Technology, particularly Big Tech, has fared well as an industry since the onset of the COVID-19 pandemic. However, certain sectors have been negatively impacted—especially start-ups and those supporting the travel and hospitality, transportation, retail, and commercial real estate industries.
Although the pandemic has impacted industries and sectors differently, all businesses could benefit from additional cash flow in the form of tax savings.
Following is a list of recent developments and tax tools that could be used to generate a one-time or recurring cash flow for your technology operation:
More details are provided for each of these strategies in the individual sections below. You can also explore additional options in this interactive resource map of tax strategies to help increase cash flow.
NOL Carrybacks and Carryforwards
The Coronavirus Aid, Relief, and Economic Security (CARES) Act restored net operating loss (NOL) carrybacks for losses arising in tax years 2018, 2019, and 2020 and extended the carryback period to five years.
If a taxpayer has an opportunity to carry back a 2018, 2019, or 2020 loss, it could be beneficial to increase the loss to the extent there’s income taxes to recover during the five-year carryback period of 2013–2017. Corporate tax rates decreased from a rate of 35% to 21%, so, if a taxpayer has a loss in 2020 that can be carried back to a pre-2018 income year, it’s beneficial to increase that loss by accelerating deductions and deferring revenue.
Taxpayers’ ability to time their deduction or income inclusion from one year to the next is generally governed by income tax accounting methods. Depending on a particular expense or revenue item, taxpayers can change the method of accounting on certain items—thereby increasing or decreasing taxable income or loss between tax years. The rate arbitrage, as a result of changes in rates, offers a unique opportunity for taxpayers to shift the deduction timing to generate permanent savings.
Accounting Method Changes
The following are a few examples of opportunities in which a technology or technology-enabled company can change its method of accounting to accelerate deductions or defer revenue through accounting method change:
- Accrual to cash reporting if the taxpayer has $25 million or less of revenue over a three-year period
- Defer revenue recognition for up to one year on advance payments for software and subscription payments
- Accelerate current-year and prior deductions for software development costs or R&D that may have been previously capitalized
- Accelerate the deduction of certain prepayments, including services, advertising, insurance, and property taxes
Accounting method changes also offer the opportunity for taxpayers using an impermissible method of accounting to correct the method and defer cost of the correction over four years while protecting against prior-year audit adjustments subject to interest and penalties.
The choice to make these elections should be part of an overall cash flow strategy that considers the enhanced carryback.
Recharacterizing Qualifying Donations
Although not a change in accounting method, a technology company may want to consider recharacterizing qualifying donations as advertising expenses. Corporate charitable contributions are only deductible for companies with taxable income, hence companies with current-year losses must carry forward charitable contributions and are unable to increase the loss contribution unless it’s able to establish it was an advertising expense.
A company must establish that the donation was publicized in a manner sufficient to enhance the brand. Technology companies of all sizes participate in well broadcasted charitable initiatives—for instance, employee or customer monetary matching programs—that might qualify as an advertising expense. This approach could increase the loss carryback refund, assuming the company paid sufficient taxes during the prior five years.
It’s important to understand how to leverage NOLs rules to create cash flow and utilize them early if possible—the opportunity sunsets for tax years beginning after 2020.
Employee Retention Tax Credit for Employers
The CARES Act established a refundable payroll tax credit for retaining employees and continuing to pay compensation to them. This credit, also known as the employee retention tax credit (ERTC) was extended through June 30, 2021. Learn more about how employers may qualify and the eligible credit during qualified quarters between March 13, 2020, and June 30, 2021.
While the employee retention credit was originally based only on qualified wages paid from March 13 to December 31, 2020, the 2021 Consolidated Appropriations Act (CAA), which was passed on December 27, 2020, introduced a variety of changes to how the employee retention credit works.
Favorable Revisions to the ERTC
- Credit extended and increased. The CAA established that the credit is also available based on qualified wages paid from January 1 to June 30, 2021, and increased that period’s maximum credit to $14,000—or $7,000 on 70% of a maximum qualified wages of $10,000 per quarter.
