Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

Enhancement 1: Start-up companies are able to use the research credits generated in tax years beginning after December 31, 2015 against payroll tax

Q. What is the definition of a qualified small business (start-up company)?
A. A qualified small business is defined, with respect to any taxable year, as a corporation (including an S corporation) or partnership with gross receipts of less than $5 million for the taxable year and no more than 5 years of gross receipts history.

Q. What part of the payroll tax is refundable?
A. The employer OASDI liability of 6.2% is refundable. The credit does not apply against the employee portion.

Q. Is there a limit to the amount of payroll tax that can be offset with the credit?
A. The payroll tax credit is limited to $250,000 per year for no more than five years.

Q. Are members of the same controlled group treated as a single taxpayer?
A. Yes. The amount of the credit is allocated among the members in proportion to each member’s qualified research expenses. Each member may separately elect the payroll tax credit for its portion of the credit.

Q. How do you elect the payroll tax credit?
A. A taxpayer makes an annual election specifying the amount of its research credit that will be applied to its payroll tax, not to exceed the $250,000 limitation. The taxpayer will make the election on or before the due date of its originally filed return, including extensions. The election cannot be revoked without the consent of the Secretary of the Treasury. In the case of a partnership or S Corp, the election to apply the credit against OASDI liability is made at the entity level.

Q. How is the credit applied against OASDI tax liability?
A. The payroll tax is allowed as a credit in the first calendar quarter beginning after the date in which a taxpayer files its tax return for that taxable year. The credit may not exceed the tax liability for a calendar quarter. The excess is allowed as a credit against subsequent calendar quarters until the entire credit amount is used.

Enhancement 2: Small businesses are able to use the research credits generated in tax years beginning after December 31, 2015 against Alternative Minimum Tax

Q. Who can apply the research credit against AMT?
A. An eligible small business can apply the credit against AMT. An eligible small business is defined as either a non publicly-traded organization, a partnership or sole proprietorship whose average gross receipts for the prior three years is less than $50 million.

Q. Will prior year credits carried forward into 2016 be usable against AMT?
A. No. Prior year credits are still subject to the AMT limitation. However, any credits carried forward will be used before any current year credits. To the extent a taxpayer has regular tax due above minimum tax in 2016, the carryforward credit would be used first down to the minimum tax amount, and then the current year credit would be applied against minimum tax.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015, extending many of the business and individual tax provisions and finally making permanent the research and development (R&D) tax credit.

 

Start-ups and small businesses benefit from changes to R&D tax credit

In addition to making the credit permanent, the Act also contains two favorable changes for small businesses and start-ups beginning in 2016. These two noteworthy enhancements are:

  • The credit is now able to offset Alternative Minimum Tax (AMT) for eligible small businesses, companies with less than $50 million in gross receipts. For small business owners, the AMT limitation was the largest obstacle that kept companies from taking advantage of the research credit. For 2016 and forward this limitation is lifted.
  • Start-up companies, whether corporations or partnerships, can apply the credit to offset up to $250,000 in payroll taxes beginning in tax years after December 31, 2015. Start-ups are defined as businesses with less than $5 million in gross receipts in the current year and less than five years of historical gross receipts.

A permanent credit provides stability and certainty to all companies while the enhancements are game changers for small businesses.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

Start-ups and small businesses benefit from changes to R&D tax credit

The House today passed a permanent extension of the Research and Development (R&D) tax credit as part of the Protecting Americans from Tax Hikes Act of 2015. Finally companies can rely on the permanency of the credit, which will allow them to better plan for investments in research.  In addition to making the credit permanent, the Act also contains two favorable changes for small businesses and start-ups beginning in 2016.  These two noteworthy enhancements are:

  • The credit is now able to offset Alternative Minimum Tax (AMT) for eligible small businesses, companies with less than $50 million in gross receipts. For small business owners, the AMT limitation was the largest obstacle that kept companies from taking advantage of the research credit.  For 2016 and forward this limitation is lifted.
  • Start-up companies, whether corporations or partnerships, can apply the credit to offset up to $250,000 in payroll taxes beginning in tax years after December 31, 2015. Start-ups are defined as businesses with less than $5 million in gross receipts in the current year and less than five years of historical gross receipts.

