The research and development (R&D) tax credit is a general business tax credit. Many companies are unaware that they may qualify for them. Simply put, R&D refers to the work a businesses does to contribute towards innovation, or an introduction of products or procedures. In general, pharmaceutical and technology companies tend to spend the most in R&D. However, Amazon ranked number one is 2018 spending 16.1 million in R&D. (https://www.strategyand.pwc.com/innovation100) For more information on research and development tax credits please see the full article below.
By Yair Holtzman, CPA, CGMA
October 2017 Issue, Feature Articles, Featured |
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Governments typically incentive private industry to produce research and development (R&D) as a strategic tool to advance their economies. Initially temporary, the federal R&D tax credit became the United States’ primary means for rewarding business for investment in research. The PATH Act of 2015 permanently extended the R&D tax credit and expanded its provisions. The author lays out the basics of R&D tax credit and investigates the initial impact of the PATH Act by surveying its effect on 40 companies.
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Rapid changes in technology over the past decades have forced most companies to constantly innovate. At every stage, companies encounter technical challenges related to developing new or improved products and trade processes and integrating them with existing assets. Being able to overcome these technical hurdles is critical to maintaining a successful, healthy business. As most business owners know, however, attempting to create and execute viable and worthwhile innovations can be extremely expensive and time consuming for management and employees. Innovative undertakings often fail with no return on investment.
Fortunately, the federal government, as well as many states, currently provides valuable economic incentives to alleviate some of the burden and reward companies for undertaking these inherently risky initiatives. These financial incentives are intended to foster innovation and technological advancement of U.S. companies, thereby creating jobs and increasing global competitiveness.
The federal R&D tax credit, also known as the Research and Experimentation (R&E) tax credit, was first introduced in 1981 as a two-year incentive and has remained part of the tax code ever since. Its purpose is to reward U.S. companies for increasing their investment in R&D in the current tax year. It is available to any business that attempts to develop new, improved, or technologically advanced products or trade processes. In addition to activities such as creating new products or trade processes, the credit may also be available to taxpayers that have improved upon the performance, functionality, reliability, or quality of existing products or trade processes.
Although many taxpayers have viewed this tax credit favorably, there were limitations on the applicability and utilization of the tax credit for certain taxpayers. On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act. This legislation retroactively renewed and made permanent a collection of expired tax provisions for both businesses and individuals and addressed some of the credit’s limitations with regard to certain small businesses and startup companies.
How Does the R&D Tax Credit Work?The rules of the R&D tax credit can be found under Internal Revenue Code (IRC) section 41 and the related regulations. The R&D tax credit may apply to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S. soil.
The R&D credit comprises the following types of Qualified Research Expenses (QRE):
Changes to the R&D Tax Credit under the PATH Act of 2015The PATH Act permanently extended the R&D tax credit. Additionally, it made two very important changes effective for tax years beginning after December 31, 2015, which are intended to expand the reach of the credit. First, the legislation allows small businesses to take the R&D tax credit against their alternative minimum tax (AMT) liability for tax years beginning after December 31, 2015. The AMT restriction has long prevented qualified companies from utilizing the R&D tax credit; the legislation removed that hurdle for eligible small businesses (ESB), defined below. Second, the PATH Act allows startup businesses with no federal tax liability and gross receipts of less than $5 million to take the R&D tax credit against their payroll taxes for tax years beginning after December 31, 2015, essentially making it a refundable credit capped at $250,000 for up to five years.
Beginning January 1, 2016, ESBs can use the R&D tax credit to offset AMT. An ESB is defined as a corporation that is not publicly traded, a partnership, or a sole proprietorship with average annual gross receipts not exceeding $50 million for the three taxable years preceding the current taxable year. Special rules under IRC section 448(c)(3) apply. If the business (including predecessor entity) was not in existence for an entire three-year period, the gross receipts test applies to the period it was in existence, and gross receipts for short taxable years are annualized. For a short tax year, gross receipts are annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period. For a partnership or S corporation, the gross receipts test must be met both by the entity and by the partner or shareholder for the tax year.
Also beginning January 1, 2016, qualified small businesses (QSB) can use the R&D tax credit to offset the FICA employer portion of their payroll tax. A QSB is defined as a business with less than $5 million in annual gross receipts and having gross receipts for no more than five years (for 2016; not available for companies that had gross receipts prior to 2012). The election to offset payroll taxes must be made on a timely filed income tax or informational return, including extensions. In the case of a QSB that is a partnership or S corporation, the election must be made at the entity level. A small business that is not a corporation or partnership (such as a sole proprietor) must take into account the aggregate gross receipts it receives in carrying on all its trades or businesses. For corporations and partnerships, the gross receipts and the credit limitation apply on a controlled group basis.
Survey Methodology and ResultsIn order to gain some insight into the impact of the PATH Act, a brief survey was sent to CEOs, CFOs, vice presidents of tax, and tax directors at 40 companies, including taxpayers currently claiming a research credit on their tax returns and others who currently compute the research credit but have been limited by AMT or startup restrictions in the past. These companies came from a wide variety of industries, including food and beverage, financial services, software, chemicals, pharmaceuticals, medical devices, engineering, technology, and manufacturing. Companies surveyed ranged in size from small startup companies to companies that had more than $3 billion in top line revenue. The author received 32 completed responses; the findings are summarized in the Exhibit.
EXHIBITAttitudes on the Impact of the PATH Act
The survey asked the following five questions, with responses ranked on a scale from 1 (not impactful at all) to 10 (extremely impactful):
As can be seen in the Exhibit, reaction to the R&D provisions of the PATH Act has been largely positive. All respondent companies agreed that a permanent incentive would help fuel increased spending on R&D initiatives. In addition, the impact of ESBs being able to utilize the R&D credit to offset AMT liability, as well as that of QSBs being able to utilize the R&D credit to offset the employer portion of payroll taxes, was rated impactful for affected businesses. Furthermore, companies agree that the permanent R&D tax credit will help their tax planning, and that the PATH Act will lead to an increase in their R&D spending.
These results suggest that there is a strong positive response by U.S. companies to the changes in the PATH Act of 2015. In particular, all survey participants gave a very optimistic response to the permanency of the credit and expect to increase R&D spending in the future. One could conclude that the permanency of the research credit is viewed as a valuable tool in tax planning and alleviates the need to shift income and optimize tax strategy when increasing research and development investments. It also eliminates the uncertainty in making R&D investment decisions and serves as a tool for lowering a company’s effective tax rate. Finally, it potentially buttresses the forces keeping U.S. scientists and engineers on U.S. soil, as opposed to shifting innovation and product development elsewhere.
Companies that participated in the survey gave very strong marks to the potential AMT benefits (where applicable), as well as the offset against payroll tax. The survey results suggest that increasing the accessibility of this tax credit to companies of all sizes has had an immediate positive impact. Finally, although this article examined the qualitative effects, a more rigorous quantitative analysis is warranted to truly understand the magnitude of the increased change in spending attributable to the changes in the tax law.
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