Now is a better time than ever for small and medium-sized businesses with qualifying research expenditures to consider taking advantage of the federal research and development tax credit.
In addition to giving the R&D credit a permanent home in the U.S. tax code, Congress made other favorable changes as part of the Protecting Americans from Tax Hikes Act of 2015—changes that allow more taxpayers to use the credit.
Alternative Minimum Tax Offset
One change created by the PATH Act allows research credits generated in tax years beginning on or after Jan. 1, 2016, to offset alternative minimum tax liabilities of small to medium-sized businesses or respective shareholders/members.
Previously, the R&D credit could not be used to offset AMT.
A small or medium qualifying entity is defined as a business with $50 million or less in gross receipts, determined by taking an average of the prior three years’ receipts.
Although credits carried forward from prior years are still subject to the AMT limitation, any 2016 credit eligible for carryback to 2015 may reduce AMT in the prior year or carry forward for up to 20 years.
Thanks to this favorable change, the ability to use R&D credits to reduce AMT as well as regular income tax will benefit many Connecticut business owners.
Payroll Tax Offset
Another favorable change under the PATH Act allows qualified small businesses to use the R&D credit to offset up to $250,000 of the employer-paid portion of FICA tax.
- Has gross receipts of less than $5 million for the current tax year
- Did not have gross receipts for any tax year prior to the 5-taxable-year period ending with the current taxable year
- Cannot be a tax exempt entity
Businesses under common control must separately make the election to use a portion of their allocated R&D credit as a QSB payroll tax credit.
The election to use the R&D credit as an offset to payroll tax can be made for up to five tax years.
Qualifying Research Expenditures
To be eligible for the R&D credit, research and development activity must meet the definition of qualifying research expenditures.
Activities performed in the United States must satisfy a four-part test:
1. The work is being performed to develop a new or improved business component (product, process, technique, formula, invention, or computer software).
2. The activities are performed to discover information that is technological in nature. The activities will involve physical, biological, engineering, or computer sciences.
3. The research is performed to eliminate technical uncertainty, determine if a desired result could be achieved, how to achieve it, or determine the specific design of a product.
4. The activities will include a process of experimentation involving identification of the technical uncertainties, alternatives to consider in eliminating the uncertainties, and a process for evaluating alternatives.
The credit is calculated for three types of qualifying research expenditures incurred in conducting qualified research.
Qualifying expenses eligible for the credit include wages, supplies used in the conduct of qualified research activities, and a percentage (65%) of third-party contract research.
The determination of qualifying research activities is subjective in nature.
The Internal Revenue Service and states that offer additional credits require the R&D credit to be supported by contemporaneous documentation.
Sooner Is Better
The changes instituted by the PATH Act of 2015 that allow (1) small and medium-sized businesses to offset AMT and (2) qualifying small businesses to offset employer-paid FICA payroll tax may provide businesses performing qualifying R&D activities the opportunity to monetize the R&D tax credit sooner than has been allowed in the past.
About the author: Ann Arpino is a director in the New Haven office of public accounting and advisory services firm Marcum LLP.