The Research and Development Tax credit is useful for companies to reduce their Federal tax bills. The R&D tax credits were introduced in 1981 to provide tax incentives to companies incurring research expenses. It was primarily done to encourage companies to spend on development activities like new and improved products, techniques, processes, software, formula and inventions and set up factories in the US.
After the initial introduction of the R&D tax credits, it lapsed in 2 years which discouraged businesses from setting up ventures as there was uncertainty about the tax credits being reintroduced. Between the periods of 1981 to 2015, the R&D credit in Texas and rest of the United States was renewed around twenty times.
Another drawback of old R&D tax credit scheme was it was only available for bigger companies and their use was limited to companies that were categorized as S corporations, limited liability partnerships, limited liability companies, and pass through entities. Such companies did not owe federal tax and paid Alternate minimum tax.
The New and Improved R&D tax Credits
The PATH (Protecting Americans from Tax Hikes) Act of 2015 has removed the uncertainty and assured the businesses that the R&D tax credit is here to stay and will remain viable for future years. The new provision in the PATH Act allows the SMBs and startups to take advantage of tax credits immediately.
Takeaway for SMBs and Startups
As per the new legislation, the R&D tax credit enables business with less than $50 million in average gross receipts for three preceding years to use the tax credits to offset AMT (Alternative Minimum Tax).
The new R&D tax credit also allows very small businesses having less than $5million revenue to claim a credit up to $250,000 against payroll taxes. This new point is great for startups that are not yet profitable but are paying payroll taxes. it will help the startups to get back tax refund and infuse the money back in businesses to sustain and grow to become profitable.
Carry Forward Unused Credits
The unused tax credits can be carried forward up to 20 years and companies can show the unused tax credits on their financial statements. This aspect of carrying forward credits is great for startups that are looking for a potential buyer or intend to go public by launching an IPO.
Investors will be attracted towards startups which have unused R&D tax credits as it will show the innovative nature of the business and also show the company will be in a position to reap these tax credits and reduce taxes once it becomes profitable.
The Traditional Credit Calculation
Consider an XYZ company, an Eligible Small Business generated $100,000 in R&D tax credits in the financial year 2016. The Regular tax eligibility of the business will be $300,000 and the AMT liability will be around $250,000. Before the new legislation was introduced, the XYX company could only claim $50,000 in R&D tax credits which represented the difference between its Regular Tax liability ($300, 00) and AMT liability ($250,000).
Under the new regulation, the XYZ company can use the R&D tax credits to offset AMT liability and it can use the entire credit of $100,000 to offset its AMT liability.
The Startup Credit Calculation
The new regulation establishes a fixed-base percentage calculation for companies that are incorporated before 1983 or has fewer than 3 years of qualified research expenditures between January 1, 1984, and December 31, 1988. the fixed base percentage is calculated in the following manner.
- 3% of-of 1st five taxable years beginning after December 31, 1993, in which the company has qualified research expenses
- For the 6th year, 1/6th of the percentage of aggregate qualified research expenses of 4th and 5th year
- For the 7th year, 1/3rd of the percentage of aggregate qualified research expenses of 5th year and 6th year
- For the 8th year, 1/2 of the percentage of aggregate qualified research expenses of 5th, 6th and 7th year
If you have been missing out R&D tax credits for any reason. Now is the time to claim your share of the $10 billion tax credit offered by the Federal government each year. Provided your company has maintained proper documentation of the research activities, there is nothing stopping you from receiving the R&D tax credits.
Have you applied for R&D tax credits in this financial year? Leave your comments below.