Since the 1980s, the U.S. federal government has offered the Research & Development (R&D) Tax Credit as a means of incentivizing companies to invest in innovation and experimentation. The R&D Credit is available to companies of all sizes and industries who satisfy the “four-part test” and participate in qualifying research activities. For the finer details of the R&D tax credit and how to qualify, visit HERE.
While the credit is now accessible to companies of all sizes, this was not always the case. In fact, it was not until 2015 that the credit expanded significantly to increase availability to small businesses and start-ups.
Today, many smaller companies and start-ups still miss out on the advantageous tax credit – mainly because either they do not know they are eligible for it or they choose to self-censor. Not anymore. Find out how the government opened up the federal R&D Credit and how your small to medium sized business can benefit.
What happened in 2015?
Throughout most of the 40-year existence of the federal R&D Tax Credit, small businesses have had the qualifying activities and other qualified research expenditures to satisfy the requirements, but were unable to capitalize on them. This was through no fault of their own. Rather, it was their net operating losses or alternative minimum tax (AMT) positions that severely limited them. As a result, it was the corporate giants and large-scale manufacturers that benefitted the most. The imbalance only continued to grow.
However, in 2015 the R&D Credit landscape shifted considerably. President Barack Obama signed the Protecting Americans from Tax Hikes Act (PATH). The Act included significant modifications to the R&D Credit, such as:
- Making the federal R&D credit a permanent fixture in American tax code;
- Permitting businesses with less than $50 million in gross receipts to offset the R&D credit against the AMT liability; and
- Allowing specified businesses with less than $5 million in gross receipts to offset the R&D credit against payroll taxes.
By eliminating the yearly uncertainty surrounding the credit, PATH cleared the way for more businesses – perhaps those with less financial resources to dedicate to an R&D assessment – to explore the option with certainty that it would continue to exist. For example, those companies operating on a fiscal year schedule could more freely explore the credit knowing for sure that it would still be available in the next calendar year.
With the option to offset AMT liability or payroll tax, the field widened considerably for small and medium sized businesses participating in R&D activities to finally utilize the credit. With increased accessibility to the credit, these businesses are able to put funds back into their business and continue to improve or develop new products and processes. This in turn leads to a more competitive marketplace and a stronger economy.
How do I offset AMT liability?
What is Alternative Minimum Tax?
The alternative minimum tax (AMT) is a tax that ensures that taxpayers pay at least the minimum. It operates alongside regular income tax and recalculates income tax after adding certain tax preference items into the adjusted gross income.
How can I offset the AMT liability with the research credit?
Businesses that find themselves in an AMT position may now be able to offset their tax liability with the R&D credit. In order to do so, the business must have less than $50 million in gross receipts and otherwise qualify as an ‘eligible small business’ (ESB).
Per the Section 38(c)(5)(C) definition, an ESB is a non-publicly traded corporation, sole proprietorship, or partnership with average annual gross receipts of $50 million or less for the three preceding tax years.
Some other rules that apply are:
- All persons treated as a single employer under Section 52(a) or (b), or Section 414(m) or (o), are treated as one person (i.e., gross receipts are aggregated);
- If the entity did not exist for three prior years, the gross receipts requirement is based on the actual period of existence;
- Gross receipts for any tax year are reduced by returns and allowances made during that same year;
- Preceding entities are include in the gross receipt calculations;
- In the event of a short year, gross receipts are annualized;
- This means gross receipts for the short period are multiplied by 12 and the result is divided by the number of months within the short year.
In regards to an S corporation or partnership, the gross receipts requirement must be met by both the entity and its various shareholders or partners. Thus, one shareholder or partner may qualify to offset the AMT liability with the research credit while other shareholders/partners do not.
Claiming the AMT liability benefit
The taxpayer does not need to make an election in order to offset the AMT liability. However, they must qualify as an ESB. Upon qualification, the business completes the applicable research credit forms and new line items. Then, the business may offset any amount of AMT with the credit, per the general limitation to designated credits. If there is any unused credit, it is generally carried back one tax year and carried forward 20 tax years.
AMT Rules Updated in 2017
The Tax Cuts and Jobs Act (TCJA) signed in 2017 eliminated the corporate AMT and loosened the individual AMT restrictions. By doing so, the research credit became even more accessible to U.S. businesses.
How do I offset payroll taxes with the R&D credit?
For businesses in a loss position, such as start-ups, the payroll tax offset is particularly appealing. In order to utilize the credit toward a payroll tax offset, the business must meet the requirements of a ‘qualified small business’ (QSB).
Per the Section 41(h)(3) definition, a QSB is a partnership, corporation or person with gross receipts of less than $5 million for the current tax year, as well as no gross receipts for any tax year preceding the five tax year period. Also, a tax-exempt organization cannot be a QSB.
Accordingly, a company may use the R&D credit against up to $250,000 of their payroll taxes each year, as long as they meet the specifications of a QSB.
Claiming the payroll tax liability benefit
A QSB can elect to apply all or part of the research credit specifically against the Old Age, Survivors, and Disability Insurance (OASDI) component of the employer portion of the Federal Insurance Contributions Act (FICA, also known as Social Security) payroll tax liability for up to five tax years. Groups treated as a single taxpayer under the aggregation rules (see above) may make the election separately for each tax year.
This payroll tax offset is huge. In 2018, the Social Security tax equaled 6.2% of an employee’s earnings, up to $128,700. Therefore, with payroll taxes adding up, this is an exciting opportunity for small businesses and start-ups.
The payroll offset election, made by completing Section D of Form 6765, Credit for Increasing Research Activities, must be attached to a timely-filed federal tax return (including extensions). Partnerships and S corporations must make the election at the entity level. To then claim the payroll tax credit, the company must complete Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and attach it to the annual employment tax return. If the business files quarterly payroll taxes, they must complete Form 941, Employer’s Quarterly Federal Tax Return.
The election must indicate the amount of the R&D credit that the company intends to apply to the expected payroll tax liability. However, there are rules that limit the amount to the smallest of:
- A $250,000 cap;
- Amount of research credit for the tax year (without regard to the election); or
- The amount of any business credit carryforward under Section 39 carried from the tax year of the election, but only for QSBs that are not partnerships or corporations.
For those treated as a single taxpayer, the election amount limit is the smallest of their allocable share of the above items.
The payroll tax offset is available on a quarterly basis beginning in the first quarter that starts after a taxpayer files their federal income tax return.
Are start-ups and small businesses the only ones eligible for the payroll offset?
The short answer is no. However the business must have:
- Gross receipts less than $5 million in the taxable credit year;
- No gross receipts for any taxable year prior to the five taxable year period ending with the taxable year; and
- Available R&D credits for the year.
According to these guidelines, companies with lifespans greater than five years and billions of dollars spent on developing or improving a business component could be eligible. For example, a large portion of life science companies generate $0 gross receipts for long periods of times before their drug receives U.S. Food and Drug Administration (FDA) approval.
How can we help?
At Squar Milner, we have a dedicated Research Credit Services team, led by Doron Bass and Brian Shin, ready to help you take full advantage of this incentivizing tax credit. We offer a cost-free assessment to address the feasibility and benefit of conducting a full blown R&D Tax Credit Study.
From there, we can work with you to capitalize not only on credits for the current year, but past years as well. If you want to know more about the credit, our team, or how we can help – reach out!
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.