Upcoming Changes to the R&D Tax Credit

Date January 3, 2022
Categories
Article Authors
HBK CPAs & Consultants

Overview

The Research and Development (R&D) tax credit is a permanent federal tax credit available to manufacturers and other businesses that conduct research and development activities domestically in the United States. To qualify for the R&D credit, the taxpayer must have the following activities and expenditures associated with those activities:

  • The first activity includes those that are intended to remove or reduce technological uncertainty at the outset of a project that relates to the development or improvement of the business component or design.
  • The second activity relates to any physical, biological or computer science and/or engineering.
  • The final activity relates to new or improved business components that seek to improve products, processes, internal-use computer software or inventions to be sold or used by the taxpayer.

In order for any of the following expenditures to qualify for the credit, they must first meet the above-mentioned activities. The expenditures that can qualify include wages paid to employees, supplies used and consumed, contract research expenditures paid to a third party allowed at 65% of the actual cost incurred and basic research payments to qualified educational institutions or scientific research organizations at 75% of the actual cost incurred.

There are two ways to calculate the R&D credit: the Regular Method and the Alternative Simplified Method. The methods are similar, but the Regular Method determines the base amount by calculating qualified research expenses (QREs) to gross receipts from 1984 to 1988 or using a formula that is based on years that R&D activities began with a limit of 50% on current year QREs. While the Alternative Simplified Method takes an average of the past three years and is adjusted each year. The Regular Credit yields a credit of 20% while the Alternative Simplified Credit yields a 14% credit.

New Filing Requirements

The IRS has issued new filing requirements to reduce audits on the R&D credit by requiring taxpayers claiming the credit to report specific and detailed information. The grace period for this filing requirement continues until January 10, 2022, with new requirements going into effect on January 11, 2022. The new requirements will apply only for AMENDED returns; all timely filed tax returns are exempt from this new 2022 filing requirement.

The IRS will have a one-year transition period after the grace period where the taxpayer has 30 days to correct their R&D credit claim before the IRS makes its final determination. This was recently clarified by Holly Paz, Deputy Commissioner in the Large Business & International division of the IRS. The new requirements for these filings are as follows:

  • List of all business components that relate to the claim
  • For each identified component, describe the research activities performed, along with the names of the individuals who performed the qualified activities
  • For such qualified activity, include information on what each individual sought to discover
  • Qualifying costs must now include details on:
    • Employee wages claimed
    • Supply costs claimed
    • Contract research costs claimed
  • Include a declaration signed by the taxpayer under penalties of perjury

While this new requirement first appears to be an overwhelming amount of documentation to compile, it is most likely already included in any formal R&D study completed.

Future R&D Tax Credit Changes

Set to begin for tax years after December 31, 2021, The Tax Cuts and Jobs Act of 2017 eliminates the option to deduct R&D expenditures and will require taxpayers to capitalize such costs and amortize over five years (180 months) starting at the midpoint of the tax year in which the qualified expenditure is paid or incurred.

Summary

The changes in the R&D tax credit filing requirements are for Amended tax filings only and will begin January 11, 2022. Those taxpayers filing timely should continue to claim their R&D credit the same as in past years. As for the change in recognition of the R&D credit scheduled to start in January of 2022, taxpayers who plan to claim the credit in the future should pay attention to the changes, if any, set forth in the coming legislation. If you have any questions or would like to discuss further, please contact a member of HBK Manufacturing Solutions at 330-758-8613 or manufacturing@hbkcpa.com.

Speak to one of our professionals about your organizational needs

"*" indicates required fields



Background on the R&D Tax Credit

Date April 5, 2021
Categories
Article Authors

The Research & Development (R&D) tax credit is a federal tax credit available to businesses of all sizes that conduct Research & Development activities domestically in the United States. The definition of R&D is broad and applies to nearly every industry, not just your typical science labs. The R&D tax credit was first introduced in 1981 as a way of rewarding businesses that were investing in American innovation to boost the economy. When first introduced it was only intended to be a two-year credit, but due to its success, it has been extended every year since. Over the years there have been many changes to the R&D Credit, but most notably in 2015 as part of the PATH Act, it was overhauled and established as a permanently available tax credit. This has allowed more businesses to fully utilize the credit without fear that it will be unavailable in the future.

