We’ve all seen by now that the Tax Cuts and Jobs Act of 2017 was a monumental tax reform act. It provided many benefits to businesses, especially C-Corporations who saw a massive reduction to their corporate tax rate and the bonus of Alternative Minimum Tax repeal.
Yet the businesses that still find themselves faced with large tax liabilities – especially manufacturers – have likely realized that the TCJA also eliminated or diminished the value of many of the tax savings credits and incentives that they once relied upon. Examples include the elimination of the Domestic Production Activities Deduction and diminished impact of the IC-DISC, the NOL deduction, and the Like-Kind Exchange tax deferral.
What options might a business facing a high tax burden have to reduce its tax liability? For some, the federal R&D tax credit might be the answer. The research credit was completely preserved under the TCJA. Eligible businesses now have the opportunity to use the research credit as a replacement to many of these aforementioned lost tax savings tools.
The research credit has been available to taxpayers for almost three decades, but it has only been in the past few years that we have seen widespread consideration of its benefit. The credit had historically been plagued with non-permanency, utilization limitations, calculation complexities and high audit risk by the IRS. Given these risks and limitations, it was common for businesses to ignore the credit and instead rely on other tax planning tools to reduce tax liability.
Today, the landscape has changed. We have a permanent credit, expanded utilization, new simplified calculation methodologies, and reduced audit risk. Thus, more companies are relying on the credit as part of their annual tax planning strategy.
What is the R&D Tax Credit?
The IRC Section 41 Research Credit (“R&D Credit”) was enacted in 1981 to incentivize domestic research and development by private businesses. Today, it’s a permanent incentive that businesses can rely on annually.
The Research Credit serves as a dollar-for-dollar offset to a taxpayer’s federal income tax liability, and it is an addition to the R&D tax deduction for the same expenses. For certain eligible small business taxpayers, it can also be used to offset alternative minimum tax and payroll taxes.
Because the R&D credit is part of the General Business Credit, if it is not used in the tax year in which it is earned it may be carried back one year or carryforward up to 20 years. Further, unclaimed credits can be secured via amended returns if the statute of limitations is open.
Who Can Claim It?
The R&D Tax Credit is a great opportunity for U.S. businesses of all industry types and sectors. It’s open to C-Corps, S-Corps, LLCs, Partnerships, Sole Proprietorships and Joint Ventures and there are no limitations or restrictions on the types of industries that can qualify for it. That said, there are definitely limitations on the types of activity that can qualify for it and these requirements are defined by a “4-Part Test” (see IRC §41(d)(1).)
Without getting into the nuances of the requirements, it’s safe to say that many manufacturers who are working to develop new or improved products or processes – along with software development companies and financial institutions who are working to develop new software solutions for their customers – will often find themselves with an opportunity for eligibility.
Just remember: The R&D efforts must take place on U.S. soil.
What Amount of Benefit Can a Company Expect to Receive?
There is no cap on the amount of credit that a company can receive, but the amount of benefit will be directly tied to the company’s investment in R&D. This investment is defined by a company’s Qualified Research Expenditures (QREs), which includes wages, supplies and contract research costs.
- Wages – The wages of employees directly involved with the R&D effort as well as those directly supervising or supporting the effort
- Supplies – Materials utilized during the R&D effort such as those purchased to build prototypes
- Contract Research – Costs of domestic contractors or vendors hired to work on the project
Based on the amount of a company’s QREs, the credit is calculated annually. These costs are then compared to historical QRE spent in the area of R&D, and then a credit rate is applied. To the extent the credit year expenses exceed the base amount, the taxpayer will earn credit.
It should also be noted that due to the TCJA’s decrease in the corporate tax rate from 35% down to 21%, taxpayers today will actually receive a greater net benefit from the Research Credit than in years past.
Pursuant to IRC Section 280C(c), the tax deduction for research expenses claimed for the Research Credit must be reduced by the amount of the Research Credit claimed. This prevents a double benefit being received by a taxpayer for the same research expenses. As an alternative to actually reducing deductions, a taxpayer may utilize a reduced credit rate, based on the maximum corporate tax rate.
Due to this percentage rate change, taxpayers will see an increase to the reduced credit rate creating an increase to the amount of credit earned. For taxpayers who do not elect the reduced credit, there will still be a greater benefit received because the credit remains a dollar-for-dollar tax offset, while the related deduction (which is lost) will continue to offset tax liabilities at a lower rate.
State Credit Opportunity
In addition to the federal R&D Tax Credit, businesses located within the state of South Carolina may also be eligible for the state credit. A taxpayer claiming a federal income tax credit for research expenses under Internal Revenue Code (IRC) Section 41 may claim a credit against Individual or Corporate Income Tax and Corporate License Fees. The credit is 5% of the qualified research expenses, as defined by IRC 41(b), made by the taxpayer in South Carolina during the tax year. The credit taken in any tax year may not exceed 50% of the taxpayer’s tax liability remaining after all other credits are applied. Any unused credit can be carried forward for up to 10 years.
Many businesses that are eligible for the research credit may not have claimed it in the past due to reliance on other tax savings tools. Because many of these credits and incentives have been eliminated or had their value diminished, you might now find yourself looking toward the R&D tax credit for the first time.
Michael Krajcer is President of Tax Credits Group. He has specialized in the R&D Tax Credit since he started with the IRS in 1986 and was a large case technical specialist on the issue. Subsequent to his government career, he continued as an expert in the credit area in Big-4 accounting, industry, and with his own national practice. Mike has worked with hundreds of companies throughout the United States and has resolved dozens of IRS and state audits of credit claims.