With all the changes associated with the Tax Cuts and Jobs Act of 2017, one pleasant constant for taxpayers is the IRC 41 Credit for Increasing Research Activities, popularly known as the R&D Tax Credit. While taxpayers can continue to rely upon the R&D Tax Credit for savings, new features of the Internal Revenue Code present some interesting considerations.
280C(c)(3) Election – More Value for Pass-Through Business Owners
When claiming an R&D Tax Credit, a taxpayer generally must add the amount of the Credit back into taxable income via an M-1 Adjustment. However, IRC 280C(c)(3) provides taxpayers with the ability to take a “reduced” R&D Tax Credit and forego the M-1 add-back. While the 280C(c)(3) election (“280C election”) reduced the R&D Credit by 35 percent (Corporate Tax Rate), it typically proved an attractive option for many taxpayers. Individual taxpayers (i.e., owners of pass-through businesses) with effective federal income tax rates more than 35 percent often realized a larger overall benefit via the 280C election. Further, the 280C election would also negate some adverse state income tax effects of claiming the R&D Credit, as well as providing simplification for return preparers.
With the reduction in the Corporate Rate from 35 percent to 21 percent, the 280C(c)(3) “haircut” also drops to 21 percent. As a result, pass through business owners will see an even greater benefit by making this election. Since TCJA reduced the Corporate Rate far more than the top rate on individual income (39.6 percent to 37 percent), we now have a greater spread between those two rates, hence a greater 280C benefit. Even factoring in a maximum 199A deduction (also known as “the pass-through deduction”), the taxpayer significantly benefits. Consider the following example – ABC Company, organized as an S-Corporation with a single shareholder, generates $1,000,000 of taxable income in 2018, and also qualifies for a $100,000 R&D Credit based on its qualified expenses. As the following tables show, ABC Company’s shareholder realizes a lower federal income tax liability with the 280C election.
|LESS: 199A Deduction||($200,000)|
|Tax Liability @ 37 percent (Individual Level)||$296,000|
|R&D Credit w/ the 280C Reduction||$79,000|
|Tax Liability after Credit||$217,000|
|LESS: 199A Deduction|
|Tax Liability @ 37 percent (Individual Level)||$296,000|
|R&D Credit w/o the 280C Reduction||$100,000|
|Taxable Income w/ M-1 Adjustment||$1,100,000|
|LESS: Revised 199A Deduction||($220,000)|
|Tax Liability @ 37 percent before Credit w/ M-1 Adjustment||$325,600|
|Tax Liability after Credit||$225,600|
Also of note – if a taxpayer’s 199A deduction is limited or excluded, the 280C election increases in value.
Fiscal year taxpayers must calculate the 280C election for the tax year including January 1, 2018, under a “blended rate” outlined in IRC 15(e). For instance, a taxpayer with a fiscal year end of 3/31/2018 would calculate the 280C blended rate as follows: (.35 x (275/365)) + (.21 x (90/365)) = 0.3155.
There are a few situations where skipping the 280C election may make sense. For one, early-stage companies generating net operating losses and claiming the Qualified Small Business R&D Tax Credit are likely to realize a greater near-term benefit by taking a “full” R&D Credit. For most of these companies, the additional payroll tax credits, which represent a near-term savings, is well worth the reduction in NOL carry-forward. Further, companies seeking to “freshen” expiring NOL carry-forwards may want the M-1 adjustment and subsequent increase in income. Taxpayers should also be aware that the 280C election is only available on an originally-filed income tax return. Finally, new IRS R&D Tax Credit guidelines may further address this issue, as well as updated Form 6765 instructions.
Thanks to the TCJA’s reduction in rates and new provisions, some taxpayers are evaluating entity options. Taxpayers looking to convert from an S-Corp to a C or vice-versa should consider that any R&D Credit carry-forwards would effectively remain “frozen” in the prior entity or at the individual shareholder/partner level (depending upon the nature of the entity conversion). In the case of a C-Corp that converts to an S-Corp, the C-Corp’s credit carry-forwards cannot transfer to the S-Corp shareholders, those credits could potentially be used to offset built-in gains tax liability generated from the sale of the business down the road.
