Don’t Overlook R&D Tax Credit
By Carolyn Bourgoin, CPA
If your business employs engineers, architects, chemists, or software developers, it is worth investigating whether the research and development tax credit is available and of benefit to your company. Any business that is working on the design or development of a new or improved product, technique, or formula that will be held for sale or used in its trade or business may have incurred qualifying expenses. Additionally, legislation signed into law in December 2015 (the PATH Act) now allows for eligible small businesses and flow-through entities to take the credit to offset the alternative minimum tax (AMT). This news alone should make taxpayers revisit the potential benefits of conducting an R&D tax-credit study.
Many businesses often overlook the R&D credit, thinking they do not fall into industries typically associated with performing research and development activities.”
Though tax-reform legislation may be passed in the near future with the expectation of eliminating certain tax incentives, the R&D credit has broad bipartisan support and will remain part of the tax code. The credit was specifically listed by the administration and the congressional tax-writing committees in their initial tax-reform framework as an incentive that must be preserved due to its proven effectiveness in “promoting policy goals important to the American economy.” Rest assured, the credit will be retained.
Many businesses often overlook the R&D credit, thinking they do not fall into industries typically associated with performing research and development activities. While manufacturers and software developers are commonly considered, other industries, such as food processing, tool & die, beverage/brewing, and construction, just to name a few, have qualified for the credit.
Qualifying Research Activities
In order to qualify for the R&D credit, a taxpayer’s activities must meet a number of requirements. The taxpayer must perform the research for the purpose of discovering information that is both technological in nature and intended to help in the development of a new or improved business component.
Substantially, all of the research activities must be undertaken as part of a process of experimentation designed to evaluate alternatives that eliminate uncertainty regarding the development of a business component. Eligibility for the credit does not depend on the research being successful.
The main types of expenditures that qualify for the research credit are employee wages for either performing or supervising the research, as well as supplies used while conducting the research. Amounts paid to another for the right to use computers when conducting research qualify, as well as 65% (which may increase) of contract research expenses paid for qualified research. Expenses related to efficiency surveys, routine data collection, and quality-control testing do not qualify for the credit.
The regular research credit is equal to 20% of current-year qualified research expenditures that exceed a base amount for that year. Due to credit limitations, no more than half of the current year’s qualified research expenditures can qualify for the research credit if this method is used.
Alternatively, taxpayers can elect to claim the Alternative Simplified Credit, which is equal to 14% of the excess of qualified research expenses for the year over 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined. This percentage may be increased under the proposed tax-reform legislation.
The credit can currently be carried back one year and carried forward for 20 years.
Creditable Against Other Taxes
As mentioned earlier, the R&D credit can offset the AMT tax for eligible small businesses (i.e. less than $50 million in average gross receipts for the prior three years) for tax years beginning on or after Jan. 1, 2016. The current tax-reform framework also calls for repealing the individual AMT tax altogether, thereby removing this restriction on the use of the credit by owners of a flow-through entity. The AMT restrictions often deterred eligible businesses from having a research study done in the past.
Certain small businesses (mainly startups) now have the ability to elect, on a quarterly basis, to use their research credit to offset the employer portion of their FICA payroll-tax liability. For tax years beginning after Dec. 31, 2015, businesses that have less than $5 million in gross receipts in the current year and that did not have any gross receipts for any tax year preceding the five-year tax period ending with the tax year, can use the R&D credit as a payroll-tax-credit offset rather than an income-tax offset. This is helpful to startup businesses that may not have a tax liability in their early years due to net operating losses.
Documentation and Substantiation
Taxpayers must be able to substantiate that their expenditures qualify for the credit. If you are considering going back to claim an R&D credit for a prior year or considering claiming the credit for the current year, it is advisable to have a persuasive research credit study done, because this will help connect the company’s expenditure records to the amount being claimed as qualified research. Time surveys and qualified activity narratives of employees with direct knowledge of the activities will result in supporting documentation that can be supplied in case of an audit.
Massachusetts allows for an R&D credit for qualifying research performed within the state. The credit is equal to 10% of the excess, if any, of the qualified research expenses for the taxable year over a base amount plus 15% of basic research payments.
Effective for tax years beginning after Jan. 1, 2015, Massachusetts now allows for an alternative simplified credit similar to the federal credit but using lower credit rates. If your business operates in states other than Massachusetts, consult your tax advisor to determine whether the R&D might apply in those states as well.
Because the research and development credit will be retained even with the potential tax reform, it is worthwhile investigating whether your business might qualify. Revisiting annually any changes that are being made to improve a product or develop a new product should be discussed with your tax advisor.
Carolyn Bourgoin, CPA is a senior manager with Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3483; firstname.lastname@example.org