RESEARCH & DEVELOPMENT TAX CREDIT BACKGROUND
The Research and Development Tax Credit (“R&D Credit”) was enacted in 1981 as part of the Economic Recovery Act. The R&D Credit has been renewed and extended every two years since its original enactment, until it became a permanent part of the tax code in 2016. The R&D Credit allows companies, large and small, to claim a dollar for dollar reduction in tax liability for conducting qualified research within the United States, as identified by examining qualifying research activities and expenditures related to employee wages, outside consulting costs, and certain material expenses. Taxpayers may claim credits back three years and carry forward unused credits for up to 20 years.
BASICS OF THE R&D CREDIT
When individuals think of research and development, they typically imagine a setting involving test tubes and lab coats. However, when it comes to the tax code, the definition of what may qualify as research and development is more expansive, and includes any work performed that involves design or development to create a new or improved business component.
The following four-part test outlines the requirements necessary for claiming the R&D Credit:
1. New or Improved Business Component – The taxpayer must design or develop a new or improved product, process, formula, invention, technique, or software.
2. Elimination of Uncertainty – The taxpayer must seek to eliminate uncertainty regarding the design or development of the new or improved business component
3. Process of Experimentation – The taxpayer must engage in a process of experimentation by evaluating one or more alternatives that eliminates the uncertainty encountered at the outset of design or development
4. Technological in Nature – The taxpayer must base their process of experimentation on the principles of the hard sciences, such as utilizing the principles of engineering, computer science, or the life sciences.
Permanent – In December of 2015, Congress passed the PATH Act that made the R&D credit a permanent part of the tax code. This was a big win for small and medium sized businesses. Companies can now forecast and budget accordingly knowing the credit will be available for years to come.
Payroll Tax – One of the enhancements to the R&D credit was the ability to offset payroll tax for startup companies. Qualified Small Businesses (less than $5 million in gross receipts and with gross receipts of 5 years or less) can use the R&D Credit to offset employer payroll tax, which is capped at $250,000 for each applicable tax year beginning in tax year 2016. This allows companies who are not profitable, but still conducting R&D activities to take advantage of the credit.
Alternative Minimum Tax (AMT) Turnoff – Another major enhancement to the credit is the ability to offset AMT. In 2010, Congress passed bill that allowed business to reduce their Alternative Minimum Tax with R&D credits. They have now applied the same rules with businesses in 2016 going forward. To qualify for the AMT Turnoff, businesses have to meet the requirements of an “Eligible Small Business”. Eligible Small Businesses (less than $50 million in average gross receipts for the preceding 3 years) may use the R&D Credits to offset their Alternative Minimum Tax beginning in tax year 2016. This is especially beneficial to companies who may be conducting R&D activities but could not take the credit due to AMT limitations.