[In case you were wondering what a tax CPA
does during weekdays, I drafted the following for a fellow CPA as a walkthrough
through the tax terrain for research expenses and the related – but different –
research credit. It is not recreational reading, but hopefully it may help another
tax practitioner out there – CTG].
The research & development tax credit has been
around since the early 1980s. Initially, only the largest of corporations
seemed able to meet its requirements. The passage of years introduced more
realistic standards, allowing even modest companies to benefit. Its decades of
changes, requirements, limitations and alternate calculations make this a
challenging area for almost any tax practitioner.
Let’s take a brief dive into the research credit.
Analysis of the credit, oddly enough, does not begin
with a tax credit itself. No, it begins with the deduction for research expenses.
§ 174 Amortization of research and experimental expenditures.
(a) In
general.
In the case of a taxpayer's specified research or experimental
expenditures for any taxable year-
(1) except
as provided in paragraph (2), no deduction shall be allowed for such
expenditures, and
(2) the
taxpayer shall-
(A) charge
such expenditures to capital account, and
(B) be
allowed an amortization deduction of such expenditures ratably over the 5-year
period (15-year period in the case of any specified research or experimental
expenditures which are attributable to foreign research (within the meaning of section 41(d)(4)(F) )) beginning
with the midpoint of the taxable year in which such expenditures are paid or
incurred.
For years – decades actually – research and
experimental expenses were deductible as incurred, although the taxpayer had
the option to capitalize and amortize such expenses if preferred. For taxable
years beginning on or after January 1, 2022, however, that option has been
eliminated. Research and experimental expenditures must now be capitalized and
amortized (that is, spread out over time). The only difference is the period:
· Domestic
research is amortized over 5 years.
· Foreign
research is amortized over 15 years.
This is a sea change in the treatment of such
expenses. Many practitioners – including me – have only known one option, and
that was the immediate deduction of relevant expenses. Granted, amortization
does not mean the deductions are lost; it means only that the deduction is
spread over a period of years. If the company is unprofitable (think a start-up),
the difference between immediate deduction and amortization may be minimal.
Take a mature company (Pfizer, for example), and the difference could be
dramatic.
What type of expenses qualify for the Section 174
deduction?
· Wages
paid to employees directly involved in R&D, and individuals who support and
supervise their work. Support or supervise is defined as one level above or
below.
· Supplies
and raw materials.
o
There is an issue here about depreciable equipment.
In general, the taxpayer decides the matter by capitalizing or not capitalizing
the equipment. If it does, then the equipment is not considered supplies and
cannot be included in the expense pool.
· Work
performed by a third party, as long as the business retains the risk of failure.
· Patent
costs
· Certain
overhead expenses (think a research lab)
Now, we know that wages may qualify for the Section
174 deduction, but obviously not all wages will qualify. There are additional “qualities”
for an expense to qualify as Section 174 expenses:
· A
permitted purpose
The underlying activity
in which wages are incurred must relate to a new or improved business purpose.
For example,
o
Something functions (at all)
o
Something functions more reliably
o
Something functions more efficiently
· Technological
in nature
o
Must be based on a hard science
§ Think
engineering, physics, chemistry
§ Scratch
sociology and the like
· Elimination
of uncertainty
o
There must be a realistic question whether
the idea will work.
§ Mind
you, it does not have to work, but there must be an initial question (or
oppositely, a hope) that it will.
· Process
of experimentation
o
Think classic trial and error.
There are best-practice recordkeeping standards for
these expenses. At this point (that is, deduction), such practices may or may
not be critical, but the recordkeeping becomes critical as we leave Section 174
and go to the tax credit under Section 41.
§ 41 Credit
for increasing research activities.
(a) General rule.
For purposes
of section 38, the research credit determined under this section for the
taxable year shall be an amount equal to the sum of-
(1) 20 percent of the
excess (if any) of-
(A) the qualified
research expenses for the taxable year, over
(B) the base amount,
(2) 20 percent of the
basic research payments determined under subsection (e)(1)(A) , and
(3) 20 percent of the
amounts paid or incurred by the taxpayer in carrying on any trade or business
of the taxpayer during the taxable year (including as contributions) to an
energy research consortium for energy research.
The research tax
credit is a big deal because it gives you a second tax bang for doing something
you were doing anyway. First, you get to deduct the expense of doing something
(immediately under old law; over time under the new law). Second, you get a tax
credit on top of the deduction.
The tax credit can
be – to be diplomatic – confusing.
There are two main
paths:
· The regular credit
· The alternate
simplified credit
The
Regular Credit
The regular credit begins with an odd
question:
· Did you have
qualifying research expenses (QREs) before 1984?
If the answer is
yes, you will have to accumulate information from the 1980s to calculate the
credit, This requirement has been enough to break the hearts of many seeking the
research credit.
