The Protecting Americans From Tax Hikes Act of 2015 (PATH Act), P.L. 114-113, contained several provisions favorable to taxpayers that incur qualified research and development (R&D) expenditures. Perhaps most importantly, it made permanent the previously temporary credit for increasing research activities (R&D credit) and added provisions allowing the credit to be claimed against payroll taxes or alternative minimum tax (AMT), advantages that eligible taxpayers may still be missing.
PAYROLL TAX CREDIT
Although an unused portion of an R&D credit can be carried forward, prior to the PATH Act, many small startups were unable to realize any benefit, as they operated at a loss and thus had no income tax liability to offset. Many such startups, moreover, incurred significant R&D expenditures. To remedy this situation, the PATH Act allows qualified small businesses (QSBs) for tax years beginning after Dec. 31, 2015, to elect to claim all or a portion of the R&D tax credit against the employer portion of Social Security taxes due. The maximum amount of the credit that can be elected to offset payroll taxes in a given year is $250,000, and the election can only be made for five tax years.
For this purpose, a QSB is a taxpayer with gross receipts for the tax year of less than $5 million that did not have gross receipts for any tax year preceding the five-tax-year period ending with the credit year. For example, a taxpayer claiming the payroll tax credit for the 2018 tax year must have had less than $5 million in gross receipts in 2018 and could not have had gross receipts in 2013 or prior. For purposes of the test, gross receipts are reduced by returns and allowances and must be annualized for short tax years, and predecessors are taken into account. For any person other than a corporation or partnership, only the aggregate gross receipts of the person in carrying on all of that person's trades or businesses are considered. Organizations exempt from tax under Sec. 501 are not eligible to claim the payroll tax credit.
All persons or entities required to be treated as a single taxpayer under the R&D tax credit aggregation rules in Sec. 41(f)(1) are also treated as a single taxpayer for purposes of the payroll tax credit. For example, a startup company formed in 2018 cannot make a payroll tax credit election for the 2018 tax year if a related company with which it is treated as a single taxpayer under the aggregation rules had gross receipts in 2013 or prior. Similarly, a startup company cannot make a payroll tax credit election if a related company with which it is treated as a single taxpayer made a payroll tax credit election in five preceding tax years. Additionally, the $250,000 of potential payroll tax credit that can be elected in a year is allocated among taxpayers treated as a single taxpayer, in proportion to the percentage that each taxpayer's qualified research expenses used in calculating the R&D tax credit is of the group's aggregate qualified research expenses.
The election must be made on or before the due date of the taxpayer's income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities, submitted with the return, and can be revoked only with consent. For partnerships and S corporations, the election is made at the entity level. The credit is claimed against payroll taxes on the taxpayer's Form 941, Employer's Quarterly Federal Tax Return, for the first quarter that begins after the income tax return making the election was filed. For example, if a taxpayer made a payroll tax credit election on a timely filed Form 1120, U.S. Corporation Income Tax Return, that was filed on Oct. 15, 2018, the payroll tax credit would be claimed on the taxpayer's quarterly payroll tax return for the first quarter of 2019. This is accomplished through completing and filing Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, along with the quarterly payroll tax return. Any credit amounts that cannot be used on that quarter's payroll tax return are carried forward to future quarters.
Prior to the enactment of the PATH Act, many taxpayers also were unable to realize the benefits of the R&D tax credit in a given year due to the application of AMT liability, which the R&D tax credit could not reduce. Fortunately, the PATH Act also allows eligible small businesses (ESBs) to use the R&D credit to offset their AMT liability for tax years beginning after Dec. 31, 2015. (The legislation known as the Tax Cuts and Jobs Act, P.L. 115-97, repealed the AMT for C corporations for tax years 2018 and following and, for individuals in tax years 2018 through 2025, increased the AMT exemption amount and the exemption's phaseout threshold.)
For this purpose, an ESB, with respect to any tax year, is a non-publicly traded corporation, a partnership, or a sole proprietorship with average annual gross receipts for the prior three years of $50 million or less. All persons treated as a single employer under Sec. 52(a) or (b) or Sec. 414(m) or (o) are treated as a single taxpayer whose gross receipts must be aggregated. Gross receipts are reduced by returns and allowances and must be annualized for short tax years, and predecessors are taken into account. Additionally, if the taxpayer was not in existence for the full three-prior-year period, the average gross receipts are determined based on the period in which the taxpayer did exist. In the case of partnerships and S corporations, the partner or shareholder must also meet the gross receipts test for the AMT offset to apply.
COMMON APPLICATIONS OF R&D CREDIT
To take advantage of these favorable changes, the taxpayer must first determine which of its projects or activities qualify for the credit, then substantiate a nexus between those projects and the expenses incurred. Based on the age of the business, the taxpayer must also determine a base amount under one of two available methods. Common industries that qualify for the R&D tax credit include software development, manufacturing, communications, engineering (including structural, mechanical, and electrical), and pharmaceuticals.
Thanks to the PATH Act changes, small business taxpayers of all types engaged in R&D can more easily take advantage of the credit despite a lack of taxable income for federal income tax purposes by claiming it against payroll taxes, or, where applicable, against AMT. For more, see "Using R&D Credits to Reduce Payroll Taxes: An Overlooked Opportunity for Startups," The Tax Adviser, Dec. 2018.
Jon Segraves, J.D., E.A., is a licensed attorney and enrolled agent specializing in the calculation, documentation, and defense of specialty tax credits for Tri-Merit Specialty Tax Services in Houston. Charlie Richardson is a vice president of business development for Tri-Merit in Fairfax, Va.
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