What Activities Qualify for the R&D Tax Credit?

The Internal Revenue Code (IRC) Section 41 and the related regulations help define what types of activities qualify for the R&D tax credit. Next, we are going to break it into two sections, what activities qualify as R&D and what expenses of the R&D activity qualify for the R&D tax credit.

To qualify as R&D according to IRC section 41, the taxpayer must show that the activities:

  • Are intended to discover information to remove technological uncertainty that exists at the outset of the project or initiative related to the capability or methodology for developing or improving the business component or the appropriate design of the business component.
  • Rely on hard science, such as physical science, biological science, computer science, or engineering.
  • Relate to the development of a new or improved business component, defined as new or improved products, processes, internal-use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business.
  • Substantially all R&D activities must contain elements of a process of experimentation.

Once we determine what activities qualify for R&D, next we need to determine what expenses are considered Qualified Research Expenses (QRE). As a reminder, only expenses incurred domestically in the U.S are eligible QREs.

  • Wages paid to employees for qualified services.
  • Supplies used and consumed in the R&D process.
  • Contract research expenses paid to a third party for performing Qualified Research Activities on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred.
  • Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.

How is the R&D Tax Credit Calculated?

There are two distinct ways to calculate the R&D tax credit. The first of which is the Regular Method and the second is the Alternative Simplified Method. Both methods are similar in that the credit is determined by comparing your current year QREs to the base amount. The difference in the methods come into the details of how the base amount is determined and the percentage of the credit. When using the Regular Credit, the base amount is determined by calculating the QREs as compared to gross receipts from 1984 to 1988 (the original years the credit was available) or by applying the start-up company rules that create a formula based on the years that R&D activities began with a limit based on 50% of the current year QREs. The Alternative Simplified Credit takes an average of the past three years and is adjusted each year. The Regular Credit yields a credit of 20% whereas the Alternative Simplified Credit yields a 14% credit.

In determining which method is the most beneficial there are several factors to consider as this decision is permanent. Some of these factors include the amount of R&D activity that will be completed in the initial years compared to the lifetime of the company, the availability of historic information needed to determine the base periods under the Regular Method, when the business or owners be able to utilize the credits, and the cost of having a formal study completed.

With both methods, there is also another election to consider, which is commonly referred to as the 280C Election. This election is required and permanently based on the first filing containing the R&D tax credit. Without this election, the business must remove the gross amount of the credit from their deductions when determining taxable income. With the 280C election, the credit is further reduced by the tax impact of the credit to simplify the reporting requirements.

As an added incentive for start-up companies to take advantage of the credit, the IRS has granted the ability to use the credit to offset payroll taxes. The credit is still nonrefundable in the event it exceeds payroll tax liability, but any excess can be carried forward. To qualify as a start-up, the company must be within the first five years of operations, have current year gross receipts of less than $5 million, and not be included in a controlled group that does not meet either of the first two requirements.

Summary

The R&D tax credit is a vital tool in generating cash flow while investing in a growing business that is overlooked by many businesses. The R&D credit often yields a cash return on investment of approximately 5-7% of the QREs. In addition to a federal tax credit, many states offer a modified version of the credit that can be easily calculated alongside the federal calculation.

If you have any questions or would like to discuss further, please contact your HBK Advisor.

Speak to one of our professionals about your organizational needs

"*" indicates required fields



The American Innovation and Jobs Act: Good News for R&D

Date December 2, 2020
Categories
Article Authors
HBK CPAs & Consultants

The Tax Cuts and Jobs Act of 2017 (TCJA) addresses both Section 174, research and development (R&D) expenses, and Section 41, R&D tax credits. The TCJA built on the Protecting Americans from Tax Hikes (PATH) Act of 2015, which made the R&D tax credit permanent and expanded credit opportunities for small businesses, by further accelerating the deduction of research expenses and expanding the availability of research credits.

