By Jason Shultz, CPA, Assurance Partner, HoganTaylor LLP
Many businesses have taken advantage of the R&D tax credit. With the pandemic, there are opportunities and legislation that could impact your credit.
We’ve also found that far too many businesses have overlooked the opportunity to claim an R&D credit. The three most common reasons are:
- Believing their business wouldn’t qualify. It’s easy for business owners to conclude that the work they’re doing doesn’t qualify because they’re in it every day.
- Another common misunderstanding is that failures don’t count. If you take on a project that would otherwise qualify, and it fails, you still qualify. That risk is part of the requirements.
- The last reason relates to profitability. Because this is a tax credit, it’s generally only applicable when a business is profitable. However, startup businesses can offset the employer portion of Social Security tax by up to $250,000 each year.
Take this opportunity to re-assess your business and find out the ways COVID-19 is impacting the R&D credit.
First Things First – R&D Credit, the Basics
Internal Revenue Code Section 41 governs the credit, which is a dollar-for-dollar offset to income tax liabilities.
The credit amount is calculated as a percentage (generally 5-10%) of employee wages, consumables, payments to third-party contractors, or other expenditures related to developing or improving software, products, or processes.
CARES Act Impact on the R&D Credit
NOL’s – Section 2303 of the CARES Act created a special rule for tax net operating losses from 2018, 2019, and 2020. It states that losses from such years can be carried back up to five years preceding the year of loss.
So, what does this mean?
- Businesses can claim refunds and gain access to cash that wouldn’t otherwise be available.
- If you’ve previously claimed an R&D tax credit, and are going to use the NOL carryback, you need to understand the impact. The NOL carryback will result in a reduction of tax due in that year and potentially free up the R&D tax credit. Any credit released because of this can be carried back one year or carried forward 20 years.
- If you’ve never claimed an R&D tax credit, and are going to use the NOL carryback, you’ll likely benefit significantly. The R&D tax credit should enable you to utilize more of the NOL carryback and can be filed simultaneously with the NOL carryback.
PPP Program – Section 1102 of the CARES Act created the Paycheck Protection Program, allowing businesses to borrow up to 2.5 months of payroll. This loan is subject to forgiveness under Section 1106 of the CARES Act.
While the CARES Act was explicit that the monies forgiven would not constitute income, the IRS issued Notice 2020-32. In this Notice, the IRS determined that otherwise allowable expenses, paid with PPP forgiveness proceeds, will not be deductible.
So, how will Notice 2020-32 impact the R&D Credit?
Unless Notice 2020-32 is revised, you will likely not be permitted to claim a credit against expenses paid and forgiven under the PPP program.
This Notice may be revised, due in part to how penalizing it is from both the deductibility of expenses and the downline impact on the R&D credit. However, it is critical to understand the consequences of the current rule.
COVID-19 Activities that Might Qualify
There are some unique activities that businesses may have undertaken in response to COVID-19. Below are some examples. However, you should speak with one of your HoganTaylor advisors to identify opportunities not listed below.
- Development of drugs or related treatments – Starting with the most obvious, would be any activity in which your business is directly combating COVID-19. The development of drugs, therapeutics, and treatments is costly, risky, and based on hard science; as a result, these activities are generally eligible for R&D tax credits.
- Conversion of manufacturing capabilities for new products – Opportunity exists if your business modified its manufacturing capabilities during the pandemic.
Below are two examples:
- Manufacture of PPE – Personal protective equipment (PPE) has been in high demand. If your business has not previously produced PPE but started to during the pandemic, the related costs could be eligible for the R&D tax credit.
- Manufacture of household goods – Not only was PPE in high demand but so too was sanitary supplies and consumables. Experimentation and testing to meet specific product specifications create an R&D tax credit opportunity.
- New processes, assembly line modifications, and quality assurance improvements – Beyond creating items specifically directed at COVID-19, it is possible that a business had to make modifications to either comply with regulations and/or to pivot completely to meet new demand.
