The intent of the Sec. 41 research and development (R&D) credit is to give companies incentive to invest in innovation within the United States. The R&D credit is available to companies in a variety of industries that develop new or improved products or processes. Certain wages, supplies, and contract research costs associated with qualifying R&D projects and activities, referred to as qualified research expenditures (QREs), form the basis of the R&D credit.
Despite having qualifying R&D activities and corresponding QREs, small businesses have often been limited in their ability to claim the R&D credit in the current tax year due to net operating losses or alternative minimum tax (AMT) positions. For example, a startup company that is not yet generating taxable income will not have the tax liability needed to use the R&D credit. Although the R&D credit may be carried forward for 20 years, the company receives no immediate tax benefit from the qualifying R&D activities. In addition, taxpayers in an AMT position do not receive an immediate benefit from the R&D credit because the credit cannot be used to offset an AMT liability.
PATH Act
The Protecting Americans From Tax Hikes (PATH) Act of 2015, part of the Consolidated Appropriations Act, 2016, P.L. 114-113, included the following important changes to the R&D credit:
- Making the R&D credit permanent;
- Allowing businesses with less than $50 million in gross receipts to offset the R&D credit against AMT liability; and
- Allowing certain small businesses with less than $5 million in gross receipts to offset the R&D credit against payroll taxes.
These changes positively affect businesses of all sizes that invest in R&D projects and activities in the United States. However, the new rules that provide for the offset against AMT and payroll taxes are the most significant for small businesses that would otherwise be limited in taking immediate advantage of the R&D credit.
Offset Against AMT
For tax years beginning after Dec. 31, 2015, the PATH Act allows eligible small businesses (ESBs) with less than $50 million in gross receipts to offset R&D credits generated after the effective date against AMT liability.
An ESB is defined as a sole proprietorship, partnership, or nonpublicly traded corporation with average annual gross receipts for the prior three tax years that do not exceed $50 million. Partners of a partnership and shareholders of an S corporation must separately meet the gross receipts requirement to use the R&D credit against their individual AMT liability.
This new rule removes a frequent obstacle associated with R&D credits, particularly for owners or members of passthrough entities.
Offset Against Payroll Tax Liability
Also for tax years beginning after Dec. 31, 2015, the PATH Act provides certain startup businesses, defined as qualified small businesses (QSBs), with an opportunity to elect to offset R&D credits generated after the effective date against the employer portion of Federal Insurance Contributions Act (FICA) payroll taxes instead of income tax.
A QSB is a corporation (including an S corporation) or partnership that meets both of the following tests: (1) It has gross receipts of less than $5 million for the credit-claiming year, and (2) it did not have gross receipts for any tax year preceding the five-tax-year period ending with that tax year.
To apply the R&D credit against the employer portion of FICA payroll taxes, a taxpayer that is a QSB must make an election for the tax year to convert a certain amount of its R&D credit to a payroll tax credit. The election 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. Also, for purposes of applying these rules, all members of the same controlled group of corporations and trades or businesses under common control are treated as a single entity.
QSBs can allocate up to $250,000 of annual federal R&D credits against their employer portion of FICA payroll tax liability. The allocated portion of the R&D credit specified by the QSB may be applied against the employer portion of old-age, survivors, and disability insurance (OASDI) payroll taxes beginning in the first calendar quarter following the date on which the taxpayer files the return. If the payroll tax credit portion of the R&D credit exceeds the QSB's employer portion of FICA tax liability for any calendar quarter, the excess is carried to the next calendar quarter and allowed as a credit for that quarter. A QSB cannot make the payroll tax election if it has made the election for five or more preceding tax years.
As the R&D tax credit is nonrefundable, this change in the law to offset payroll taxes provides a significant cash flow opportunity for startups that do not have a tax liability to otherwise offset the credit.
Summary
Overall, the new AMT and payroll tax offset rules provided by the PATH Act present a significant cash flow opportunity to certain small startup businesses and other small businesses that will now be able to realize the tax advantages of generating R&D expenditures.
EditorNotes
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
