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The Research & Development (R&D) tax credit has been a compelling tax incentive available to companies committed to certain research activities. For years, it was most accessible to the largest companies with extensive research budgets, formal innovation departments – and large tax liabilities. When the regulations were changed, many did not investigate the credit as an option because of past misconceptions. In fact, there are several false R&D tax credit myths circulating, causing executives to dismiss the opportunity because eligibility seemed unlikely.
Despite this, recent changes to the credit are causing some organizations to take another look. Most recently, the Inflation Reduction Act significantly expanded the tax savings opportunity for certain businesses. Starting in 2023, the maximum credit amount that can be claimed against a qualified start-up company’s payroll tax liability doubles from $250,000 to $500,000 per year. This significant benefit increase spells opportunity for those engaged in qualifying activities. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
The R&D Credit and Inflation Reduction Act
Much has been made of the Inflation Reduction Act and its impact on energy, healthcare, and the new corporate book tax. Amid other more newsworthy updates, there was a notable and welcome change for small and startup companies wanting to claim the R&D credit. The payroll tax offset will be increased from its current $250,000 to $500,000.
Though this change wouldn’t take effect until 2023, meaning companies wouldn’t see the tax benefit until 2024, doubling the tax credit is almost guaranteed to incentivize more businesses to engage in research and development activities.
Looking Back: Using the R&D Credit to Offset Payroll and AMT Taxes
Using the payroll tax provision, even companies operating with a loss can claim the R&D credit. This went into effect for tax years beginning in 2016.
The payroll tax provision can only be used for up to five years, and the business must have gross receipts of less than $5 million in the applicable tax year. In addition, there cannot be any gross receipts for more than five years looking back. In other words, if a company has $3 million in gross receipts in 2022, it could be eligible for the payroll tax provision of the R&D credit if there weren’t any gross receipts in 2017 or earlier, provided other requirements are met.
The related AMT provision was passed simultaneously (in the PATH Act) and expanded the R&D credit further so companies with AMT liability could claim the credit. Previously, the credit couldn’t be used to offset AMT. Eligibility for the AMT provision is limited to companies with average annual gross receipts of $50 million or less over the last three years. Newer companies prorate average annual receipts.
Companies that may need a refresher in qualifying R&D activities should start with the four-part test. This litmus test is what taxpayers must demonstrate to qualify for the credit, including:
- Permitted Purpose
- Technological in Nature
- Process of Experimentation
Qualifying activities don’t need to involve a major technological advancement, a substantial budget, and expenses; they don’t even need to succeed. Common examples of what would qualify might include digital transformation through custom software investment, process improvements, new designs and upgrades for facilities, new fraud detection methods, product customizations, and much more.
New Section 41 Refund Requirements
Companies that plan to claim the R&D credit on an amended return need to be aware of documentation requirements. In 2022, new instructions to claim the R&D credit went into effect.
These instructions require taxpayers to list the following information on Form 6765 along with their tax return.
- Business components
- Research activities performed
- Individuals who performed each research activity
- The information they sought to find
- Total qualified employee wage, supply, and contract research expenses
Incomplete or inaccurate documentation will render the R&D credit refund claim void, so it’s important to follow the instructions closely.
It’s also interesting to note that the five-year amortization requirement remains intact for tax years 2022 and beyond at this point in time for Federal credits. Previously, qualified R&D expenses could be used to offset tax owed in the same tax year, providing a more significant immediate impact. This has been a sticking point in various other pieces of legislation that didn’t pass. Build Back Better, for example, would have delayed R&D amortization until 2026. Similar House and Senate bills proposed essentially the same thing but have not moved forward currently. It is also important to note that this does not affect how state R&D credits can be used. For California, for instance, the R&D credits generated in a year can still be used to offset franchise tax liability on the entity level as well as personal tax liability for pass-through businesses.
We’re here to help
While it is clear the IRS and Treasury will need to provide guidance, the Inflation Reduction Act changes are certainly welcome news. If you have questions about the information outlined above or need assistance with R&D qualification, JLK Rosenberger can help. For additional information, call 949-860-9902 or click here to contact us. We look forward to speaking with you soon.