Those of you who follow our posts know that we don’t have a high opinion of U.S. Tax Law, or of the Senators and Congressmen who have enacted such a convoluted mess. But when they do something positive, we’re happy to take note and give them credit. The Protecting Americans from Tax Hikes (“PATH”) Act, enacted in December 2015, is one such positive piece of legislation. As the name suggests, it’s positive in the sense that it counteracts the overly onerous tax burden already imposed. Moreover, the PATH Act specifically targets startups with a very substantial tangible tax benefit and a real near-term cost reduction. So it’s right in our sweet spot.
The PATH Act makes two substantial improvements to the U.S. corporate tax regime. First, it makes the R&D tax credit permanent (well as “permanent” as anything in the Code – remember this under the realm of politics). Second, it allows early-stage startups to use R&D tax credits to offset employer payroll social security taxes. This is a huge benefit for early stage startups!
R&D Tax Credit
What types of business activities qualify for the R&D tax credit?
To qualify for the R&D tax credit, business activities must meet a four-pronged test, as described below.
- Technology – The R&D tax credit is available only for business activities involving the hard sciences and applied sciences, for example, physics, chemistry, biology, engineering, and yes, computer science.
- New Technology / Innovation – The R&D tax credit is available only to business activities involved in the development of a completely new technological product or process, or a substantial improvement to an existing one – so much so that the improved product or process is substantially new. For an improvement to an existing product or technology to qualify, the improvement must provide enhanced performance, increased functionality, greater reliability or better quality. (Maintenance of and bug fixes to an existing product or technology do not qualify for the R&D tax credit.)
- Technological Uncertainty / Risk – There must be some real uncertainty about whether the new technology will work as hoped, and business activities must be focused on resolving such uncertainty and eliminating risk.
- Testing / Experimentation – To address the technological risk, business activities must include some process of testing or experimentation, which should include evaluation of alternative possible approaches or solutions through such activities as modeling, simulation, trial and error or other such methods.
What types of costs are eligible for the R&D tax credit?
The costs outlined below are potentially eligible for the R&D tax credit.
- Salaries & Wages – A portion of the salaries and wages of regular employees directly involved in qualified R&D activities, as well as their direct supervisors, are eligible for the R&D tax credit.
- Independent Contractors / External Services – The costs of independent contractors and eternal service providers can be included in the R&D tax credit, if their activities and services qualify. To qualify, the taxpayer to receive the R&D tax credit must retain the risks and rewards of ownership of the research activities. For example, payment for services cannot be contingent on successful results, and the beneficiary of the R&D tax credit must retain ownership rights to the technology developed. (Ownership rights can be shared.)
- Supplies – The costs of supplies used in qualified research activities can be included in the R&D tax credit. Such supplies can be physical supplies or software tools. (Capital equipment purchases are not eligible for the R&D tax credit.)
- Web Hosting / Server Hosting – Hosting costs are eligible to be included in the R&D tax credit, as long as the software application being hosted is under development. (A viable, stable software application release is not eligible for the R&D tax credit.)
- Not Funded by Some External Source - To be eligible to be included in the R&D tax credit, the costs cannot be paid for by a federal research grant or similar source.
- In the United States - To be eligible to be included in the R&D tax credit, the costs must be incurred with the United States.
How much money are we talking about?
Real dollars saved will range from 6% to 14% of a company’s qualified R&D costs. Most startups who qualify will realize cost savings of 10% their qualified R&D costs.
If the analysis above reminds you of your business, keep reading!
Payroll Tax Offset
Many companies that qualify for the R&D tax credit have little or no current taxable income and so little or no opportunity to use their R&D tax credits to offset taxable income. Therefore, under U.S. tax law, R&D tax credits can be carried forward 20 years, to offset future taxable income. A 20-year tax credit carryforward, however, is not very exciting to an early-stage startup that is trying to figure out when it will break even and turn cash flow positive and how many months of runway it has left. But the R&D tax credit just got a lot more exciting for startups!
For the first time ever, small, early-stage startups can use R&D tax credits to offset payroll taxes! This, needless to say, is a huge benefit. (It’s YUGE! It’s YUGER than YUGE!)
New startups can potentially utilize the payroll tax offset for up to five years, for a maximum payroll tax credit of $1,250,000 ($250,000 per year)! The payroll tax offset can be applied only to the employer portion of Social Security taxes. The employer social security portion is 6.2% of employees’ salaries, capped at $118,500 of salary per employee. Accordingly, most startups that qualify for the payroll tax offset will not be able to realize the maximum payroll tax offset potential. But still, the savings for qualifying startups will be significant. And remember, whatever credit is not able to be applied to offset payroll tax can be carried forward to offset taxes on future taxable income.
In order to use R&D tax credits to offset payroll taxes, a company must have less than $5,000,000 in annual sales, and it must have had sales for fewer than five years. Companies that began earning revenues in 2012 or earlier are not eligible to offset payroll taxes with the R&D tax credit.
Surprisingly, this is a bit of really good tax legislation, offsetting to a small extent, a ton of bad tax law.
What are the risks? Will the IRS target my company if we take this credit?
As you might expect the IRS hates to see anyone getting a break on its taxes and will do whatever it can to make it as hard as possible for qualified companies to receive the benefit of R&D tax credits. Companies that utilize the tax credits can expect a higher level of scrutiny, including audits, by the IRS. If a company’s R&D tax credit is denied, the IRS can impose a penalty of up to 20% of the credit applied for. (Does it ever seem to you that those people at the “Service” are just looking for ways to punish and penalize people? It looks that way to us too!)
The threat of harassment by the IRS is real, and it should be taken seriously. Companies should exercise due care and good judgment in determining which costs qualify for the R&D tax credit and in documenting the evidence and rationale for taking such credit. Carelessness, laxness and recklessness should be avoided. High standards of documentation and evidentiary matter are required, and the basis for taking such credits should be strong.
We can help. We don’t mind taking on the IRS. In fact, we rather relish it. We enjoy using their rules to maximize the benefits to our clients.
Amending Past Years’ Tax Returns
What if I think my company qualified for these R&D tax credits in past years, but I didn’t claim them.
The payroll tax offset is available, starting in 2017, for R&D tax credits in the current year, as well as R&D tax credit carryforwards from prior years. In light of the new payroll tax offset potential, for some companies, it will make sense to file amended tax returns to take advantage of R&D tax credits that were not claimed in past years. If you think this may be the case for your company, let’s talk. We can help you determine if that would be a wise course of action for your company.