In December 2015, the R&D tax credit was permanently extended, and two key features were added making it more attractive and easier for some taxpayers to utilize. These new features present a significant cash flow opportunity for certain small businesses, and other businesses with limited gross receipts. For example, start-ups may now be able to realize the tax advantages associated with R&D expenditures in the tax year in which they were incurred. These enhancements to the R&D tax credit, which are effective beginning 2016, allow certain small businesses the option of applying for the R&D tax credit against the taxpayer’s payroll tax due, and also against any alternative minimum tax (AMT) liability which the taxpayer may have.
Offset Payroll Taxes By Up to $250,000
Under the new rules, a “qualified small business” (QSB) can make an election to apply for its R&D credit against payroll tax instead of income tax. As the R&D tax credit is non-refundable, this change in the law provides a significant cash flow opportunity for start-ups that do not have enough income tax liability to apply the full amount of the credit against. In the past, these companies would have had to carry forward any excess of credit over their income tax liability (or the full credit amount if no income tax liability existed), to be utilized in future years. With this new feature, eligible taxpayers can instead elect to apply any credit amount they cannot use against their payroll tax liability, allowing them to realize a benefit in the current year.
New businesses or start-up companies meeting the criteria below may be eligible to apply up to $250,000 in R&D tax credit per year against the Social Security portion of their federal FICA tax liability, for up to five years, for a total potential payroll tax benefit of $1.25 million in total credits claimed on their quarterly payroll tax returns filed with the federal government.
The benefit will be between 6 percent and 14 percent of a company’s eligible R&D costs. For the majority of new businesses and start-up companies that incur at least $300,000 in eligible R&D costs, the federal credit to offset payroll tax will be equal to 10 percent of their total R&D expenses.
For example, a company with $500,000 of eligible expenses—let’s say engineering costs—could have a credit of $50,000, while a company with over $2.5 million in eligible expenses in 2016 could have a credit subject to the full $250,000 annual limitation. If the amount of the credit exceeds a company’s Social Security tax (OASDI tax) liability in any given quarter, the excess will be carried forward to the next calendar quarter.
Qualifying For Payroll Tax Offset
What companies qualify for the payroll tax offset?
The new payroll tax offset is available only to companies that have:
1. Not generated any gross receipts for any taxable year before the 5-year period ending with the taxable year at issue. For example, a calendar-year taxpayer would not be eligible to claim the credit for the 2016 tax year against payroll tax if it generated gross receipts in any year before 2012.
2. Less than $5 million in gross receipts in the tax year for which the credit is claimed.
In determining whether the gross receipts requirements are satisfied, the same aggregation rules used in calculating the R&D tax credit apply, meaning that all persons treated as a single taxpayer in calculating the credit are treated as a single taxpayer in determining whether the gross receipts thresholds are satisfied. Each separate entity belonging to an aggregate group may elect to apply their portion of the tax credit against payroll tax liability. However, the $250,000 yearly limit would be prorated to match that entity’s proportionate share of the credit. Taxpayers must make the payroll tax election for a taxable year on or before the due date of the return (including extensions).
What are the qualifying activities to receive the payroll incentive?
Regardless of industry, if a company’s activities meet the following requirements, known as the four-part test, then they could potentially be eligible for this credit:
1. Qualified purpose. The purpose of the activity must be intended to develop or improve a business component by way of performance, function, reliability, or quality.Technical uncertainty. The activity encounters a technical uncertainty related to capability, methodology or appropriateness of design.
2.Technical uncertainty. The activity encounters a technical uncertainty related to capability, methodology or appropriateness of design.
3.Process of experimentation. The activity includes some process of experimentation undertaken to eliminate or resolve a technical uncertainty.
4.Technological in nature. The process of experimentation relies on principles of hard sciences, such as engineering, physics, chemistry, biology, or computer science.
Offset Alternative Minimum Tax (AMT)
Under prior law, taxpayers who generated a minimum alternative tax (AMT) liability received no immediate benefit from the R&D tax credit since it could not be used to offset AMT. However, for tax years beginning after Dec. 31, 2015, eligible small businesses (ESB), including start-up companies, with average annual gross receipts of less than $50 million will now be able to claim the R&D credit against their AMT liability. The ability to offset the credit against AMT removes a major obstacle associated with utilization of R&D credits.
What is the Alternative Minimum Tax (AMT)?
Alternative Minimum Tax (AMT) is a supplemental federal income tax imposed on taxpayers that have certain tax “preferences” affecting their income tax liability.
How does the R&D tax credit effect AMT?
The 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) made R&D expenditures a “preference” for purposes of the Alternative Minimum Tax as it applied to individuals and personal holding companies. As such, when claiming the R&D tax credit, some amount of the R&D expense must be added back to income when computing AMT for individuals. This is the case for shareholders of entities that are disregarded for federal tax purposes and claiming the R&D tax credit. This increase in income may result in a new or increased AMT liability which historically could not be offset by the R&D tax credit that created it.
Qualifying For R&D Credit to Be Applied Against AMT
How do I qualify for the R&D tax credit to be applied against AMT?
The taxpayer must be an “eligible small business” meeting the following requirements:The taxpayer must be a sole proprietorship, partnership, or a corporation whose stock is not publicly traded.
1.The taxpayer must be a sole proprietorship, partnership, or a corporation whose stock is not publicly traded.
2. The average annual gross receipts of the taxpayer for the 3-taxable-year period before the taxable year at issue must not exceed $50,000,000, and
- If the entity was not in existence for the entire three years, then the average gross receipts for the length of time the entity was in existence should be used.
- Gross receipts should be reduced by returns and allowances.
- Any predecessor of an entity should be included in the examination of gross receipts.
- Gross receipts for a taxable year of fewer than 12 months must be annualized by dividing the gross receipts by 12 and multiplying this figure by the number of months in the short period.
- Special aggregation rules apply in determining gross receipts.
3. Credits for a partnership or S Corporation cannot by treated as eligible small business credits by a partner or shareholder unless that partner or shareholder satisfies the gross receipts test itself.
Our services range from strategic planning or one day tutorials to large-scale studies for multinational companies. We have strong collaborative relationships with our international colleagues. This allows us to act as a global preferred provider for our multinational clients interested in reducing their global effective tax rate through multi-jurisdictional R&D incentives.
Jon Segraves is an RTC Associate at Braithwaite Global. Jon has helped companies identify R&D opportunities in multiple industries, including manufacturing and software development. As a licensed attorney with federal and state tax experience, Jon has the proficiency required to analyze and apply the R&D credit within its technical, legislative, and regulatory framework.