A permanent credit provides stability and certainty to all companies while the enhancements are game changers for small businesses. The bill is now waiting for Senate approval after which the president is expected to sign it into law.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

A recent court case provides guidance on owner compensation and when it qualifies as a research expense under §174.  This qualification under §174 then dovetails with the §41 research and development (R&D) tax credit calculation and can have a huge impact.  Many companies are led by entrepreneurs who spend significant time developing or improving the company’s products and processes rather than managing day-to-day operations.  These qualifying activities can have a substantial impact on the size of a company’s credit.

In Eric G. Suder vs. Commissioner, Mr. Suder claimed that 75 percent of his time was devoted to research activities.  Mr. Suder was the creative genius behind the company’s products, spending most of his time guiding product development from idea generation through testing. As a result, the company grew from a one-man, garage-based startup to a thriving 125-person organization. Like many entrepreneurial CEOs, Mr. Suder spent very little time managing day-to-day operations. Instead, his time was spent contributing to senior product strategy and follow up product meetings, reviewing product specifications, and researching networking technology that could be incorporated into the company’s products.

However, the IRS disallowed Mr. Suder’s R&D credits and also challenged whether the compensation paid to Mr. Suder was reasonable under §174.  Mr. Suder argued that engineering’s role was to execute on his innovative ideas, and that his compensation was based on his creative contributions. Mr. Suder’s total compensation package during the period in question ranged from ~$8-11 million and was comprised of a base salary and bonuses, with bonuses based on growth, overall value and cash flow.

After a thorough analysis by the court, 75 percent of Mr. Suder’s salary was confirmed as qualified.   Mr. Suder was able to convince the court through documentation and oral testimony that he participated heavily in research. Mr. Suder provided credible documentation supporting his research efforts.

With respect to his compensation, according to the law, “Under §174(e) a taxpayer may deduct a research and development expenditure only to the extent that the amount thereof is reasonable under the circumstances.” The amount of an expenditure is considered reasonable if “the amount would ordinarily be paid for like activities by like enterprises under like circumstances.”  The court addressed the issue of “reasonable” with respect to how much of an owner’s compensation can be included in the credit computation.  The court evaluated eight factors including the employee’s qualifications, the nature, extent and scope of the employee’s work, the size and complexities of the business, and the prevailing rates of compensation for comparable positions in comparable concerns.

After evaluating these factors and hearing from expert witnesses for Mr. Suder and the IRS, both of whom compared Mr. Suder’s wages to those of other CEOs performing similar services in similar companies, the court determined that while they agree with Mr. Suder’s high compensation as a CEO, the amounts were unreasonable under §174.  The court determined that reasonable wages under §174 would be $2.3-2.6 million. These wage amounts represented base salary, annual incentive and long-term incentive.  The court confirmed that wage comparison should be to that of other CEOs not to that of other employees within a company or other engineers or researchers.

The Suder case highlights that owners and other highly compensated executives who participate in R&D activities can be included in calculating the R&D credit.  It also highlights the importance of supporting documentation as evidence of participation in qualified research activities.

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Provisions Offer Additional Tax Benefits

In late July the Senate Finance Committee approved a modified and expanded version of the tax extenders bill that would provide a two-year retroactive extension of more than 50 expired business and individual tax provisions. Most noteworthy are enhancements to the research and development tax credit; §179 expensing provision; and the §179D deduction for sustainable design and construction of commercial properties.

R&D tax credit expansion would benefit small and medium sized businesses

The proposed R&D tax credit extension includes an AMT patch, which would allow companies paying AMT with less than $50 million in average sales over the prior three years to claim the credit. Start ups, defined as companies with less than $5 million in gross receipts and less than five years old, would be able to use the credit to offset up to $250,000 in payroll taxes annually.

Fixed asset benefits from enhancements to bill

The proposed bill would index the increased §179 expensing and phase-out limits ($500,000 and $2 million, respectively) to inflation. This is in addition to the extension of bonus depreciation and 15-year recovery for qualified properties.

Energy-efficient commercial building deduction expanded

The §179D commercial green building deduction would be expanded to allow nonprofits and tribal organizations to allocate the deduction to the primary designer of the property, a provision currently in place for government or other public entities.

If passed, all of the extenders would be set to expire on December 31, 2016. The modifications proposed for the extenders listed here could potentially provide significantly higher benefits for many small to medium sized businesses. The bill now has to make its way to the full Senate, although congressional debate will likely delay enactment until year-end.

