Under current law, the research and development (R&D) credit under section 41 applies only to amounts paid or incurred on or before December 31, 2014. Section 121 of the Protecting Americans from Tax Hikes Act of 2015 reinstates the credit retroactively for amounts paid or incurred during calendar year 2015 and makes the credit permanent going forward. This permanent extension should provide businesses with greater certainty that the R&D credit will be available moving forward, which should improve the ability of the R&D credit to act as an incentive, especially with respect to research projects with a long time horizon. In the past, the R&D credit has expired numerous times, although it generally has been retroactively reinstated back to the date of its expiration.
The legislation also permits certain small businesses to use the R&D credits determined for taxable years beginning after December 31, 2015 against alternative minimum tax (AMT) and employer payroll taxes. The scope of small businesses that will be able to use R&D credits to offset payroll taxes generally is smaller than the scope of small businesses that will be able to use R&D credits to offset AMT.
Offset Against AMT
The legislation permits the R&D credit to be used against AMT for “eligible small businesses” under section 38. For these purposes an eligible small business generally means a corporation the stock of which is not publicly traded, a partnership, or a sole proprietorship for which the average annual gross receipts (reduced by returns and allowances) of such corporation, partnership, or sole proprietorship for the three-taxable-year period preceding the taxable year in which the credit is claimed does not exceed $50 million. Certain special rules apply in measuring the gross receipts of businesses that (i) are treated as a single employer with another person; (ii) were not in existence for the entire three-year period; (iii) have a short taxable year during the three-year period; or (iv) are the successor to another entity.
Partners of a partnership and shareholders of an S corporation will have to separately meet this annual gross receipts test in order to use the R&D credit against their AMT.
Offset Against Payroll Taxes
The legislation also permits the R&D credit to be used against a portion of the payroll taxes paid by “qualified small businesses.” This provision should allow some small businesses that do not have sufficient income to offset with the R&D credit to still make use of the credit. This provision is similar to provisions that have been included in a series of proposed bipartisan Startup Innovation Credit Acts since 2012.
Under the bill, qualified small businesses generally would be able to elect to use any portion of the R&D credit allowed, up to $250,000, to offset payroll taxes due in calendar quarters following the filing of the income tax return on which the election is made. For these purposes, a qualified small business generally means persons for which (i) the average annual gross receipts (reduced by returns and allowances) of such person for the three-taxable-year period preceding the taxable year in which the credit is allowed does not exceed $5 million and (ii) such person did not have any gross receipts for any taxable year preceding the five-taxable-year period ending with the year in which the credit is allowed. Special rules similar to those described above (with some modifications) apply in measuring annual gross receipts. For persons other than corporations and partnerships, gross receipts would be measured on an aggregate basis across all trades or businesses of such person.
An ordering rule applies to qualified small businesses other than partnerships and S corporations to prevent such businesses from using the election to circumvent the limitations on the use of general business credits.
The use of the R&D credit to offset payroll taxes will not reduce the allowable deductions for the underlying research expenses. In general, businesses must reduce any deduction for research expenses by the amount of any R&D credits they claim against income tax liability.
Rob Kovacev, a partner in Steptoe’s Washington office, commented: “The R&D tax credit has been almost useless to many startup companies with substantial R&D costs, because currently the credit may only be used to offset income taxes. Startups need an up-front benefit like this that they can use now, not when (and if) they eventually become profitable and start paying income tax.”
Simplification of R&D Credit Not Included in the Final Legislation
The draft extenders legislation released on December 8 by Rep. Kevin Brady (R-TX), chairman of the House Ways and Means Committee, included provisions that would have simplified the R&D credit. Under current law, businesses generally may elect to claim either the regular R&D credit (based on the calculation of a relatively complicated “base amount” of research expenditures) or an alternative simplified credit. Rep. Brady’s bill would have replaced this approach with a streamlined and simplified R&D credit.
This simplification, however, has been dropped from the final legislation. This is regrettable because the difficulty of computing and documenting the base amount under the regular credit creates unnecessary uncertainty and complexity for taxpayers. This is particularly true in the context of a permanent extension. Because the calculation of the base amount uses, in part, research expenses paid or incurred between 1984 and 1988, such amount will become increasingly outdated and difficult to document in the future.