U.S. taxpayers claim nearly $10 billion in R&D tax credits each year. Many people assume that those credits are going only to the large companies that are revolutionizing the world. That’s not true.
In fact, R&D tax credits are available for companies of all sizes, particularly because of new legislation enacted in December 2015.
Those that claim the credit are involved in a diverse range of industries, all of which are making incremental improvements to their products and processes. These industries include construction, software, manufacturing, wine, aerospace subcontracting, boat building, and biotech — encompassing virtually any company that’s designing or developing new products or processes.
One sign of potential eligibility for the R&D tax credit is having engineers, scientists, or product development personnel on staff.
The R&D tax credit has had a somewhat shaky history. Since it was created in 1981, it’s been a purely temporary credit. During the past 35 years, the credit would expire periodically and remain expired for up to a year. Then Congress would extend the benefit retroactively — and sometimes forward — for up to a year.
The Protecting Americans from Tax Hikes Act of 2015 extended the R&D tax credit, which had expired at the end of 2014, retroactively to Jan. 1, 2015. More significantly, the law made the credit permanent going forward. In the same act, Congress made two other significant changes to the R&D tax credit that left the benefit more available to small businesses and start-up companies.
Effect of Making the R&D Credit Permanent
With the credit continually expired or set to expire within a year, many businesses weren’t taking this incentive into account in their long-range budgeting and forecasts. Now, that’s likely to change.
The United States was one of the first countries to enact an R&D tax credit. Since then, more than 30 countries have incorporated incentives to encourage R&D investment within their borders.
Many of the incentives offered by foreign countries were more lucrative and provided a permanent benefit. As a result, these incentives were attractive to U.S. companies as well as foreign entities evaluating where to locate their R&D-eligible investments. So as countries competed to attract multinational companies, the lack of a permanent U.S. credit was a strike against the United States.
Further, prior to being made permanent, the R&D tax credit couldn’t be claimed on quarterly financial statements during the periods in which it was not a legal benefit.
So investors, lenders, and other users of financial statements saw the tax provisions distorted through the year. No credits were accounted for in each quarter, and then there was a windfall when the credit was extended near the end of the year.
Takeaway: With the credit permanent, U.S. companies can quantify the value of R&D tax incentives and complete their long-term budgeting with confidence, and financial statements and quarterly estimated taxes now reflect the R&D tax credit as well.
SMBs: Cause for Celebration
Another significant past drawback of the R&D credit was that companies’ ability to use it was limited if they — or their shareholders, in the case of pass-through entities like S corporations, limited liability companies, and limited liability partnerships — either didn’t owe federal income tax or were subject to the alternative minimum tax (AMT). Those rules hindered most small companies from taking advantage of the credit. The new legislation, however, contains two provisions that let small and midsize businesses take advantage of the credit immediately.
Small businesses, now defined as having an average of less than $50 million in gross revenue over the prior three years, will be able to offset AMT with R&D credits generated after Jan. 1, 2016. This provision opens up the credit to small corporations subject to the AMT, as well as pass-through entities (where the credits flow through to shareholders). In the past, these credits were suspended and carried forward for up to 20 years until they were no longer subject to the AMT.
Takeaway: Removing the AMT limitations makes the credit available to many smaller entities that are stuck paying AMT. Credits that may previously have been unusable now can reduce AMT and allow reinvestment in the company.
The second key provision of the new law addresses a frequent complaint of start-up businesses: that the R&D credits they were generating weren’t very useful because, as start-ups, they were years away from turning a profit.
During the start-up phase, significant expenses are incurred in the hope of developing new products and processes that will generate revenue and taxable income in the future. Even though these companies aren’t paying federal income taxes, they are paying a significant amount in payroll taxes.
These start-ups, described as “qualified small businesses” (defined as businesses with less than $5 million in gross receipts and no more than five years of gross receipts), under the new legislation can now allocate up to $250,000 of federal R&D tax credits generated after Jan. 1, 2016, to offset the FICA portion of their payroll taxes.
Takeaway: A company starting operations in 2016 can reduce its payroll taxes by up to $250,000 a year for five years as long as its gross receipts are less than $5 million and its payroll exceeds $4 million. Companies may be able to claim the credit if they didn’t have gross receipts prior to 2012. The R&D credit is calculated on the 2016 tax return as usual, but the taxpayer has the opportunity to claim the payroll portion starting the quarter after the credit is claimed on the federal tax return. In other words, the earliest payroll taxes can be reduced is July 2017.
After 35 years as a temporary tax credit, it comes as a great relief to many businesses that the R&D tax credit is now permanent — and improved. Further, a number of court cases, regulatory changes, and updates to guidance have clarified and expanded what activities and expenses are eligible for the credit.
If you’re currently claiming the credit, these changes are probably welcome news from both an administrative and financial standpoint. And if you haven’t claimed the credit? Then you may be missing out on a significant benefit to reduce your federal taxes — and the opportunity’s never been better.
Tom Sanger is a partner with accounting and advisory firm Moss Adams.