However, several of the provisions within TCJA are set to expire by December 31, 2021, most notably, Sec. 174(a), which allows the deduction of all R&D costs incurred in the current year. For tax years after December 31, 2021, these costs must be capitalized and amortized over 60 months as of July 1 (for calendar year taxpayers) of the tax year in which the research and development costs are incurred. As such, the current tax strategy for business owners already taking advantage of the R&D expense deductions has been to accelerate all R&D costs where possible before the clock runs out on December 31, 2021. A bill to retain Sec. 174(a) allowances has been requested and lobbied for but is not expected to make its way through the currently divided House and Senate.

On another front, U.S. Senators Todd Young (R-Ind.) and Maggie Hassan (D-N.H.) have introduced a bipartisan bill named The American Innovation and Jobs Act (AIJA) that would not only make R&D expenses fully deductible but double the refundable tax credit. As a result, more small businesses and startups would qualify for the R&D credit. Endorsed by the National Associate of Manufacturers and the R&D Coalition, the new provisions would:

  • Amend Sec. 174 to permit the deduction of 100 percent of current year R&D expenses.
  • Increase the R&D credit cap for qualifying startup companies1 from $250,000 to $500,000.
  • Incrementally increase the R&D credit cap for qualifying startup companies to $750,000 over 10 years.
  • Increase the gross receipts threshold for qualifying startup companies from $5 million to $15 million.
  • Increase the period qualifying startups can claim the credit from five years to eight years (after generating at least $25,000 in gross receipts).

All modifications to the R&D tax credit under the AIJA apply to entities electing tax treatment under the qualifying startup company provisions of the PATH Act. Businesses not claiming a credit under the qualifying startup election would not directly benefit from these changes. However, the fact that AIJA is being supported by lawmakers on both sides of the aisle and that thousands of additional businesses will benefit from these changes demonstrate that R&D is considered by our policymakers as vital to our economic future.

1 – Qualifying startup companies as defined under the PATH Act of 2015 must meet two requirements in order to qualify and apply the R&D credit against payroll taxes as opposed to income taxes.

  1. Have under $5 million dollars in gross receipts
  2. Have $0 gross receipts for five years preceding the year the credit is claimed

Speak to one of our professionals about your organizational needs

"*" indicates required fields



Hemp Production Rising with Farm Bill, Possible R&D Credits

Date January 23, 2020
Categories
Article Authors
HBK CPAs & Consultants

Christopher T. Marrie, CPA, CCIFP and Principal in the Naples, Florida office of HBK CPAs & Associates is also the southern tier region leader of the firm’s Cannabis Industry Group. He performed a technical review of this article, which was written by Sally Frizzell Coleman, CPA, PA. Sally is a Senior Director in HBK’s Fort Myers, Florida office and has been with the firm since she merged with HBK in 2017. She is a member of the firm’s Cannabis Industry Group.

With the passage of the Agriculture Improvement Act of 2018 (U.S. Farm Bill), farmers can now legally grow industrial hemp throughout the United States.

Holly Bell, Director of Cannabis for the Florida Department of Agriculture and Consumer Services, spoke of the more than 25,000 uses for hemp. “The CBD craze is what the plant is used for and what will get this industry going,” she said. Adding that hemp will remain a valuable commodity and is not a fad.

Industrial hemp affects multiple industries which include agriculture, manufacturing, energy, medical, nutrition and technology. With the passing of the U.S. Farm Bill, researching can be performed to develop ways in which to use this versatile plant for both profits and the sustainability of our planet.

Research and development will be instrumental in exploring many of the ways in which to process and use the hemp plant. Entrepreneurs may be able to benefit from Federal Research and Experimentation (R&D) Tax Credit to help reduce their Federal income tax burden.1 Potentially eligible expenses include wages, the cost of testing, supplies, as well as contract research expenses.

