For many years, the Sec. 41 research and development credit has provided incentives for businesses to increase their investment in research activities. (1) To further this congressional intent, the Protecting Americans From Tax Hikes (PATH) Act of 2015 created, in the authors' opinion, an important but overlooked provision for small startup businesses that cannot use an income tax credit in their critical early years of operation. (2)
Effective for tax years beginning after Dec. 31,2015, a qualified small business (QSB) may elect under Sec. 41(h) to use its research credit as a credit against the employer portion of its old age, survivors, and disability insurance (OASDI) liability. (3) The credit does not apply against the employer portion of Medicare taxes nor against the employee portion of Federal Insurance Contributions Act (FICA) taxes that the employer is required to withhold and remit to the government. (4)
This article presents an overview of the rules governing the computation of the research credit and then examines when a taxpayer may elect to claim the credit against its OASDI liability if the taxpayer has little or no income tax. (5) This use of the research credit against payroll tax for qualified small businesses that are startup companies can save critical resources for them in their early years.
To understand the election to claim the research credit against an employer's payroll tax, a brief description of the research credit itself is in order so that taxpayers can determine if they are eligible for a credit in the first place. This description is not intended to analyze the rules of the research credit in detail but simply to assist taxpayers in understanding the types of expenditures that qualify for the credit that might offset payroll taxes.
Research expenditures qualifying for credit
The Sec. 41 research credit is a percentage of the qualified research expenditures (QREs) that a taxpayer incurs in a year in connection with its trade or business over a certain base amount. (6) QREs are the sum of "in-house research expenses" and "contract research expenses." (7)
In-house research expenses (8) are: (1) wages paid to an employee engaged in qualified research or in direct supervision or support of qualified research; (9) (2) amounts paid for supplies used to conduct qualified research; (10) and (3) amounts paid for the use of computers for the conduct of qualified research. (11) Contract research expenses are 65% of amounts paid or incurred by the taxpayer to persons other than employees for qualified research. (12)
Qualified research (13) for this purpose is research that meets the following four tests: (14)
* The expenditure is a trade or business expenditure that would otherwise be capitalized but for Sec. 174 described below; (15)
* The research is undertaken to discover information that is technological in nature (i.e., based on physical, biological, engineering, or computer science principles); (16)
* Substantially all the research must contain elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality; (17) and
* The research is intended to be useful in the development of a new or improved business component of the taxpayer. (18)
Expenses related to efficiency surveys, (19) management studies, (20) market research, (21) routine data collection, (22) and quality control (23) do not qualify. Finally, the following types of research are specifically excluded from the definition of qualified research: research conducted after the beginning of the commercial production of a business component; (24) research related to the adaptation of an existing business component to a particular customer's requirement or need, or the duplication of an existing business component; (25) foreign research; (26) research in the social sciences, arts, or humanities; (27) and funded research. (28)
Amount of credit
In general, a taxpayer may claim a research credit of 20% of the amount of the taxpayer's QREs for a tax year that exceed its "base amount" for that year. (29) The base amount is defined as the product of the fixed-base percentage (30) and the taxpayer's average annual gross receipts for the four years preceding the credit year, (31) but not less than 50% of the QREs for the credit year. (32) Alternatively, taxpayers may elect a simplified credit of 14% of the excess of the QREs for the tax year over 50% of the average QREs for the three years preceding the year for which the credit is being determined. (33)
The research credit is one of the credits that make up the general business credit, (34) which cannot exceed the excess of the taxpayer's "net income tax" over the greater of the tentative minimum tax for the year or 25% of the taxpayer's "net regular tax" that exceeds $25,000. (35) Net income tax means the regular tax and alternative minimum tax less nonrefundable personal credits, foreign tax credits, and certain credits dealing with motor vehicles. (36) Net regular tax means the regular tax less the same credits. (37)
In addition, certain "eligible small businesses" may use the research credit to offset their alternative minimum tax. Eligible small businesses for this purpose are nonpublicly traded corporations, partnerships, and sole proprietorships with less than $50 million in average gross receipts for the three preceding tax years. (38) Credits for a partnership or S corporation are not allowed to a partner or shareholder unless the partner or shareholder meets the $50 million gross receipts limit for the year the credit is claimed. (39)
Any unused portion of the credit may be carried back one year and forward 20 years. (40) Any unused credit at the end of the 20-year carryover period may be deducted in the 21st year. (41) Reporting requirements
Form 6765, Credit for Increasing Research Activities, is filed to claim the regular and the alternative simplified research credits. If there is a general business credit in addition to the research credit or a carryback or carryforward of the general business credit, the research credit is carried to Part III of Form 3800, General Business Credit. (42) Partnerships and S corporations must file Form 6765 to claim the credit. All other taxpayers are generally not required to complete or file the form if their only source for the research credit is a partnership, S corporation, estate, trust, or cooperative. Instead, they can report this credit directly on Form 3800. However, this rule does not apply to a taxpayer that is an estate or trust, and the credit can be allocated to beneficiaries. (43)
Deducting research expenses
The research credit of Sec. 41 is not the only Code provision favoring research expenditures. Sec. 174 allows an immediate deduction for research or experimental expenditures that would otherwise have to be capitalized. (44) But deductions are permitted only to the extent they are reasonable. (45) For this purpose, research or experimental expenditures are "expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense." (46) An activity is research and development in the experimental or laboratory sense if (1) uncertainty exists concerning the development or improvement of a product, i.e., the information available to the taxpayer does not establish the capability or method for developing or improving a product or process or the appropriate design of a product...