Over the past year, there has been uncertainty, fear, and doubt when it came to how the Research and Development Tax Credit, or R&D Tax Credit, would emerge from tax reform. At times, special interest groups claimed that the credit may become irrelevant or even disappear altogether. Meanwhile, those involved in drafting the legislation provided reassurance that the credit would remain, keeping the provisions that were recently added by Congress in 2015 to benefit startups and small businesses.
The R&D Tax Credit is a constant line item in the budget sheets of large corporations whose profits reach several billions of dollars, but the truth of the matter is that this credit can be an even greater tool for small businesses and startups. The impact of this credit could provide small businesses with the resources to acquire more personnel, invest in innovation, and propel their businesses to greater success. The R&D Tax Credit has especially been key to the growth of companies in industries such as robotics, biomed, and pharma, where the highly technical nature of those industries allows for a significantly larger credit size. However, the R&D Tax Credit has also been utilized to benefit businesses that you may not normally associate with traditional research and development concepts—including app developers and even craft breweries. Additionally, the credit can serve as a great resource to Venture Capital firms when an evaluation is being made on the costs associated with funding a start-up.
The R&D Tax Credit has been a stimulus to the US economy since its inception in 1981. The law was drafted by the Reagan administration at a time when Japanese and European companies were generating massive profits from high technology. To encourage American companies to invest in domestically created high technologies, the R&D Tax Credit was implemented, which rewarded testing the bounds of science and creating revolutionary solutions, as well as new or improved products or processes. In 2003, to offset the loss of jobs to foreign labor markets, the applicability of the R&D Tax Credit was further expanded when the requirement that a qualified activity had to be “revolutionary” was removed. This requirement was replaced with the more feasible requirement that the qualified activity simply involve overcoming a “technical uncertainty”—one that was satisfied by the demonstration that the activity was new to the company, rather than new to the world. The “Four-Part Test” was created to summarize the above rules.
For an activity to be considered a Qualified Research Expense (QRE) the following test must be met:
1. Permitted purpose: The purpose of the research must be to create a new or improved product or process, resulting in increased function, performance, reliability, or quality.
2. Uncertainty: The taxpayer must encounter uncertainty regarding the most appropriate design of the new product or process, the appropriate methodology for achieving that design, or whether they are capable of developing it at all.
3. Process of Experimentation: The research must involve elements of experimentation, evaluating alternatives for achieving the desired result.
4. Technological in Nature: The research must rely on principles of the physical or biological sciences, engineering, or computer science.
Over the past few years, undoubtedly influenced by the technological boom and the influx of start-up companies into the US, Congress realized that the start-up and small business community had tremendous amounts of QREs, but could not benefit from the tax credit with the way the tax code was written. To allow the R&D Tax Credit, a major tool of innovation, to be used by the businesses that innovate the most, Congress revamped the R&D Tax Credit in 2015 with the passage of the Protecting Americans from Tax Hikes (PATH) Act.
The PATH Act removed the major pre-2016 hurdles that restricted small businesses and start-ups from claiming the R&D Tax Credit. First, Congress increased the credit’s accessibility by allowing businesses with less than fifty million dollars ($50,000,000) in average gross receipts for the three years preceding the filing year to use the R&D credit regardless of whether the company was subject to AMT restrictions. This exception began with tax year 2016 and it applies to privately held corporations as well as the owners of pass-through entities such as S-Corporations and partnerships. Second, since most start-ups do not make profit in their first few years of operation, and the credit is non-refundable, Congress created what has become known as the “Start-Up Exception,” which allows start-ups to use the R&D credits to offset their payroll tax. The purpose of the Start-Up Exception was to allow start-ups to enjoy the benefits of the R&D Tax Credit when it was needed most, rather than having the R&D Tax Credit sit on tax returns as a carry-forward for future income tax liabilities.
To qualify for the Start-up Exception, a company must:
1) have less than five million dollars ($5,000,000) in revenue from gross receipts, and
2) not have had revenue that precedes the 5 taxable-year period that includes the tax year in question.
To simplify, if you are looking at this exception for tax year 2017, you cannot have revenue from 2012 or earlier, and your gross receipts from 2017 cannot exceed five million dollars.
It should be noted that the benefits from the Start-up Exception can only be realized when requested via special forms in a timely filed tax return, so an amended tax return will only create the traditional benefits of offsetting income tax liability.
In conclusion, start-ups and small businesses have a resource available in the R&D Tax Credit that will propel their growth by allowing them to keep more of their earnings and allocate further resources to innovation and creating jobs. The next appropriate step is to speak with your tax professional, or a specialist who will work with your tax professional, to find out what needs to be done so you can be rewarded for helping to keep innovation in the US. The biggest obstacle preventing start-ups and small businesses from claiming the R&D Tax Credit is their own self-censorship (assuming they don’t qualify) or hesitance to learn more. With the tax season already approaching, sooner is better than later to see how your company might qualify for this lucrative tax break and claim a sizable credit by next year.
If you would like to learn more about the R&D Tax Credit, or how the credit benefits your specific industry, please explore our previously written articles.
About Apex Advisors
Focusing on the R&D Tax Credit, Apex Advisors' specialization and highly skilled workforce equals maximum value for clients. Apex Advisors' unique approach combines credit maximization and conservatism and has proven to be more efficient and effective than any other service provider. Apex Advisors' team consists of attorneys and CPAs from Big 4 accounting firms; in-house engineers with industrial experience; PhDs; and former IRS agents. Rather than one expert being assigned to an entire R&D Tax Credit study, each study has a number of experts assigned with the specific tasks that most benefit from the expert's knowledge.
As a result of a high level of expertise, and a unique study methodology, Apex Advisors' has never had a credit denied under audit. With one of the strongest track records in the industry for defending R&D tax credit claims with the IRS, due to meticulous documentation and a tax controversy team comprised of former IRS agents and attorneys, Apex Advisors stands by its clients and provides full audit representation for no additional cost.
About David Porada Esq.
At Apex Advisors, David Porada advises businesses throughout the nation and across a diverse set of industries on Federal and State tax incentives, including the R&D Tax Credit, to help them save significant tax dollars and remain competitive in the global marketplace. In addition to being a Lean Six Sigma Black Belt, Mr. Porada has a Bachelor of Arts in Political Science from Kalamazoo College, a Juris Doctor from the University of Detroit Mercy, is licensed to practice law from the State Bar of Michigan, and serves on two Board of Directors. Lastly, and probably most importantly, throughout the year Mr. Porada dedicates a few hours a week to coaching youth baseball, basketball, and track and field.
Ashley Sloat, Ph.D.
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