The research and development (R&D) tax credit is one of the most significant, and often misunderstood, incentives in the U.S. tax code. In a time when businesses are struggling to find the cash necessary to survive until the economy returns to its new normal, those who might qualify should take a closer look at eligibility and those who have previously qualified need to understand how some of the COVID-19 relief legislation may interact with previous claims.
R&D tax credit basics
The R&D tax credit isn’t just about scientists in lab coats trying to find a cure or vaccine for a virus. To qualify for the credit, a company must:
- Develop a new or an improved product or process. Remember, it doesn’t have to be new to the world — just your organization.
- Experiment with alternative designs to resolve technical uncertainty related to the product or the process being developed.
- Use hard sciences like chemistry, engineering, or mathematics to research improvements to the product or the process.
- Maintain substantial rights in the resulting product or process.
The credit is available only for amounts spent on R&D in the United States and won’t apply to any research funded by outside sources like grants. It doesn’t apply to amounts spent to license a new technology from a vendor, although amounts paid to a consultant who helps develop a product or process to which your business retains the rights may qualify.
With so many businesses developing workarounds to limit customer and employee exposure to the COVID-19 pandemic, it’s also important to remember that the credit can apply to something that you develop for internal use — it doesn’t have to result in a product or process that you sell or license for profit. In fact, the IRS even issued some helpful guidance in recent years on how costs related to internal use software may qualify.
NOL carrybacks and previous R&D tax credit claims
The Coronavirus Aid, Relief, and Economic Security (CARES) Act included a provision that enables businesses to carry back net operating losses (NOLs) incurred in 2018, 2019, and 2020 for up to five years to reduce taxes owed in prior years and claim refunds that can provide much-needed cash. Businesses that have claimed R&D tax credits in recent years need to understand how an NOL carryback affects those prior-year claims. If R&D tax credits haven’t been previously claimed, doing so while applying NOL carrybacks to prior years can provide significant benefits. An R&D tax credit claimed on an amended return will increase the taxable income of that year, thereby creating more income to be offset by the NOL carryback.
It’s important to remember that the R&D provision results in a credit that reduces income tax due in a particular year, not an expense that reduces taxable income. When a business qualifies for the credit in a year that it doesn’t generate taxable income, it will carry the credit back one year then forward up to 20 years to apply against tax due in a year that it generates income (with some exceptions for startup businesses discussed below). If a business utilizes an NOL carryback under the CARES Act to reduce or eliminate taxable income in a prior year in which it also claimed the R&D credit, the resulting reduction in income tax due for that year will “release” the credit previously used in that year. The business can then carry that credit amount back one year then forward for up to 20 years to apply against income tax owed at that time.
Startups and payroll taxes
To support startup companies that often spend heavily on R&D but don’t generate taxable income, the tax law permits some qualifying businesses to apply the R&D credit against the employer’s share of payroll taxes that they owe based on wages paid to employees. If the R&D credit is more than the payroll taxes owed, the remainder can be carried forward indefinitely to offset future payroll taxes. The R&D payroll tax offset is available to startups with under $5 million in current-year gross receipts and that have had gross receipts for no more than five years. For example, a startup tech company that generates a $25,000 research credit and has an estimated FICA liability of $30,000 for the year can use its $25,000 R&D tax credit to offset the FICA liability from $30,000 down to $5,000.
As part of the CARES Act, the employee retention credit (ERC) was introduced as another benefit to offset employer payroll taxes, up to $5,000 per eligible employee. The ERC is refundable and is applied after the R&D credit. So, some startups may be able to use their R&D credit to eliminate payroll taxes and receive a refund for the amount of ERC. Realizing the benefit of both the R&D tax credit and the ERC provides startups with fast access to cash when it’s needed most.
Looking forward
Technically speaking, the R&D credit is calculated based on increasing research and development expenses. Most businesses will compare the current year’s costs to a calculated percent of what was spent during the prior three years. For businesses cutting costs to the bone in 2020, their R&D credit might be lower than in prior years, but the threshold spending necessary to qualify for the credit may also be significantly lowered for the three years that follow. If you cut back on R&D activities in 2020, watch for those potentially qualified costs to increase over the next several years.
Document and support your claims
One of the most important components of an R&D tax credit claim is the supporting documentation. Businesses that qualify for the credit need to be able to show that only the portion of wages and other costs directly attributable to R&D activities are included in the calculation. To learn more about how your business might qualify for the R&D tax credit or how the CARES Act carryback rules might affect credits you have claimed in prior years, please give us a call.