If the answer no,
then calculations become more doable.
The basic
calculation is:
Current QREs – base amount = excess
QREs
The base amount
involves a five-year period and can be any 5 years between the company’s 5th
and 10th taxable year.
Add up the 5-year QREs. [A]
Add up the 5-year gross receipts [B]
Divide [A] by [B] (called the fixed
base percentage)
Let’s pause for a
moment.
For its first 5 years, the company can
just use 3% for its fixed base percentage.
The fixed base percentage cannot exceed
16% (i.e., once outside the five year window).
Back
to math.
Multiply the fixed base percentage by
average annual gross revenues for the 4 preceding years (this is called the “base
amount”).
Use the greater of the base amount or
50% of current QREs.
Subtract that amount from current year
QREs (let’s call this the golden earring).
Now what?
We multiply the golden earring by a
percentage.
Easy:
20%, right?
Nothing is easy.
If we use 20%, then we have to add the
amount of the research credit back into taxable income, meaning there is a
loop-the-loop.
Fortunately, one
can elect to use a reduced credit to avoid the loop-the-loop. The reduced
credit is directly tied to the maximum corporate tax rate. Presently the
maximum rate is 21%, so the reduced credit would be 20% times 79% = 15.8%.
The election must be claimed on an
original, timely filed return and is good only for the year of election.
Let’s look at an
example.
|
Current year QREs
|
|
|
|
|
164,000
|
|
Sum of 5-year QREs
|
[A]
|
250,000
|
|
|
|
Sum of 5-year gross receipts
|
[B]
|
960,000
|
|
|
|
Fixed base percentage
|
|
26%
|
|
|
|
Limit on fixed-base percentage
|
|
16%
|
|
|
Average gross receipts preceding 4
years
|
|
744,000
|
|
|
Base amount
|
|
|
|
119,040
|
|
|
Greater of base amount or 50% of
current QREs
|
|
119,040
|
|
Subtract
|
|
|
|
|
44,960
|
|
Credit rate
|
|
|
|
|
20%
|
|
Credit
|
|
|
|
|
8,992
|
The Alternative Simplified Credit
This option came
into the Code in 2007, offering an alternative to working with (possibly)
decades-old data, There is a price for the simplification, though:
The credit is 14%
if the company has at least 3 years of QREs, otherwise …
The credit is a
flat 6% of current year QREs.
You again have the
loop-the-loop or you can elect to use the reduced credit.
The nice part of
the calculation is that you look at only the three years preceding the current
year.
Here is an example.
|
Current year QRE
|
|
|
|
164,000
|
|
Average QREs previous 3 years
|
[A]
|
105,000
|
|
|
Multiply [A] by 50%
|
|
|
|
52,500
|
|
Subtract
|
|
|
|
|
111,500
|
|
Credit rate
|
|
|
|
14%
|
|
Credit
|
|
|
|
|
15,610
|
Here is an example with the reduced credit.
|
Current year QRE
|
|
|
|
164,000
|
|
Average QREs previous 3
years
|
[A]
|
105,000
|
|
|
Multiply [A] by 50%
|
|
|
|
52,500
|
|
Subtract
|
|
|
|
|
111,500
|
|
Credit rate
|
|
|
|
11%
|
|
Credit
|
|
|
|
|
12,265
|
What
if the company does not have 3 years of QREs? Then a flat 6% of current QREs
applies.
|
Current year QRE
|
|
|
|
|
164,000
|
|
Average QREs previous 3 years
|
[A]
|
|
|
|
|
Multiply [A] by 50%
|
|
|
|
|
0
|
|
Subtract
|
|
|
|
|
|
164,000
|
|
Credit rate
|
|
|
|
|
6%
|
|
Credit
|
|
|
|
|
|
9,840
|
The Payroll Tax
Offset Option
The PATH Act of
2015 introduced yet another option to the research credit: use it instead to
offset employer payroll tax.
More specifically:
(1)
The
offset applies to both the social security portion (6.2%) and Medicare portion
(1.45%) of the employer FICA tax.
(2)
There
is a $500,000 maximum.
(3)
Only
companies with gross receipts for 5 years or less (think startups) qualify.
(4)
Only
companies with gross receipts of $5 million or less in the year of the election
qualify.
(5)
The
election goes with the income tax return.
(6)
The
offset applies to the first payroll tax quarter after the company files its
income tax return.
(7)
Any
unused credit carries over to the next payroll tax quarter.
(8)
Any ultimately
unused credit, however, will not be refunded.
The provision was
clearly directed at companies with payroll tax obligations but little or no immediate
income tax liabilities to sop up that research credit.
Be cautioned,
however: you would be exposing your tax filings (both income and payroll) to
heightened scrutiny. R&D credits are a high priority for the IRS.