Simply ask yourself these questions:
- Have we created any new processes?
- Have we created any new products?
- Were there significant changes made to our assembly line?
- Did we implement additional quality assurance improvements, or set higher quality standards?
- Did we incur costs to operate differently than we were before?
Remember, these changes don’t have to be new to the world, just new to your business.
- Virtual collaboration – More businesses started to work from home requiring technological investments required to support secure remote working and virtual collaboration. Implementing a third-party tool will not be enough to benefit from the R&D credit. However, the costs of adapting a third-party solution, to your business environment, could qualify.
The following would likely have opportunities:
- Internally developed software
- Custom development to accompany a third-party solution
- Technology investments and system reconfiguration to support remote working capabilities and the related cybersecurity
- E-commerce functionality – Regardless of the level of e-commerce your business had previously, significant enhancements or functionality create an opportunity for the R&D tax credit. E-commerce functionality that is developed and integrated internally or by a third-party may qualify for the R&D credit.
- Offering services via a mobile option
- Expanding online solutions so customers no longer need to visit physically
- Providing pick-up and/or delivery options
- Improving system performance due to increased traffic
- Security enhancements
The IRS Four-Part Test to Qualify
Below are the four criteria that must be met for an activity to meet the definition of qualified research:
- Qualified Business Component – it must relate to a new or improved product, process, formula, computer software, program, technique, or invention.
- Technological in Nature – it must fundamentally rely on the principles of physical science, biological science, chemistry, computer science, or engineering.
- Eliminate the uncertainty – it must be intended to discover information to eliminate technical uncertainty concerning the capability or method for developing or improving a product or process or the appropriateness of the product or process design.
- Process of Experimentation – it must constitute a process of experimentation focused on evaluation and testing one or more alternatives.
Information for Startups
As mentioned above, the R&D credit is generally available to businesses that are generating income. However, for young companies that have qualifying activities but don’t yet generate significant income, there’s still an option.
The R&D tax credit can offset the employer’s share of payroll taxes. Here are the criteria:
- Less than $5 million in current-year gross receipts
- Have had gross receipts for no more than five years
Let’s see an example.
If a company has a FICA (Payroll Tax) liability of $50,000 in the current year, meets the criteria above, and has a research credit of $30,000. The credit is applied directly to the FICA liability bringing the liability down to just $20,000.
A bipartisan bill, Furthering Our Recovery With American Research & Development (Forward) Act has been introduced and would provide significant changes to the current credit. We’ve outlined some key elements below:
- Why has the bill been introduced?
- To boost federal investment in private American businesses that perform R&D activities, including those to help fight COVID-19 and to rebuild the economy.
- How will it expand the current definition of Qualified Research Expenditure?
- The definition would also include employee training expenses. So, training employees to perform, oversee, or support qualified activities will be eligible for the credit.
- How will more businesses be able to participate?
- The criteria described in the Information for startups (above) will be adjusted to include businesses with up to $20 million in gross receipts and no gross receipts further back than eight years. However, the 8-year window doesn’t begin until gross receipts exceed $25,000.
- Does the incentive increase?
- For R&D performed by domestic manufacturers or in collaboration with other entities, the credit rate is increased by 25%.
The world isn’t becoming any less complex. Think of all of the changes from COVID-19, new laws, evolving working environments, and the current economic uncertainty. Businesses must not overlook opportunities that may exist with the R&D tax credits.
The process is simple and can start with a quick conversation with your HoganTaylor advisor. We’ll help you assess the possibility of opportunity and if a feasibility analysis would be warranted. If so, a feasibility analysis is generally a low effort and free process to determine if a full tax study is beneficial.
Connect with your HoganTaylor advisor today. If we determine an R&D credit is available to your business, we want to ensure the benefit is fully understood in advance, the level of effort necessary to obtain the credit, and that the credit will withstand IRS scrutiny. More information is also available on the Advisory practice page of this website.