Federal and state research credits (often referred to as the “research and development,” “R&D” or “research and experimentation” credit) are among the most valuable tax incentives available today. But many businesses overlook these tax breaks because they mistakenly believe that they don’t qualify or wouldn’t benefit. In recent years, federal legislation has expanded the availability of the credit for many businesses. So, if your business hasn’t been claiming the R&D credit, it’s worth another look.
What’s it worth to you?
To claim the federal R&D credit, simply conducting research isn’t enough; it’s for “increasing research activities.” Generally, it’s equal to 20% of the amount by which qualified research expenditures (QREs) in a tax year exceed a base amount derived from your company’s historical R&D expenditures. There are alternative computation methods for start-ups and other companies without sufficient historical data.
Calculating the credit is complex, but qualifying companies can reduce their federal income tax liability by as much as 13.5 cents for every dollar they spend on QREs. This includes wages, supplies, and certain consulting and contract research fees related to qualified research activities. The credit is nonrefundable — that is, it can’t be used to generate a loss — but unused credits may be carried back one year or forward up to 20 years. In addition, limits on general business credits prevent companies from using tax credits to erase their tax liability entirely. Many states offer tax credits in addition to those available at the federal level, so be sure to consider those benefits.
Are you eligible?
The R&D credit isn’t just for scientific research. In brief, qualifying research must relate to development or improvement of a business component with an uncertain probability of success, involve activities that are technological in nature, and use a process of experimentation. These criteria are broad enough to encompass a wide range of business activities, including developing new products, improving processes (including business or financial processes that involve computer technology) or developing software for internal use.
Two recent tax law changes expanded the availability of the R&D credit and enhanced its benefits: The Protecting Americans from Tax Hikes (PATH) Act of 2015 and the Tax Cuts and Jobs Act (TCJA). The PATH act, in addition to making the R&D credit permanent, made it available to start-up businesses that hadn’t been able to take advantage of the credit because they had insufficient federal tax liability.
In general, businesses in operation for less than five years, with less than $5 million in gross receipts, may use R&D credits to reduce up to $250,000 in employer-paid payroll taxes.
The TCJA didn’t make any direct changes to the R&D credit, but several of its changes have a significant, indirect impact on the credit. For example, by eliminating the corporate alternative minimum tax (AMT) and increasing exemption amounts for individual AMT, the TCJA made the credit available to many businesses that otherwise wouldn’t be able to use it. That’s because the credit may not be offset against AMT (with an exception for certain smaller businesses). The TCJA removed this obstacle for businesses no longer exposed to AMT.
The TCJA also affected the R&D credit by reducing the corporate income tax rate from a top rate of 35% to a flat 21% rate. This enhances the value of the credit for pass-through businesses — such as partnerships, S corporations and LLCs — that elect a reduced credit. To avoid a double tax benefit, the tax code prohibits businesses that claim R&D credits from also deducting those amounts as a business expense. But businesses have the option of preserving those deductions by electing to reduce their credits by the maximum corporate tax rate.
For most C corporations, the election is a wash — it has no impact on their federal tax liability. But it may allow them to reduce their state income tax liability. For pass-through owners, however, who are taxed at individual rates as high as 37%, the election may offer significant benefits. Why? Because, by making the election, an owner in the top tax bracket trades a 21% reduction in the credit for deductions that reduce his or her tax liability on the same amount by 37%. Note that another change made by the TCJA will reduce the benefits of R&D deductions starting in 2022. (See “The end of expensing R&D?”)
Revisit the credit
If your business engages in research activities but hasn’t been claiming the R&D credit, now’s a good time to revisit it to see if recent changes affect your eligibility. Contact your tax advisor to see if you may have an opportunity to reduce your federal and state tax liability on future returns and even claim credits you missed during certain prior years by filing amended returns.
Sidebar: The end of expensing R&D?
As you evaluate the tax implications of your research spending, keep in mind that, under the Tax Cuts and Jobs Act, most research and development expenditures incurred in tax years beginning after 2021 must be capitalized and amortized over at least five years (15 years for research conducted outside the United States). Currently, businesses have the option of amortizing these expenditures or deducting them as current expenses. This change will affect not only the deductibility of R&D expenses, but also the value of the reduced R&D credit.
Some commentators believe that Congress will modify or eliminate this provision before it takes effect, so be sure to keep abreast of future developments. If the provision is maintained, it’ll be important for you to incorporate it into your tax planning.