The Protecting Americans from Tax Hikes (PATH) Act, which was signed into law on December 18, 2015, extends permanently or temporarily many business-related tax rules. In this blog, I focus on the tax credit for certain research activities.
According to the National Science Foundation, “small businesses produce many of the radical innovations that lead to groundbreaking new products and even new industries.” The SBA reports that small businesses produce 16 times more patents per employee than large firms.
If you engage in certain research and development activities, you can claim a research credit equal to 20% of the amount by which your qualified research expenses for a taxable year exceed a base amount for that year (i.e., the credit applies to incremental increases in qualified research). There is an alternative simplified credit of 14% that can be claimed instead of the regular research credit.
The research credit was introduced in the Economic Recovery Act of 1981; it originally expired in 1985. Since then the credit has expired nine times and been extended 16 times. Finally, as a result of the PATH Act, the credit has been made permanent.
Payroll tax credit
Until now, the credit has only been allowed as an offset to income taxes, and is subject to the general business credit limitation. This means you must have profits in order to utilize the credit. Many start-ups pour all their funding into R&D and don’t have any revenue to show at the moment, so they have been unable to use the research credit.
Under the new law, for taxable years beginning after December 31, 2015, a qualified small business may elect to claim a certain amount of its research credit as a credit against the employer’s Social Security tax liability, rather than against its income tax liability. A qualified small business is defined as a corporation (including an S corporation) or partnership with gross receipts of less than $5 million for the taxable year, and that did not have gross receipts for any taxable year before the five taxable year period ending with the taxable year. A sole proprietor can also be treated as a qualified small business.
The payroll tax credit portion is the least of:
- An amount specified by the taxpayer that does not exceed $250,000,
- The research credit determined for the taxable year, or
- In the case of a qualified small business other than a partnership or S corporation, the amount of the general business credit carryforward
The election to use the payroll credit is made on an annual basis; it is made on an original return filed by the due date (including any extension). Once made, the election is irrevocable; it can be revoked only with IRS consent. In the case of a partnership or S corporation, an election to apply the payroll credit is made at the entity level and not by the individual owners.
Don’t assume you cannot qualify for the research credit because you aren’t a drug company trying to find the cure for cancer or a tech company coming up with the next break-though. You don’t have to be working on something you plan to market in order to take the credit. In fact, research costs for developing software for internal use can qualify. Proposed regulations cover this topic.
Now that the research credit is permanent, you can budget for your R&D expenditures, and reap a tax break. The rules on the research credit are complex. If you are confused, work with your tax advisor to nail down a research credit if applicable.