Guest Blog: CliftonLarsonAllen - R+D Tax Credit
Does your technology company employ information technology professionals (i.e., data scientists, computer programmers, systems engineers, etc.) that develop software, or offer technology solutions to your customers? If so, your company may be engaged in research and development activity, and eligible to claim a tax credit for that effort.
The R&D tax credit was originally enacted into law in 1981 to incentivize companies to increase investments in developing new or improved products, processes, software, techniques, and formulas in the United States. Since its inception, the tax credit expired several times due to the temporary nature of the credit. However, in 2015, the Protecting Americans against Tax Act (PATH Act) made the credit a permanent part of the tax code and expanded its benefit for certain small businesses and startups. Most recently, with tax reform, Congress preserved the R&D tax credit, ensuring that it remained a permanent part of the tax law.
Although Fortune 500 companies account for a significant portion of the overall research performed and the credit dollars claimed each year, it is important to understand that even smaller companies without well-established R&D departments can claim the credit. Any company in a wide array of industries (manufacturing, software, specialty contractors, technology, life sciences, etc.) that develops new or improved products, processes, or software could qualify for the R&D tax credit under IRC Section 41 as long as the activity it undertakes meets the four-part test noted below.
- Qualified purpose. The purpose of the research must be to create a new or improved product (e.g., software) or process, resulting in increased performance, function, reliability, or quality.
- Technological in nature. The activity undertaken relies on the principles of hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Technical uncertainty. The activity seeks to eliminate technical uncertainty about the development or improvement of a product or process.
- Process of experimentation. The activity seeks to eliminate or resolve a technical uncertainty, which involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial, and error, or other methods.
If the identified activity meets all four parts, the company has qualified research activity, and is one step closer to claiming the credit. The second step is identifying the costs (qualified research expenses) associated with the qualified research activity. The amounts paid for salaries, supplies, contract research, and computer leasing could all qualify for the R&D tax credit. Salaries paid to employees who conduct qualified activities, as well as to first-line managers and personnel who directly support these individuals, can qualify.
The tax law allows companies to calculate the credit through either the Regular Research Credit (RRC) or the Alternative Simplified Credit (ASC). The main advantage of the ASC method is that it is a practical, simpler alternative when it is difficult to obtain the information needed to compute the figure under the RRC method. Traditionally, a company can claim an annual R&D tax credit in the amount of 4.5% - 6% (depending on the industry) of its qualifying research expenses. Additionally, a company does not have to have a significant amount of R&D expenses to benefit. For example, if a company has only $500,000 of qualifying research expenses, it could claim approximately a $30,000 federal R&D credit, and possibly higher with state credits, if it operates in states that permit the R&D tax credit.
Offsetting Payroll Tax Liability
As the R&D tax credit is not a refundable credit, traditionally, a company has to be paying income tax to take advantage of this incentive. However, with recent tax law changes, businesses in a loss position (e.g., start-ups) may now be able to monetize their research credit by applying it against their payroll tax liability. In order to offset its payroll tax liability with the research credit, a business must be a ‘qualified small business’ (QSB). A QSB is defined within the tax rules as a partnership, corporation, or person with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year.
Offsetting AMT Liability
Another favorable recent change to the tax law affects companies that are in an alternative minimum tax (AMT) position. Businesses in an AMT position may now be able to offset their tax liability with the research credit, a new category of ‘specified credit’ under the tax law. In order to offset its AMT liability with the research credit, a business must be an ‘eligible small business’ (ESB). An ESB is defined in within the tax rules as a sole proprietorship, partnership, or non-public corporation with average annual gross receipts of $50 million or less for the three preceding tax years.
Benefit of an R&D Tax Credit Study
An R&D tax study involves both a quantification and a qualification component. Although it is important to quantify the figure and incorporate the number on the company’s tax return, it is equally, if not more important to properly document the company’s qualified research activity. If a company’s R&D tax credit is challenged by IRS and/or state revenue departments, there is a higher likelihood the credit will be sustained upon audit if the activity is properly and contemporaneously documented, and the company is able to draw the nexus of qualifying research expenses to qualifying research activity.
The R&D credit provides a permanent tax benefit for companies. Additionally, recent changes to the tax law permitting start-ups and certain taxpayers in AMT position to take advantage of the R&D credit make this an even more attractive provision to help companies reduce their tax liability.
For a deeper discussion on how your company can potentially claim the R&D tax credit, please contact Mathew Abraham at CliftonLarsonAllen (E: mathew.abraham@claconnect.com P: 813.384.2741).