R&D Tax Credits: New Opportunities for Small Businesses

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The federal research and experimentation tax credit, popularly known as the “R&D credit,” has been available since the 1980s to taxpayers who develop new products or manufacturing processes or improve upon existing products or manufacturing processes. But while the credit can be quite beneficial, historically it has been underutilized by small businesses — even those that devote a significant portion of their budgets to R&D. This may be changing, however, as legislation passed late last year inspires many small businesses to revisit the credit.

The Protecting Americans from Tax Hikes (PATH) Act of 2015 made the R&D credit permanent, and also made it easier for small businesses to benefit from the credit.

Eliminating the obstacles

Prior to the PATH Act, there were two obstacles that may have deterred small businesses from claiming R&D credits. One was the alternative minimum tax (AMT), which may apply to many small businesses as well as to shareholders of pass-through entities. The R&D credit could not be used to offset an AMT liability, which substantially reduced or even eliminated its benefits. Instead, taxpayers were forced to carry unused R&D credits forward in the hope they could use them in later years when they were no longer subject to AMT. (Unused R&D credits may be carried forward up to 20 years.)

The second obstacle, which plagued many start-up businesses, was the lack of federal income tax liability against which to apply the credit. It’s not unusual for start-ups to invest heavily in R&D in their early years with an eye toward substantial returns in later years. But many start-ups are reluctant to invest in tracking and documenting their research expenditures if it won’t produce immediate cash-flow benefits.

The PATH Act removed both of these obstacles for qualifying small businesses.

Offsetting AMT liability

The PATH Act allows “eligible small businesses” to offset R&D credits against their AMT liability, as well as their regular tax liability. An eligible small business is a sole proprietorship, partnership (including an LLC taxed as a partnership) or non-publicly traded corporation whose average annual gross receipts for the preceding three years are $50 million or less. For partnerships and S corporations, both the entity and its partners or shareholders must meet the gross receipts test.

To determine whether they’re eligible, corporations and partnerships must measure their gross receipts on a controlled-group basis. Sole proprietorships must consider their aggregate gross receipts from all businesses.

This provision applies to R&D credits generated in 2016 or later years. Unused credits carried forward into 2016 from previous years are not eligible to offset AMT.

New benefits for start-ups

To assist start-ups that are not yet generating taxable income, beginning in 2016 the PATH Act permits “qualified small businesses” to utilize its R&D credits to offset up to $250,000 in payroll taxes for up to five years. For purposes of this provision, a qualified small business is one with:

  • Gross receipts of $5 million or less in the tax year for which the credit is claimed
  • No gross receipts prior to the five-year period that ends with the year for which the credit is claimed.

Like the AMT credit, the payroll tax credit applies to R&D credits generated in 2016 or later. And similar rules apply in calculating a taxpayer’s gross receipts.

Are you eligible?

If your business hasn’t taken advantage of R&D credits in the past, now may be the time to gain an understanding of how the credit may improve your cash flow by offsetting certain tax liabilities. And remember, the credit isn’t just for companies that conduct laboratory research.

You may be eligible if:

  • You invest in developing new products, manufacturing processes or prototypes.
  • Your business relies on engineers or other technical personnel (as employees or on a contract basis).
  • Your business implements sophisticated software systems.

Our tax professionals can help you determine whether you qualify and implement policies and procedures to make the most of R&D credits.

Published in Manufacturing

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