- Qualifying receipts threshold reduced. For the two quarters in 2021, the CAA reduced the ERTC reduction criteria—as compared to the 2019 base-year quarters—of the qualifying gross receipt to 80%, versus the 50% reduction requirement for 2020. Special rules for newer businesses and elections apply for the first quarter of 2021.
- Increased allowable employees to meet the small business definition. The number of employees needed to qualify as a small business increased from 100 to 500. The small business exception allows wages for employees continuing to work to qualify for the credit, as compared to wages paid by nonqualifying employers whose employees may not provide services to qualify for the credit.
- The aggregation rules continue to apply. For purposes of the above employee test, the aggregation rules require combining all employees of companies with certain levels of common ownership—often disqualifying each of them from the small business status. The rules are complicated, and each situation warrants an analysis. In general, however, the aggregation rules often apply when institutional funds own at least 50% of a portfolio company, or five or few shareholders own at least 80% of more than one company. Therefore, companies whose institutional investors are limited to minority stakes with dispersed ownership are often the ideal candidates to avoid the aggregation rules.
- Retroactively removed absolute preclusion of ERTC for taxpayers receiving PPP loans. The CAA revisions allow employers to retroactively claim the ERTC back to its inception in March 2020 as well as qualify for the credits in 2021. However, wages covered by the PPP that are forgiven aren’t eligible for the ERTC.
These revisions offer many employers that may not have previously qualified under the initial CARES Act to now qualify for the ERTC. However, the revisions often require strategy to increase cash savings. For instance, because wages used to forgive the PPP loan amounts are not wages eligible for the ERTC, taxpayers should consider the interplay between payroll and nonpayroll expenses eligible to qualify the PPP loans for partial or full forgiveness and the wages eligible for the ERTC.
As an administrative matter, the recent CAA revisions allows for amending payroll returns as necessary to retroactively claim the credit and claim refunds as well as file for an advance payment where the credit exceeds the payroll liability.
California Competes Tax Credit
The California Competes Tax Credit (CCTC) is an income tax credit available to businesses that want to locate in California or stay and grow in California. The CCTC is a discretionary credit awarded by the statutorily created California Competes Tax Credit Committee, which consists of various government representatives and appointees.
Incentive to Stay in California
Given the number of technology companies that have moved out of California, including industry leaders such as Oracle and Hewlett Packard, it’s no surprise that the committee recently awarded the credit to businesses that are not only committed to increasing well-paying jobs—which historically was the primary criteria—but also contemplated leaving California.
Companies contemplating leaving California should document these efforts and consider including the information in their application, should they apply for the CCTC.
The number of well-paying jobs employers are projecting for California is still a primary factor for consideration and highly correlates with the size of the reward successful applicants will ultimately receive. However, based on recent trends, it may no longer be enough as the verifiable threat of a business exiting California has been the recent differentiator for successful applicants.
The next application window is from March 8, 2021, to March 29, 2021, wherein $71.1 million—plus any remaining unallocated amounts from the previous application periods—are expected to be awarded.
R&D Tax Credit
The technology industry is well positioned to utilize the R&D credit, more so than many other industries. One impediment to monetizing the credit could be that technology companies run tax losses for years as they spend to gain market share and develop new product.
The R&D credit has a 20-year carryforward, so companies that choose to defer a full R&D study until they are profitable should have a plan to retain the information necessary to claim the credit in the future. This record retention can also have value in the context of a transaction because a potential buyer may be able to monetize the credits but would need to validate the potential credit during diligence.
Special R&D Rules for Start-Ups
Special rules apply to start-up businesses that justify an R&D study even if the business is running in a tax loss. Specifically, businesses that meet the following criteria may be eligible to apply the R&D tax credit against the employer payroll tax:
- Eligible expenses are used for qualifying R&D activity
- Revenue was generated for five years or fewer, including separate short-tax years
- Gross receipts are less than $5 million in the tax year of credit claim
Because every employer, regardless of taxable income status, must pay payroll tax, companies that qualify can more than justify the cost of a study with the current benefit of the payroll offset.
The maximum amount of the R&D credit that can be utilized to offset the payroll tax is $250,000 per tax year. Get a closer look at R&D credits for technology companies or software companies.
We’re Here to Help
If you’d like assistance pursuing any of these opportunities or have questions about cash flow, please contact your Moss Adams professional.