R&D credit now?
First, the federal R&D credit expired on December 31, 2013. Thus, no estimated-tax or financial-statement benefit can be taken for it for expenses paid or incurred during 2014. Fiscal-year taxpayers can currently include the benefit generated by creditable expenses paid or incurred during 2013, but no one can properly take a benefit for expenses paid or incurred after 2013.
To be sure, the R&D credit has expired and been renewed 15 or so times since first enacted in 1981. For example, there was no federal credit for all of 2012, and it wasn’t until January 2, 2013 that the credit was renewed retroactively for 2012 and for all of 2013. If Shakespeare is correct, and past is prologue, then the R&D credit will be extended — a view supported by most commentators and recent activity in Washington.
House Ways and Means Committee chair Dave Camp and the Senate Finance Committee chair and ranking member, Ron Wyden and Orrin Hatch, respectively recently announced plans to extend the credit, saying they’ll hold hearings and markups in April. Reflecting many studies showing a strong correlation between local R&D activities and the creation of high-paying, high-quality jobs, 10 or so bills have also been introduced to extend the credit and make it permanent.
Many of these bills also call for additional enhancements, including, for instance, increasing the credit’s rate, allowing it to be used against alternative minimum tax (AMT), and increasing its benefit for start-up companies. President Obama supports similar enhancements. Further, most developed countries provide similar and often more generous incentives to attract businesses to locate or expand their operations in their countries’ jurisdictions.
Considering that optimistic outlook, CFOs should plan for the R&D credit to become available for their 2014 qualified activities and expenses. Generally, activities qualify if they are conducted to develop or improve the functionality or performance of their products, manufacturing processes, software or other components. The activities must be ones in which engineering or physical, biological or computer science is used to evaluate alternatives to eliminate uncertainty regarding a component’s appropriate design.
The level of technological advancement is generally not a consideration, and the activity can fail and still qualify. Qualified expenses include related taxable wages and the cost of supplies, contractors and certain computer or cloud-computing services.
What’s more, industry doesn’t matter. In 2010, R&D credits were reported by companies in virtually every industry. They include manufacturing, information, professional, scientific and technical services; wholesale and retail trade; finance and insurance; management and holding companies; utilities; mining; support and waste management; real estate; transportation; and warehousing.
What does matter, especially for high-growth companies?
Location. Growing companies seeking to expand operations into new territories should be aware that different states and countries provide widely varying incentives for R&D and R&D-related investments. Most states provide R&D credits, but some don’t. Among the states that do, the benefit ranges from very low to up to 40 percent of qualified spending. More than 10 states also provide a refundable or transferable credit, so even companies in a loss or AMT position can get a cash-benefit currently if they locate in one of them, whether or not they’re paying taxes now. In addition, more than 30 countries provide similar or more generous benefits.
Legal Structure. As a company grows and considers changing legal structure, it should keep in mind that its legal structure can influence how it and its owners benefit from the R&D credit. Credits generated by a C corporation, for example, may be used to offset only corporate level income or franchise tax. C corporations are also subject to the standard change-in-ownership limitations that also affect net operating losses, for instance. Credits generated by S corporations and other pass-through entities, partnerships, and limited liability corporations taxed as partnerships, on the other hand, pass through to partners and shareholders and can typically offset tax associated only with the activity that generated the credits. Passive shareholders or partners can become subject to unfavorable — and unexpected — AMT treatment because their proportionate share of the pass-through entity’s R&D expenses has to be added back when determining their AMT income.
Acquisitions and Dispositions. Transactions involving a major portion of a viable trade or business can affect how the credit is calculated. Taxpayers who evaluate the R&D credit impact of such transactions before making them have been able to increase or protect their credits; taxpayers who don’t sometimes unwittingly have seen their credits reduced.
Elections Required on Original Returns. Certain elections must be made on an original (rather than amended) return that’s filed on time. Taxpayers who don’t consider whether and which elections to make have sometimes learned later that they have lost most or all of the credits to which they would otherwise have been entitled.
Identifying and Documenting Qualified Activities and Expenses. Ideally, these would be done at the same time as the activities. If a time-tracking or project-accounting system is in use, modifications to accommodate a more precise and supportable R&D credit may make sense. If such a system is not in use, CFOs should consider whether such a system would provide other business benefits to make its implementation worthwhile. Currently, tax examiners find reports from such systems to be more credible and supportive than surveys prepared long after the relevant activities were performed. Finally, companies should leverage existing documentation, especially documentation relating to such things as the company’s development process, technological objectives and risks and test plans and test results.
Chris Bard is the national leader of R&D tax credit services for BDO USA.