Potential Changes to R&D Tax Credit Could Spill New Benefits for Startups

With a proposal on the table that could benefit startups, another that is promising for small and medium-sized businesses, and with the federal R&D tax credit still expired since December 31st, 2014, all eyes are on Congress as tax practitioners and taxpayers await the credit’s highly expected extension.

R&D tax practitioners from across the country recently flocked to Washington, D.C., to attend the Research and Development Tax Credit Symposium presented by Bloomberg BNA. They discussed  developments impacting the credit and the implications for taxpayers, including two key proposals concerning the application of the R&D tax credit toward payroll taxes and the Alternative Minimum Tax.

Another temporary extension?

Although the House passed a bill in May that would make the credit permanent, the general expectation from practitioners who attended the symposium is that the credit will remain in its current form and will again be deemed temporary. Despite its temporary nature, the credit, enacted in 1981, has been consistently renewed (with only a one-year period exception where the credit was not available) since its original expiration in 1985.

The House bill would also eliminate the “traditional credit” calculation method, which uses a historical base to compute the credit, in favor of an enhanced “alternative simplified credit” method (increased from 14% to 20%), which calculates the credit based on a company’s research and development spending in the preceding three years.

Payroll tax election for startups

The first proposal, contained in a tax extender bill approved by the Senate Finance Committee in July, could be a boon for startups. It addresses the inability of many startups to immediately benefit from the federal R&D tax credit because they rarely have a tax liability to offset in their early days.

Currently, startups that qualify for the federal R&D tax credit but aren’t yet paying taxes have the option to carry forward the credit to use in later years when they do have a tax liability. The proposal would allow qualified small businesses to elect to use a portion of their R&D tax credit now to offset payroll taxes instead of waiting to use the credit.

The election to use the R&D tax credit against payroll taxes would be available to a qualified small business for a period of 5 years, and the annual limit of credit that could be used would be $250,000. A qualified small business under the proposal would be a corporation or partnership that had less than $5 million in gross receipts for the taxable year and that did not have gross receipts for any period preceding the five taxable-year period ending with such taxable year.

Alternative Minimum Tax

The second R&D-related proposal concerns the Alternative Minimum Tax (AMT) and is proposed in both the House and the Senate bills. This proposal would allow eligible small and medium-sized pass-through entities (e.g., S corporations and partnerships) who have an AMT liability to use the R&D tax credit to offset the AMT, addressing an issue that has been a barrier to claiming the credit for these businesses in the past.

Internal-use software

Another hot topic at the R&D tax symposium was the 2015 proposed regulations on internal-use software, published earlier this year by the U.S. Treasury in IRS REG-153656.

The long-awaited set of proposed regulations on internal-use software is generally perceived as taxpayer-friendly and would make it easier for companies using proprietary software in the delivery of their product or service to qualify for the R&D tax credit.

The proposed regulations would change the definition of internal-use software and adopt a more favorable innovation standard as part of the high threshold of innovation test. Prior IRS guidance generally suggested that software developed for purposes other than to be commercially sold, leased, licensed or otherwise marketed to third parties was classified as internal-use software and therefore was not eligible for the R&D tax credit in most cases.

Under the 2015 proposed regulations, the definition of internal-use software would no longer include software developed to enable interactions with third parties or to allow third parties to initiate functions or review data; therefore this type of software would not be required to satisfy the most stringent high threshold of innovation test in order to qualify for the credit.

With these and other exciting changes potentially on the horizon for the R&D tax credit, businesses should keep an eye on the latest developments. To learn more about this lucrative credit and how it may be able to benefit your company, contact me or another of Kaufman Rossin’s tax specialists.