Just as individuals receive a dollar-for-dollar tax savings from tax credits, the same is true for businesses that qualify for tax credits. The Protecting Americans from Tax Hikes (PATH) Act of 2015, passed in 2016, expanded the ability of small companies to use the research and development (R&D) tax credit. The R&D credit is based not on the total amount a business spends on R&D, but on increases in R&D spending. Not only is a tax credit better than a tax deduction, but R&D costs not covered by the credit may not be immediately deductible.
The spending that counts for the R&D credit might be for in-house wages and supplies, as well as for outside contracts that are considered qualified research expenditures. Money spent on activities such as developing new or improved products, processes, or formulas; developing prototypes or models; developing new technology; and developing or applying for patents may qualify.
To obtain the R&D credit, diligent recordkeeping is required. Defining which outlays qualify as R&D can be a challenge, so companies should be able to support their claims. Moreover, certain small businesses may run into additional obstacles, such as the alternative minimum tax (AMT) and a lack of taxable income that prevents using tax credits currently.
Addressing the AMT
Generally, a company that owes the AMT cannot use the R&D tax credit to reduce its AMT obligation. However, in some cases, the PATH Act allows the R&D credit to offset the AMT. Eligible companies are sole proprietorships, partnerships, or non-public corporations with average annual gross receipts less than $50 million for the prior three tax years. In the case of pass-through entities, partners and S corporation shareholders may be able to use the R&D credit against their individual AMT liability.
Offsetting payroll taxes
The R&D tax credit is non-refundable, so it generally does not help companies with no income tax liability. Another PATH provision addresses this problem for young companies that do substantial R&D yet have no tax liability to reduce. Eligible firms can use the credit to reduce payroll tax, rather than income tax.
To qualify, a corporation or partnership must have less than $5 million of gross receipts in the year of claiming the credit and no gross receipts in any year before the fourth preceding year. Thus, this tax break is mainly for startups. A company that qualifies can use up to $250,000 of R&D tax credits to reduce its employer share of Social Security payroll tax outlays, so cash can be retained. If current payroll tax does not equal the amount of the R&D credit a company can claim, carryforwards may be possible.
The complexity of the R&D tax credit and the required recordkeeping may discourage small companies from claiming it. If your company is devoting resources to developing new products and technology, our office can determine if seeking this credit will be worthwhile and help you provide the necessary documentation.