As a result, taxpayers should consider options for utilizing these credits before making the switch. Diligent planning may help a taxpayer improve credit utilization prior to entity conversion.
New Opportunities to Utilize Credits
With the introduction of new provisions such as Global Intangible Low Tax Income (GILTI) tax, the one-time “deemed repatriation” tax, and future “tax free” repatriations of foreign income, coupled with lower effective tax rates on US income, some US taxpayers may experience a shift in overall tax liabilities more towards the US. As a result, R&D Tax Credits may become a more valuable tool for managing tax liabilities. Companies who have not considered R&D Tax Credits in the past might benefit from an evaluation or re-evaluation in light of changes to overall global tax strategy.
Long-Term Considerations (174 Amortization)
One of the items of “bad news” in the TCJA was a change to IRC 174 - Research & Experimental Expenditures. Currently, 174 provides taxpayers with the option of an immediate deduction for research expenses or a 5-year amortization. Under TCJA, for tax years beginning after December 31, 2021, 174 expenditures must be amortized over five years for domestic expenditures or 15 years for foreign expenditures, without regard to abandonment or disposition. TCJA also requires software development expenditures to be covered under 174.
Other Considerations – QSB, ESB
Two relatively new features of IRC 41 which phased in before TCJA were Qualified Small Business (QSB) and Eligible Small Business (ESB). QSB and ESB were established under the PATH Act of 2015, which also provided a permanent Research Credit extension (no more relying on an annual “Tax Extenders” bill). Under IRC 41(h), a QSB, defined as a company that, as of the current tax year, has less than five years of gross receipts and fewer than five years of gross receipts, may elect to apply up to $250,000 of R&D Credits against OASDI payroll taxes. The “QSB Credit” has proven quite valuable for early-stage technology companies, providing a mechanism for these companies to realize the cash value of the R&D Credits much quicker than simply carrying credits forward. Taxpayers should consider the following when evaluating QSB Credit opportunities:
Qualifications – pay careful attention to “5 years / $5MM” gross receipts tests.
Timing – QSB is an election that can only be made on an originally-filed return. While the IRS provided relief for taxpayers in the 2016 tax year under Notice 2017-31, as of the time of this publication, no similar relief has been provided for 2017 and beyond. An otherwise-qualified taxpayer filing a 2017 tax year return without making the QSB election may lose out on the credit.
Monetization – QSB Credits cannot be applied against OASDI taxes until one-quarter after the federal income tax return is filed; there are no carry-backs to prior quarters. Also, each payroll provider has different policies and procedures for applying QSB Credits, so taxpayers should speak with payroll providers to understand necessary requirements.
Long-Term Planning – the QSB election is only available for five tax years. Eligible companies should take a strategic look at which years may make sense for the election. For instance, if a company currently is only incurring minimal research expenses, but anticipates increasing R&D significantly over the next few years while only incurring minimal revenues, it may make sense to forego the QSB election until R&D spending ramps up. Further, if an eligible business anticipates a transaction in the near future, a “regular” non-QSB R&D Credit may be more-valuable depending upon the transaction.
Also, effective for 2016-forward is the ability for Eligible Small Businesses to apply R&D Tax Credits against alternative minimum tax (AMT) liabilities. Prior to 2016, the “AMT Limitation” prevented many small businesses from utilizing R&D Credits. Now, Eligible Small Businesses – defined as non-publicly traded companies with less than $50MM in average annual gross receipts for the preceding four tax years – are no longer AMT-limited. Since TCJA eliminated AMT for C-Corps, the Eligible Small Business – AMT benefit is exclusively of-interest to pass-throughs for 2017 and beyond.
Alvarez and Marsal Taxand Says:
While TCJA has presented many planning opportunities and challenges for taxpayers and advisors, the R&D Credit remains a consistent and increasing-valuable option for reducing income tax liabilities. The team at A&M will continue to share insights in this area and others as events progress.
• Fiscal Year-Filers – Calculate 280C in accordance with IRC 15(e).
• If making an entity conversion post-Tax Reform, be mindful of the effect on R&D Credit carryforwards.
• Startup Companies: Remember that QSB Credit election can only be made on an original return – no amendments! If you might qualify as a Qualified Small Business, assess the qualifications and potential benefit before filing 2017 federal income tax returns.
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