Some examples of business activities that may qualify for R&D tax credits include but are not limited to:

  • Experimenting with fertilizers, plant spacing, lighting, watering techniques, etc. to increase yield or production
  • Improving efficiency in production techniques during growing and/or harvesting
  • Developing new strains of hemp
  • Developing automated systems for greenhouse production
  • Developing new edible products with CBD derived from hemp
  • Experimenting with topical creams and skin absorption formulations
  • Testing new CBD oil products and extraction techniques
  • Testing of new filtration systems for air and water
  • Developing new software analytical tools
  • Developing new irrigation/hydroponic systems
  • Testing new equipment to shorten the life of a growth cycle
  • Studying hemp uses for energy fuels, textiles and other materials

The four-part test required for claiming any Federal R&D tax credit is as follows:

  • Qualified Purpose: The purpose of the research must be to create a new or improved product, process, or formulation, resulting in increased performance, function, reliability or quality.
    • Technological in Nature – The research must rely on principles of the hard sciences, such as engineering, physics, chemistry, biology or computer science.
    • Elimination of Uncertainty – Activities must overcome some unknowns, such as uncertainty as to capability, optimal design, or optimal methodology.
  • Process of Experimentation – Experimentation can be demonstrated through test batches, simulations, systematic trial and error, or other methods of evaluating alternatives to achieve a desired result.

The possibilities of processes involving hemp eligible for the Federal R&D Tax Credit seem endless. Please contact Christopher Marrie, CPA, CCIFP and Director of the firm’s Cannabis Industry Group in the southern tier service region, at CMarrie@hbkcpa.com for more information.

——————–

1 Some states also offer similar credits.

Speak to one of our professionals about your organizational needs

"*" indicates required fields



Opportunities Regarding the R&D Tax Credit

Date March 14, 2017
Categories

The 2015 PATH Act made the R&D tax credit permanent and expanded benefits to many taxpayers. Historically, many qualifying taxpayers have failed to take advantage of the credit. This is, in part, due to misunderstanding whether their activities qualify for credit. In addition, many taxpayers are simply unaware that the credit exists. The R&D tax credit has been in the Internal Revenue Code since 1981. It has survived all major overhauls of the Code since its adoption.

Considering the expanded benefits (outlined in this article) and the potential of the credit to offset taxes while also maintaining a deduction for these costs, taxpayers should consider how it can be applied to their businesses.

Expanded benefits due to the PATH Act are twofold. Businesses and certain startups with less than $5 million in annual revenue can now use the credit against their payroll taxes, assuming they have had employees engaged in R&D for five years or less. Under the new law, the maximum benefit an eligible company is allowed to claim against payroll taxes each year is $250,000. The payroll tax offset is available to companies that meet the following qualifications:

  • Generated gross receipts for five years or less
  • Less than $5 million in gross receipts in 2016, and for each subsequent year for which the credit is elected
  • Conducted qualifying research activities

In addition, qualified small businesses with less than $50 million in gross receipts are now able to use the R&D tax credit to offset the Alternative Minimum Tax (AMT). Prior to 2016, the AMT often limited the benefits of the R&D tax credit.

Many businesses fail to take advantage of the R&D credit. If your business performs any of the activities listed below, you are likely performing qualifying R&D activities:

  • Improving product quality
  • Developing second generation or improved products
  • Developing products through use of computer-aided design tools
  • Designing and/or developing tooling and equipment fixtures
  • Optimizing manufacturing processes
  • Designing manufacturing equipment
  • Prototyping and modeling three-dimensional products
  • Designing, evaluating and/or developing cost-effect operational processes or alternatives
  • Performing alternative material testing
  • Integrating new materials for improved product performance and manufacturing processes
  • Evaluating and determining the most efficient flow of material
  • Designing, creating and testing product prototypes
  • Increasing manufacturing capabilities and production capacities
  • Achieving compliance with changing emission regulations

Considering the expanded benefits, the underutilization, and the permanent nature of the credit, now is the perfect time to consider this opportunity. Please contact David Downie with questions on the R&D Credit and its many potential applications.

This is an HBK Tax Advisory Group publication.
Speak to one of our professionals about your organizational needs

"*" indicates required fields