The R&D credit was permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. It includes some enhancements starting in 2016, including offsets to alternative minimum tax and payroll tax for eligible businesses. The credit is still based on credit-eligible R&D expenses, but offsets apply to only those costs incurred beginning in 2016. The new payroll tax offset allows companies to receive a benefit for their research activities regardless of whether they are profitable.
The maximum benefit an eligible company is allowed to claim against payroll taxes each year under the new law is $250,000.
With this change, Moss Adams LLP has received a lot of questions related to applying the R&D credit against payroll tax and how it’s utilized. We’ve compiled the most relevant questions and their answers to help clarify this opportunity.
When does this new payroll tax offset take effect?
The payroll tax offset will be available for qualified expenses incurred in 2016. The credit must be calculated and shown on a taxpayer’s 2016 federal income tax return, and the portion of the R&D credit that will be applied to offset payroll taxes will need to be identified and elected when that return is filed in 2017. The payroll tax offset will be available on a quarterly basis beginning in the first calendar quarter that begins after a taxpayer files their federal income tax return. Taxpayers would need to file their 2016 federal income tax returns by March 30, 2017, to apply the payroll tax offset to the second quarter. As a result, the earliest taxpayers are likely to see a benefit is July 2017, when they file their quarterly payroll tax returns for the second quarter (Form 941).
How quickly does a company need to move on this? When does it need to get started?
Because the opportunity to offset payroll taxes is based on 2016 expenses, companies should act quickly to determine their eligibility under the new rules and start planning so they know what types of information will need to be gathered at the end of the year. Again, this credit must be specified, elected, and filed on the original 2016 tax return before you can begin to offset payroll taxes in 2017. Under the current rules, taxpayers won’t be able to take advantage of this opportunity on an amended return.
What companies qualify?
The new payroll tax offset is available only to companies that have gross receipts for five years or less, so a company isn’t eligible if it generated gross receipts prior to 2012. Additionally, the company must have less than $5 million in gross receipts in 2016 and for each subsequent year that the credit is elected. The company must also have qualifying activities and research expenditures to be eligible. Each of these requirements is further clarified below.
Who qualifies as having gross receipts for five years of less?
The new payroll tax offset is only available to companies that have gross receipts for five years or less, so a company isn’t eligible if it generated gross receipts prior to 2012. However, a company that was in existence prior to 2012 but didn’t receive gross receipts could still qualify. Although the law is intended to benefit small businesses, larger businesses could potentially benefit under the rules as they’re currently written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives US Food and Drug Administration approval.
How is $5 million in gross receipts defined?
A company must have less than $5 million in annual gross receipts in 2016 to be eligible. For businesses that are just starting in 2016, their gross receipts must fall under the $5 million limit after being annualized for a full 12 months. The gross receipts of businesses that are related or share common ownership will need to be calculated on a combined basis for purposes of determining eligibility under this provision.
Gross receipts are generally characterized as those reported on Line 1c of the company’s federal income tax return; however, the IRS and Treasury Department have been instructed to create new regulations that should provide further guidance on the definition of gross receipts for purposes of the payroll tax offset as well as other provisions related to the rules and overall implementation of the credit.
Although the gross receipts limitation helps to define a company’s eligibility for the credit, it’s important to note that the R&D credit itself isn’t based on gross receipts. The actual credit is based on the company’s eligible R&D expenses (defined below).
What are qualifying activities?
Regardless of industry, if a company’s activities meet the following requirements, known as the four-part test, then they could potentially be eligible for this credit:
- Technical uncertainty. The activity is performed to eliminate technical uncertainty about the development or improvement of a product or process, which includes computer software, techniques, formulas, and inventions.
- Process of experimentation. The activities include some process of experimentation undertaken to eliminate or resolve a technical uncertainty. This process involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial and error, or other methods.
- Technological in nature. The process of experimentation relies on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- Qualified purpose. The purpose of the activity must be to create a new or improved product or process (computer software included) that results in increased performance, function, reliability, or quality.
Additional thresholds may apply if a company develops software for internal use. Also, activities must be performed in the United States and can’t be funded by another party.
What are eligible R&D costs?
Eligible R&D costs include these categories:
- Wages. W-2 taxable wages for employees offering direct support and first-level supervision of research.
- Supplies. Supplies used in research, including so-called extraordinary utilities but not capital items or general administrative supplies.
- Contract research. Certain subcontractor expenses (provided the subcontractor’s tasks would qualify if they were instead being performed by an employee). These can include labor, services, or research, but payment can’t be contingent on results. In addition, the taxpayer must retain substantial rights in the results, whether exclusive or shared.
- Rental or lease costs of computers. This could include payments made to cloud service providers (CSPs) for the cost of renting server space, as longs as payments are related to hosting software under development versus payments for hosting a stable software release.
What are some examples of the potential benefit?
Brand new businesses could potentially claim the credit for up to five years with a maximum of $1.25 million in total credits claimed on their quarterly payroll tax returns filed with the federal government.
The benefit will be between 6 percent and 14 percent of a company’s eligible R&D costs. For the majority of new businesses and start-up companies that incur at least $300,000 in eligible R&D costs, the federal credit to offset payroll tax will be equal to 10 percent of their total R&D expenses.
