For many companies, the Research & Development (R&D) credit is an often-misunderstood tax savings tool. There are several common misconceptions about the credit, including believing it is only for large companies or those with an official R&D department. While untrue, these myths discourage companies from leveraging this compelling federal tax savings tool. Even for those familiar with the eligibility criteria, the R&D credit is a small mystery due to the complex regulations that feature ongoing changes. Despite the challenges, many Texas and California businesses are enthusiastic about claiming the credit but are often unaware of how it can be applied against federal taxes. To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.
R&D Tax Credit Utilization
Once secured, a business has several options for utilizing the federal R&D tax credit. Under current law, a company can apply against current liabilities for a dollar-to-dollar reduction, elect to carry back the credit for one year, carry it forward for up to 20 years, or can be used to offset payroll taxes owed in certain circumstances. Beyond this, if an amended return is filed, the taxpayer can also receive a tax refund up to three years back.
For state-level R&D tax credits, there are no consistent rules to follow. Each state will have different processes but typically credit amounts can be utilized to offset outstanding franchise taxes. California also allows the owners of pass-through entities to offset personal tax.
PATH Act & TCJA
The Path Act of 2015 made it possible for many small businesses to claim the R&D credit. Specifically, it allowed pass-through entities to leverage general business credits, including the R&D credit, to reduce tax liability below the tentative minimum tax (TMT) threshold. Concurrently, it created a way to use the credit to offset certain payroll taxes. To be eligible, a business must have annual gross receipts over the previous three years of $50M or less.
The Tax Cuts and Jobs Act (TCJA) of 2017 increased credit usability more by repealing the Corporate Alternative Minimum Tax (AMT). More importantly, it continued the permanency of the credit but also changed the way it can be used. It is important to remember the section 38(a) limitation, which prevents using the credit to reduce tax liability, remains.
Under existing guidance, taxpayers should follow the 25/25 Rule. This rule limits the reduction of tax liability against net income and does not allow a reduction below 25% of the amount by which regular tax liability (RTL) exceeds $25,000. The basic calculation can be made by subtracting RTL- 25K and then multiplying it by 25%. The resulting amount cannot be reduced by most general business tax credits (including the R&D tax credit).\
Payroll Tax Offset Requirements
Starting in 2016, certain businesses can elect to apply federal R&D credits to offset payroll taxes up to $250,000 per year for a maximum five-year period. Starting in 2023 onward, Qualified Small Businesses (QSB) can offset payroll taxes for up to 500,000 per year. To be eligible, an organization must be a QSB and meet the following conditions:
- No prior gross receipts (for startups) or no gross receipts for any taxable year preceding the 5-taxable-year period ending with the current taxable year; and
- Less than $5 million in gross receipts as determined under the rules of Section 448(c)(3) in the current taxable year.
This means you do not have to be a startup company but instead need to be a qualified small business to elect to use R&D credits to offset payroll taxes.
A QSB that is a partnership or S corporation must elect the payroll tax credit election at the entity level.
The payroll tax credit does have a limit on the amount you can claim per quarter. Specifically, the amount claimed cannot exceed the employer portion of the social security tax imposed for any quarter for wages paid for its employees. However, the excess that is not used can be carried into and used in subsequent quarters.
It is important to note that the R&D Credit cannot be claimed against wages that were already covered under COVID-19 relief funding, such as the Employee Retention Tax Credit or the Paycheck Protection Program. So, it is imperative to double check that claims do not include these ineligible wage types.
We’re Here to Help
There are several options to consider when determining how to use federal Research & Development Tax credits to reduce corporate tax liability. If you have questions about the information outlined above or need assistance claiming the R&D tax credit, 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.