With the passage of the Protecting Americans from Tax Hikes Act of 2015, hereinafter the PATH Act, many parts of the tax law were changed. Most notably, the PATH Act made section 179 expensing permanent, changed numerous depreciation provisions, and delayed the processing of refunds for many individuals who were claiming the earned income and child tax credits. However, that is not all the PATH Act changed. Despite not being heavily publicized, one change to the Research and Development (“R&D”) tax credit has the potential to benefit many new small businesses significantly.
To further illustrate, the R&D tax credit was established to benefit small businesses which incur research and development expenditures in their first few years of operations. R&D expenditures are defined very specifically in the Internal Revenue Code, but for simplicity purposes they include many costs related to the development or improvement of a product, including R&D staff payroll and fees paid to certain organizations. Taxpayers use these expenditures and other information including their business’ gross receipts and prior years’ expenditures to calculate their R&D credit. The only caveat is that in order to claim the credit, the taxpayer must reduce their R&D expenses claimed by the dollar amount of the credit. For example, if a taxpayer calculates a R&D credit of $20,000, they must reduce the amount of claimed R&D expenses by $20,000, and their taxable income will effectively increase by $20,000.
Prior to the PATH Act changes, the R&D credit was treated solely as a component of the nonrefundable general business credit. As such, if a taxpayer did not have sufficient tax due to use the credit in the current year, it would be carried forward up to 20 years. This is all well and good, but most new businesses do not see profits early on, and as a result, they may have to wait years to benefit from their accumulated tax credits. With the passage of the PATH Act, a new method of utilizing R&D tax credits was created. Eligible taxpayers can elect to use up to $250,000 of their R&D credits against the employer portion of their FICA taxes for tax years beginning after December 31, 2015.
To be eligible to take advantage of this new method, taxpayers must both meet the definition of a qualified small business and make the election on their original, timely filed (including extensions), tax return for the tax year. A qualified small business is defined as a business with under $5,000,000 of gross receipts for the current tax year who also had no gross receipts prior to the five-year period ending with the current tax year. For example, if determining eligibility for the 2016 tax year, the taxpayer must have under $5,000,000 in 2016 gross receipts, and they must not have had any gross receipts in any tax year prior to 2012. Once a taxpayer has determined that they are eligible and makes the election, they can begin claiming their R&D credits on their Form 941 payroll tax return for the following quarter. Any credit not utilized during one calendar quarter is eligible to be carried forward to the next.
It should also be noted that taxpayers who are utilizing a Professional Employer Organization (PEO) for their payroll needs are also eligible to use their R&D credits against their payroll taxes. However, it is highly recommended that the taxpayer contact their PEO prior to making the election on their tax return. Following the election, the PEO will be responsible for completing Form 8974 and submitting it along with their quarterly Form 941 and Schedule R, which details all of the PEO’s clients.
If a taxpayer has already filed their 2016 return and did not make the R&D payroll tax election, it is not too late. Due to delays in releasing the 2016 R&D payroll tax credit forms, the IRS issued Notice 2017-23. This allows taxpayers to claim the R&D payroll tax credit on an amended return filed prior to December 31, 2017. Taxpayers taking advantage of this provision will need to include the wording “Filed Pursuant to Notice 2017-23” on the top of Form 6765 and also include a statement with the return indicating the same.
In short, the PATH Act provides an excellent new method of utilizing R&D credits immediately instead of carrying them forward for years until the business is profitable. Prior to claiming the making the R&D payroll tax credit election, it is highly recommended that the taxpayer contact a tax professional. The R&D credit is part of a very nuanced area of the tax code, and a tax professional will not only be able to assist the taxpayer to navigate it and remain compliant, but they will be able to help them to get the maximum benefit possible under the law.
Jacob Lutz, CPA, MBA
Jacob joined Cerini & Associates in January of 2013 and has been actively providing tax, compliance, and business advisory services to a wide variety of both for-profit and non-profit clients.