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 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.
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):
- Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes)
- Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process
- Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred
- Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
To qualify as research according to IRC section 41, the taxpayer must show that the activities—
- are intended to resolve technological uncertainty that exists at the outset of the project or initiative, related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;
- rely on a hard science, such as engineering, computer science, biological science, or physical science;
- relate to the development of a new or improved business component, defined as new or improved products, processes, internal use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business; and
- substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
If the development is related to internal use software (IUS), there are an additional three tests that must be satisfied:
- The software must be innovative. It should result in a reduction of cost or an improvement in speed that is substantial and economically significant.
- Developing the software involves significant economic risk, requiring the commitment of substantial resources and subject to substantial uncertainty of recovery in a reasonable time period.
- The software is not commercially available. The taxpayer cannot purchase, lease, or license and use the software for the intended purpose without having to make significant modifications that satisfy the first two requirements.
There are numerous activities that are not within the definition of qualified R&D activities. The following are 10 primary types of activities that are specifically excluded from the definition of qualified research:
- Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions)
- Adaptation or duplication of existing business components
- Surveys, studies, or activities related to management functions or techniques
- Market research, testing, or development (including advertising or promotions)
- Routine data collection
- Routine or ordinary testing or inspection for quality control
- Computer software, except where developed for internal use
- Any research conducted outside of the United States
- Any research in social sciences
- Funded research.
The cost of acquiring fixed assets used in a taxpayer’s trade or business is also excluded.
Changes to the R&D Tax Credit under the PATH Act of 2015
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.
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 Results
In 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.
Attitudes 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):
- Will a permanent R&D tax credit help your company increase spending on research and development?
- For tax years beginning after Dec. 31, 2015, eligible small businesses (ESB) can use the research credit as an offset against AMT liability. Will this impact your business in a positive way?
- For tax years beginning after Dec. 31, 2015, qualified small business (QSB) may elect to claim a portion of their research credit as a payroll tax credit against their employer Federal Insurance Contributions Act (FICA) tax liability, rather than against their income tax liability. Will this be beneficial to your company in the coming year(s)?
- Does a permanent research credit help you with your tax planning?
- Are you more likely/less likely to further increase your R&D spending as a result of the changes in the PATH Act of 2015?
It eliminates the uncer tainty in making R&D investment decisions and serves as a tool for lower ing a company’s effective tax rate.
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.
Research and Development Tax Credits for Businesses
The PATH Act of 2015 includes some increased incentives in the form of tax credits for small businesses who use the R&D (Research and Development) tax credit.
What Qualifies as Research and Development?
Many types of businesses do research, and you may not even be aware that the activities of your business may be available as tax credits. Your business may be able to qualify for a tax credit for activities such as:
- development of proprietary products, including inventions,
- improving product quality, reliability, or functionality
- work on developing or improving software products
- research to improve business performance
- payments to third parties who conduct research for your business
- payments to employees who work on research projects in your business
The IRS says that research that qualifies for the tax credit must be
undertaken for discovering information that is technological in nature, and its application must be intended for use in developing a new or improved business component of the taxpayer. In addition, substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality....
What Tax Credits are Available? How Do These Tax Credits Work?
Usually, a tax credit is taken directly against the income of the business, as shown on the business tax return.
In this case, as noted above, the PATH Act has expanded the tax credit for smaller businesses, effective beginning in 2016, and makes the credit permanent. This removes the guess-work of businesses trying to make plans.
More specifically, newer businesses (under 5 years old) and small businesses with under $5 million in gross receipts for the tax year may be able to qualify for a credit of up to $250,000 a year.
Here's how these tax credits work: a business spends money, then makes an application for a tax credit. The credit is applied directly against business income, which is better than taking a deduction for the expense.
There are three types of tax liability against which the tax credit can be taken. The 2015 legislation allows small businesses to take the tax credit against:
These options allow businesses more flexibility in where they apply the tax. Newer small businesses, for example, may not have enough income tax liability against which to apply the tax, so the business can select one of the other options.
Taking the credit against the employer's share of Social Security taxes means you might be able to take the credit even if your business isn't making a profit.
Note that the R&D tax credit can be taken against Alternative Minimum Tax. This alternative tax is applied to the owner's personal tax return, so it would only be available for pass-through taxes. These are business taxes that pass through to the personal tax return of the business owner and would include sole proprietorships, LLC's, and partnerships.
How to Apply for This R&D Tax Credit
You would apply for the credit for a specific tax year by filing IRS Form 6765- Credit for Increasing Research Activities. The form offers you two options for taking the credit:
- Taking the "regular" credit, or
- Using the alternative simplified credit.
Each option includes a list of included costs (like wages, computer costs, and cost of supplies) and calculations. It's best to read the details in the instructions for form 6765 before you begin. The IRS suggests working through both methods to see which results in a greater credit.
Deducting or Amortizing These R&D Tax Credits
You may also want to look into deducting or amortizing (spreading out) the cost of these research activities. The IRS has guidelines for deducting or amortizing research tax credits.
In Conclusion: Check With Your Tax Professional
As usual with these types of tax benefits, the qualifications and the process are complicated.
The purpose of this article is not to give you tax advice, but to provide you with general information to use in your conversation with your tax professional.