R&D Tax Credits
Enacted in 1981, the Research and Development Tax Credit (“R&D Credit”) has been renewed and extended since its original enactment, becoming a permanent part of the tax code in 2016. Companies both large and small enjoy the benefit of a dollar for dollar reduction in tax liability for conducting qualified research within the United States, as identified by examining activities and expenditures related to employee wages, supply costs, and contractor expenses. Taxpayers may claim credits back three years and carry forward unused credits for up to 20 years.
BASICS OF THE R&D TAX CREDIT
As written in the tax code, the definition of what may qualify as research and development is more expansive than the simplified mental image of test tubes and lab coats. Areas of research and development are expansive, and qualifying R&D elements often include any work performed that involves design or development methods used to create a new or improved business component, regardless of industry.
Below is a four-part test that outlines mandatory requirements for claiming the R&D Credit:
New or Improved Business Component: The taxpayer must design or develop a new or improved product, process, formula, invention, technique, or software. These are the six enumerated business components as defined in section 41 of the Internal Revenue Code.
Elimination of Uncertainty: The taxpayer must seek to eliminate uncertainty regarding the design or development of the new or improved business component. This test is commonly known as the hypothesis stage, where initial ideas and concepts are formed to eliminate unknowns to enable the taxpayer to proceed with design or development.
The Process of Experimentation: The taxpayer must engage in a process of experimentation by evaluating one or more alternatives that eliminates the uncertainty encountered at the outset of design or development. This test is defined broadly to include trial and error testing, evaluating the capability of alternative ideas or concepts, and utilizing any set of broad scientific principles to overcome uncertainty encountered during design or development.
Technological in Nature: The taxpayer must base their process of experimentation on the principles of the hard sciences, such as utilizing the principles of engineering, computer science, or the life sciences.
2016 UPDATES AND ENHANCEMENTS
Permanent: Congress passed the PATH Act that made the R&D credit a permanent part of the tax code in December of 2015. This was a milestone for small and medium sized businesses. Knowing that credit will be available for years to come, companies can now budget and forecast accordingly.
Payroll Tax: The ability to offset payroll tax for startup companies was one of the enhancements to the R&D credit. The R&D Credit is capped at $250,000 for each applicable tax year beginning in the tax year 2016, therefore, qualified Small Businesses (less than $5 million in gross receipts and with gross receipts of 5 years or less) can use this to offset employer payroll tax. Companies who are not profitable but still conduct R&D activities are still allowed to take advantage of the credit.
Alternative Minimum Tax (AMT) Turnoff: The ability to offset AMT is another major enhancement to the credit. Congress passes a bill that allowed business to reduce their Alternative Minimum Tax with R&D credits in 2010. Same rules now apply to businesses since 2016. Businesses have to meet the requirements of an “Eligible Small Business” to qualify for the AMT Turnoff. Since the tax year 2016, Eligible Small Businesses (lesser than $50 million in average gross receipts for the preceding 3 years) may now use the R&D Credits to offset their Alternative Minimum Tax. This is particularly beneficial to companies who could not take the credit due to AMT limitations but may be conducting R&D activities.