For example, a company with $500,000 of eligible expenses—let’s say engineering costs—could have a credit of $50,000, while a company with over $2.5 million in eligible expenses in 2016 could have a credit subject to the full $250,000 annual limitation. If the amount of the credit exceeds a company’s social security tax (OASDI tax) liability in any given quarter, the excess will be carried forward to the next calendar quarter.
Social Security Tax
Companies are required to pay Social Security tax of 6.2 percent on up to $118,500 of each employee’s salary in 2016. A company that employs 50 employees with an average salary of $75,000 per person would pay approximately $232,500 in Social Security payroll taxes in 2016. The credit can only be applied to the employer’s Social Security portion of payroll taxes. As such, a company would need to have more than $4 million in annual payroll subject to social security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.
Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis and also file a quarterly payroll tax return (Form 941). The credit will be applied against the Social Security tax on the quarterly return, not when it’s deposited monthly or semiweekly. It’s important to note, however, that the IRS is still formulating a plan for how the process will be formally implemented.
Are there risks to claiming the R&D credit yourself?
Once a company starts to use these credits, they see a much higher level of scrutiny from the IRS. In fact, R&D credits are often a high priority for the agency every year and it’s assembled project teams by industry with technical specialists that assist in reviewing R&D credit claims. Even at the small business level, it’s common for IRS technical specialists to be involved in R&D credit examinations.
In general, larger credits may receive more scrutiny from the IRS and, therefore, require a higher degree of review and documentation.
Although many companies in the technology industry are likely engaged in activities that would otherwise be eligible for R&D credits, the rules surrounding the credit are complex and ever-changing. New legislation, regulations, court cases, and IRS guidelines have drastically shifted the landscape of R&D tax law over the past few years and will continue to do so in the future.
Considering these complexities and potential financial penalties, companies should have their activities analyzed by a CPA, attorney, or enrolled agent familiar with the intricacies of tax law and accounting rules that govern the R&D credits as well as the IRS examination and appeals process. To deter companies from claiming credits without the proper level of review and documentation, the IRS has the ability to impose penalties in excess of 20 percent of the credit amounts claimed. For example, if a taxpayer claims a $250,000 R&D credit and the credit is then audited by the IRS, it’s possible that the agency could deny the entire credit and fine the company with accuracy-related penalties in excess of $50,000.
What should I know about documentation?
It’s important that companies have the right documentation in place. It’s also key to know there isn’t a one-size-fits-all approach to documentation. The level of documentation deemed to be adequate varies based on the size and scope of the credit amounts claimed.
Expect a greater time commitment to get set up in the first year a company claims an R&D credit. You’ll also need to put the appropriate measures in place to completely utilize the credit going forward. Depending on the company, it’s possible that any historic R&D spending incurred may need to be evaluated.
In many instances, taxpayers will need to provide a nexus between their R&D expenses and qualified research activities. This can be a challenge, even for companies that have some level of project tracking in place, because time- or expense-tracking systems aren’t generally intended to track eligible R&D expense to business components or activities that fall within the definition of R&D for tax purposes.
The subjectivity and interpretation of the R&D rules make it nearly impossible to develop the perfect software tool for tracking eligible expenses and documentation, particularly when considering updates in tax law, regulations, and IRS guidance each year. Nevertheless, it’s important to note that project accounting and time tracking systems aren’t a prerequisite to claim the R&D credit.
At a minimum, a taxpayer’s qualitative documentation should demonstrate how its underlying activities meet the four-part test. Examples of adequate documentation can vary by industry, but it’s possible for companies to leverage documentation they’re already generating in their day-to-day operations. Qualitative documentation may also require review and analysis of any contracts between the company and its customers, partners, or vendors.
Taxpayers who have some level of familiarity with the R&D credit should carefully evaluate their methodology and documentation standards with respect to R&D credits being used under the new rules.
Companies in the software and pharmaceutical industries are especially encouraged to review the IRS audit guidelines applicable to their industries, which are available to the public on the IRS Web site:
Remember that the payroll tax offset may be available to new businesses and start-up companies for up to five years. Any unused R&D credits that aren’t elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.
Can proper documentation assist with my company’s financial statement reporting (ASC 740-10/FIN 48)?
All public companies and entities adhering to US generally accepted accounting principles (GAAP) are required to analyze and disclose uncertain tax positions on their financial statements. Many corporations are also required to report those positions on their federal income tax return.
For public companies and companies with audited financial statements, the rules surrounding how R&D credits are recognized on their financial statements can be very complex and subjective. In fact, the credits often receive a high level of scrutiny from lenders, investors, and financial statement auditors, especially when a company hasn’t performed an R&D study that management could use to assist in their decision-making processes.
Many unprofitable companies claim R&D credits every year with little support and without fully considering the risk of an audit by the taxing authorities. With the help of specialists, companies can create a higher degree of certainty around their credits and assist management with their decision-making processes with respect to R&D credits in 2016 and beyond.
We’ve created an infographic titled R&D Payroll Tax at a Glance as a quick reference to help simplify the process.
We're Here to Help
Moss Adams has an experienced team of tax and industry professionals who can help leverage the R&D credits your company is entitled. Contact us for a preliminary consultation to estimate the potential benefit and level of work that will be necessary to substantiate the credits.
To learn more about the credit, whether your business qualifies, or our R&D tax services, e-mail our Credits & Incentives team. You can also become a part of the conversation and stay up to date on R&D-related news by joining our R&D Tax Credits Forum on LinkedIn.