Governments typically incentivize 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 businesses for investment in research. The PATH Act of 2015 permanently extended the R&D tax credit and expanded its provisions.
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.
What is the R&D Tax Credit?
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.
The PATH Act
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 concerning certain small businesses and startup companies.
The 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.
What Does This Mean for the R&D Tax Credit?
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.
Additionally 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 (Note: It only applies for 2016 and is not available for companies that had gross receipts before 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.
The activities that qualify for the R&D tax credit are the same ones driving growth in your business:
- Creating improved products, processes, formulas, software, and techniques
- Automating or improving internal manufacturing processes
- Designing tools, jigs, fixtures, and molds
- Integrating new equipment
- Development of data center, big data, and data mining tools
- Integration of APIs and other technologies
- Development of financial or pricing models
- Hiring outside consultants to perform any of the listed activities
- Manufacturing new or improved products
- Developing prototypes, first articles, models
- Evaluation of alternative materials
- Development of firmware
- Network hardware and software development and optimization
- Developing simulators
- Development of risk management systems
- Searching for ways to apply new research findings
- Streamline your manufacturing process
- Utilizing integration analysis
On average, companies are typically able to claim 7-10% of their qualified expenses as a federal R&D tax credit. For example, a single software developer, engineer, or lab technician who receives a W2 of $100,000 a year may generate a tax savings of up to $10,000.
