The federal R&D tax credit was made permanent by the Protecting Americans from Tax Hikes Act, effective for 2016 tax returns. That broke the pattern of annual year-end—and often retroactive—extensions of the R&D credit. Further, new offsets for the alternative minimum tax and payroll tax allow even more companies to receive a benefit for their research activities.
Thanks to the credit’s now-permanent status, companies can factor a federal income tax reduction into their financial planning. Tax frameworks from both the House and President Trump include provisions for the R&D tax credit, but without specifics about the definition, usability, or other positions that may affect the credit in future years.
There’s no question that large Fortune 500 companies account for a significant portion of the overall research performed and the credit dollars claimed each year. But it’s important to note that the R&D tax credit isn’t limited to large companies with established R&D departments. Any company that develops new or improved products, processes, or software could qualify under the U.S. tax code.
Do You Qualify?
Regardless of industry, size, or revenue, any business that performs activities that meet the following four tests may qualify for R&D tax credits:
- Technical uncertainty. An activity performed to eliminate technical uncertainty about the development or improvement of a product or process, which includes computer software, techniques, formulas, and inventions.
- Process of experimentation. Activities undertaken to eliminate or resolve a technical uncertainty, which involve an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial, and error, or other methods.
- Technological in nature. The process of experimentation relying on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Qualified purpose. Creating a new or improved product or process (computer software included) that results in increased performance, function, reliability, or quality.
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. These salaries are generally one of the largest components in an R&D tax credit claim, but they may differ by industry. For example, the most prominent expense for pharmaceutical and construction companies is often contract research.
A portion of payments made to U.S.-based contractors, as well as any supplies consumed in the R&D process, are also eligible. Further, a portion of payments made to cloud service providers may qualify if they relate to such qualified R&D activities such as testing or development in the cloud, rather than simple file storage or hosting for stable software releases.
Up to 9.1% of a company’s annual eligible costs can be applied, dollar for dollar, against its federal income tax liability. Moreover, 36 states have their own R&D tax credit programs, some of which are permanent. They have varying incentive amounts, and many closely resemble or even mirror the federal rules governing what types of activities and expenses are eligible.
Credit Carryforward and Retroactive Claims
Even if your company doesn’t currently have a tax liability but its activities qualify, it’s still important to document along the way. R&D tax credits incurred in years when a company has no taxable income can now be carried forward to offset tax on future taxable income. In most cases, credits that can’t be used immediately (because of losses, for example) will carry forward for up to 20 years.
Federal taxpayers can also claim the R&D tax credit retroactively by filing amended returns for the past three tax years (or more, if your company endured losses during that time). That’s a good way to recoup tax previously paid or to capture credits generated in prior years to be used against future taxes. State taxpayers may also be able to amend returns that go back even further. For example, the California statute is open for four years.
Offset Alternative Minimum Tax
Eligible small businesses whose R&D credits may have been limited by the AMT in the past can now use the R&D tax credit to fully offset AMT without regard to tentative minimum tax. Credits generated in 2016 can now immediately reduce a company’s tax liability, freeing up cash that can be reinvested in the business. Eligible small businesses are sole proprietorships, partnerships, and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years.
Payroll Tax Offset
The new payroll tax offset is available to companies that have gross receipts for five years or less, under $5 million in gross receipts in the current year and for each subsequent year the payroll tax offset is elected, and qualifying research activities and expenditures, regardless of whether they’re profitable.
The maximum benefit an eligible company can claim against payroll taxes each year under the new law is $250,000. Brand-new businesses could potentially use the R&D credit to offset payroll taxes for up to five years, with a maximum of $1.25 million in total credits used on their quarterly federal payroll tax returns. Benefits go into effect in the second quarter of 2017 for qualified expenses incurred in 2016.
Documentation is Key
To claim the R&D tax credit now or in the future, start by documenting potential projects, products, or processes that may qualify. Evaluate all your company’s activities for potential eligibility, then begin tracking qualifying expenses and gathering documentation to support the costs.
If you think your company might be performing work that qualifies for the R&D tax credit, don’t let the potential tax savings go unclaimed — and don’t be intimidated by preconceived notions of what R&D is or what companies can qualify. Across industries, the possibilities for qualifying activities are out there, and if you’re willing to take a look, you could uncover vital tax savings to reinvest in your business and fuel your next big project.
Tom Sanger is a partner with accounting and advisory firm Moss Adams.