By Kenneth H. Bridges, CPA, PFS February 2017
In order to encourage companies to invest in R&D, and to reward them for doing so, Federal and Georgia tax rules provide what can be very significant tax credits (dollar for dollar reduction in tax liability) for R&D (or “research and experimentation” to use the actual terminology used in the law). The rules in this area are very complex, change frequently, and the credits can be subject to a number of limitations, but, in general, from a very high level, the net benefit of the Federal credit is usually about 6.5 cents for each dollar spent on qualifying R&D and the Georgia credit about 10 cents per dollar of qualified expenses.
For flow-through entities (e.g. S-corps and LLCs), the credit generally passes through to the shareholders. However, a special rule which has been in effect for Georgia for a number of years permits the entity to instead elect to apply the credit as an offset against Georgia tax withheld from employee pay (i.e. the company gets to keep the withheld tax instead of remitting such to GA DOR), and recent Federal legislation (effective for R&D incurred in 2016 and later) provides a similar rule at the Federal level for small early-stage companies.
For years prior to 2016, the benefit of the Federal R&D credit was often limited either by the alternative minimum tax (R&D credits could not offset AMT) or simply the lack of tax liability (e.g. an early stage company with no profits). However, beginning with 2016, R&D credit generated by companies with average annual revenue of $50 million or less (as computed over the three preceding years) is no longer limited by the AMT. Further, a “qualified small business” (those with gross receipts of less than $5,000,000 for the current year and no gross receipts in any year preceding the 5-taxable-year period ending with the current tax year) can elect to claim up to $250,000 of its research tax credit as a credit against employer FICA (the 6.2% OASDI portion). The credit is utilized in the first calendar quarter following the date on which the income tax return reporting the research credit is filed, and any excess carries forward. S-corps and partnerships can make this election at the entity level. This provision could be huge for early stage companies with no income tax to otherwise utilize the research credit against.
Federal and Georgia rules use the same definition of qualifying R&D expenses, except that Federal rules provide that the research must be conducted in the U.S., whereas Georgia further limits qualifying expenses to be only those which are incurred within the state. You must be eligible for the Federal credit in order to claim the Georgia credit.
While R&D tax credits can generally be claimed on original or amended returns (subject to the statute of limitations on making claim for refund), there are some potentially serious limitations and drawbacks with respect to claiming on amended returns (e.g. you cannot make the election to take reduced Federal credit in lieu of addback to deductions and you cannot elect to claim Georgia credit as an offset against withholding).
When it comes to computing the R&D tax credit, the grayest area tends to be in determining what activities qualify as “research and experimentation”. The term “research or experimental expenditures”, for purposes of the R&D tax credit, means expenditures which represent research and development costs in the experimental or laboratory sense. The term includes generally all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property of the type mentioned. The term does not include expenditures such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions. However, the term does include the costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application. On the other hand, the term does not include the costs of acquiring another’s patent, model, production or process, nor does it include expenditures paid or incurred for research in connection with literary, historical, or similar projects. In addition to meeting the requirements above, the activity must be one which is undertaken for the purpose of discovering information which is technological in nature and substantially all of the activities of which constitute elements of a process of experimentation for a purpose related to a new or improved function, performance or reliability or quality. Expenditures do not qualify for the credit to the extent the research is funded by another party (i.e. the taxpayer claiming the credit must be at-risk with respect to the expenditures incurred).
Many years ago, the IRS took the position that software development could not qualify for the R&D tax credit. However, Congress directed the IRS to treat software companies in the same manner as any other tech companies.
Once you determine what activities, if any, you have undertaken which qualify, the next step is to determine the eligible expenditures. The types of expenditures which qualify are taxable W-2 wages, 65% of amounts paid to independent contractors, certain computer leasing time, and supplies consumed in the process. Nontaxable fringe benefits, payroll taxes, rent, overhead, etc. do not qualify. If any employee spends 80% or more of their time on qualifying R&D, then you can count 100% of their taxable wages. For the Federal credit, the R&D must be conducted in the U.S. For the Georgia credit, the R&D must be conducted in Georgia.
While the credit is designed to encourage companies to conduct R&D and to reward them for doing so, there are a number of limitations and potential drawbacks associated with claiming the credit; especially in the case of a flow-through entity, and even more so with respect to claiming the credit on an amended return. Such limitations and drawbacks include:
- 10-year amortization for AMT if passive – A “passive” shareholder of a flow-through entity conducting R&D must, for purposes of the alternative minimum tax (AMT), capitalize their share of the company’s R&D expenses and amortize such over 10 years. This can create a situation whereby the shareholder would have been much better off tax-wise if the company had incurred no R&D expenses. “Passive” for these purposes is generally defined as spending less than 500 hours per year working in the business.
- IRC 41(g) limitation – An LLC member or shareholder in an S-corp can utilize the Federal R&D credit only to offset tax incurred on K-1 income from the LLC or S-corp.
- AMT limitation – For most years prior to 2016, Federal alternative minimum tax cannot be offset by the R&D tax credit. This has tended to greatly limit the benefit for many owners of flow-through entities. Recent legislation has changed this for R&D credits generated by small companies during 2016 and later years.
- IRC 280C[c] addback – The general rule is that you must reduce your deductions by the amount of the Federal R&D tax credit claimed. A special rule provides that you can instead elect to take a reduced credit of 65% of the amount of the credit you are otherwise eligible for. To the extent a taxpayer is not in the AMT and is in a 35% marginal Federal rate bracket, then their result will generally be the same whether they take full credit with add-back to deductions or take reduced credit. However, where a taxpayer is in the AMT, for years prior to 2016 they are much better off to elect the reduced credit. Accordingly, we generally elect the reduced credit. Unfortunately, the election to take reduced credit must be made on a timely-filed original return. The election cannot be made on an amended return. This can create a situation whereby claiming the credit on an amended return actually results in a balance due from the taxpayer.
- Georgia limitation – The amount of Georgia R&D credit utilized to offset income tax cannot exceed 50% of the taxpayer’s otherwise Georgia tax liability for the year.
Federal credit which cannot be utilized in the current year due to the above limitations can be carried back 2 years or forward 20 years (subject to the same limitations with respect to each carryback or carryforward year). Georgia credit which cannot be utilized in the current year due to the 50% of tax liability limitation can be carried forward for up to 10 years.
Georgia has a special rule whereby an LLC or S-corp can elect to retain some portion or all of its credit at the entity level and apply against Georgia taxes withheld from employee pay. However, this election must be made at least 30 days before you file the Georgia income tax return for that year.
As noted above, recently-enacted Federal legislation provides that for R&D incurred in 2016 or later by companies with average annual gross receipts of $50,000,000 or less the R&D credit will not be limited by the AMT, and that for R&D incurred in 2016 or later by early stage companies with average annual receipts of $5,000,000 or less the credit can be used as an offset against FICA withheld from employee pay.
The IRS recently added the R&D credit to its “Dirty Dozen” list of tax scams. In its news release, the IRS acknowledged that the credit is an important feature in the tax code to encourage R&D by the private sector, but indicated that it continues to see significant misuse of the credit, generally involving a failure to participate in or substantiate qualified research activities and/or a failure to satisfy the requirements related to qualified expenses. This is no reason to avoid claiming the credit if you are entitled to it, but it does mean that the IRS is likely to be more closely scrutinizing claims of the credit, and so you should be sure to have your documentation in order.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.