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Many Los Angeles and Orange County companies had to experiment with new processes and procedures in 2020 to respond quickly to COVID-19. What if some of those new or changed processes could be tax-deductible? In a year where every business is looking at ways to increase cash flow and reduce taxes, one area often overlooked is the Research and Development (R&D) tax credit. It is a dollar-for-dollar credit to offset federal and/or state taxes, and in some cases, payroll tax liability.
The R&D tax credit has been around for decades with varying benefit levels. What was once thought to only apply to large corporations or tech companies has been retooled so small businesses can also benefit. Adding to the many advantages is the R&D credit is available as a federal tax credit as well as R&D incentives in more than 40 states, including California and Texas. However, the credit remains vastly underutilized because of lingering misperceptions or lack of awareness about qualifying activities.
With the full value of the R&D tax credit set to decrease for tax years beginning in 2022, businesses in all industries should be looking at whether their activities in 2020 or 2021 will qualify.
The Four-Part Test
Qualified R&D activities must meet each requirement listed below.
- Research is technological in nature,
- Intended to develop a new or improved business component,
- Part of an experimentation process related to a new or improved function, performance, reliability, or quality, and
- Meant to eliminate uncertainty about the capability or method of a product or process, or product design.
It is often assumed that to qualify, an activity must involve innovative or breakthrough ideas or that it must succeed–both are incorrect. An activity simply must be new or improved to the company. Businesses with losses or even zero dollars in sales can still benefit from the R&D credit.
There is a wide range of research activities that qualify for the credit. Examples include but are not limited to:
- Taxable wages (except management)
- Cost of supplies
- Up to 65 or 100 percent of contract research expenses, but only if the business retains substantial rights to the results
- Rental or lease costs of computers, such as payments to cloud service providers or server rental space
- Software development costs
The IRS excludes research expenses that are:
- Conducted after the start of normal production
- Adapting an existing product or process to meet a particular customer’s need
- Duplicating an existing product or process
- Studies or surveys
- Related to certain internal computer software, like intranets
- Conducted outside the U.S., Puerto Rico, or a U.S. territory
- In social sciences, arts, or humanities
- Funded by someone else
Partnerships, Sole Proprietors, and Other Small Businesses
Certain private corporations, pass-through entities, sole proprietors, and other small businesses can elect to take the R&D credit against payroll taxes or AMT. This is helpful because many start-ups may operate at a loss in their early days – this is also true in 2020, thanks to COVID-19.
With the payroll tax election, up to $250,000 can be used to offset the employer portion of FICA taxes. Small businesses with no gross receipts in the previous five years and with gross receipts of less than $5 million in the current tax year can take the payroll tax credit election. To claim the R&D credit against payroll taxes, include the credit amount on Form 941 quarterly estimated income taxes.
Certain small businesses may also elect to offset AMT if their average annual gross receipts are $50 million or less for the three years preceding when the credit is claimed. This election is most helpful for sole proprietors. Enterprising entrepreneurs who founded the business less than 12 months ago can find annual gross receipts by multiplying gross receipts by 12 and dividing the results by the number of months in operation.
Impact of the Tax Cuts and Jobs Act
When TCJA was passed in 2017, it temporarily delayed the effective date for Section 174(b) expenses. Basically, this means that the current law allows R&D expenses to be fully deducted in the current year. These are called Section 174(a) expenses. When Section 174(b) modifications take effect on January 1, 2022, R&D expenses must be amortized over five years.
As a result of this change, claiming the R&D credit in 2022 and beyond for certain research or experimental expenses would require a change in accounting method and a reduced face value benefit, as well as more complexity in calculating the credit.
We’re here to help
While the R&D tax credit is permanent, the impact can vary according to tax law. In 2020 and 2021, conditions are favorable to make the most of the credit and put money back into your business. If you have questions about the information outlined above or are interested in exploring if your company qualifies, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us.