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Michael Warady CFP, National Director, Software R&D Consulting

Michael Warady CFP, National Director, Software R&D Consulting

Many companies have difficulty understanding the value of the R&D tax credit to the organization. To help put it in perspective, we recently conducted an equivalency assessment for a custom manufacturer. The chart below compares the additional revenue that would need to be generated from ordinary business operations to equal the value created by the R&D tax credit opportunity.

Gross Receipts $49,500,000
Cost of Goods Sold $40,000,000
Gross Profits $9,500,000
Total Deductions $8,000,000
Net Income $1,500,000
Profit margin 3.03%
R & D Tax credit $300,000
Revenue equivalents $9,900,000

 

The project encompassed approximately 45 hours of time by company employees, including document collection, interview participation and final deliverable review. At the conclusion, two things were worth noting:

  1. The resulting credit amount divided by the number of hours invested equated to an hourly revenue rate of more than $6,500.
  2. The credit equated to a revenue equivalency of $9.9 million. The CFO mentioned that it would take years to generate that type of top line revenue growth and impossible given only 45 hours.
  3. Even if the credit were half this amount, the company would need to grow revenues by nearly $5 million in order to achieve the same $150,000 benefit provided by the R&D tax credit.

The R&D tax credit is one of the most efficient and effective ways to create cash flow that can be reinvested into additional R&D, new equipment, talent or other areas of the business.

The SourceHOV|Tax R&D team has more than 85 years of collective R&D experience at both Big Four and boutique firms. Each member has worked with companies across a wide range of industries to complete more than 1,200 studies totaling more than $1 billion in credits claimed.

For more than 30 years, SourceHOV|Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, §179D deductions and LIFO inventory accounting. For more information, please call 800-806-7626 or visit www.sourcehovtax.com.

Michael Warady CFP, National Director, Software R&D Consulting

Michael Warady CFP, National Director, Software R&D Consulting

For more than 10 years, I have been talking to companies about claiming research and development tax credits. But when I learn they are in a loss position, the conversation typically stops. The argument has always been that claiming the credit while in a loss position is pointless since there is no immediate benefit.  While many companies recognize the credit, they don’t value the carryforward opportunity.   Why would a company go through the process now versus waiting until they can use it? The theory is they can always go back and capture past credits and carry the credits forward when they need them.  Plus, time is precious and resources limited.

In the past I agreed with this reasoning.  However, recently I wondered if there wasn’t value being missed. While traditional thinking seems logical, I concluded that the R&D tax credit should be included on a company’s tax return each year even if it is in a loss position. Waiting can be costly.  Here’s why:

Taxes have not gone down.  As your company grows and reverses its loss position, the credit may bring value sooner than anticipated.  Budgeting for taxes can become a very real issue and knowing what you have in reserves can help.  The carryforward of an R&D tax credit will also help with quarterly tax estimates.  When your tax position becomes positive, you will know the value of your R&D tax credits so you can offset your tax liability.

Learn it now versus figuring it out later.  Companies that claim the credit on an ongoing basis will have stronger and cleaner project tracking.  And they will better understand where internal resources are committed and where resources should continue to be dedicated.

There’s value to putting the process in place.  Establishing an ongoing process versus retroactively conducting studies is less labor intensive. Our clients find that conducting current studies simplifies the process.  They know what they need to collect and have implemented processes for data gathering throughout the year.

It’s cleaner than amending tax returns.  Each year a company goes back and captures credits to carry forward requires amending the tax return for that year.  It’s an even bigger issue for flow through companies with multiple shareholders.  In one recent case, a client with multiple shareholders wanted to capture credits from 2011-2013 and carry them forward into the current and future years for utilization. As an S-Corp with nine shareholders, they had to file 30 amended federal tax returns in addition to a similar number of state tax returns to do so.  By claiming the credit currently, you can avoid amended returns, aggravated shareholders and additional tax fees.

The credit is an asset.  For companies that are not flow through entities, the credit stays with the corporation.  As companies transition ownership, they recognize the R&D tax credit as an asset.  Many of our CPA firm partners recognize the value of such an asset and recommend their clients capture the credit prior to pricing negotiations.

 

Michael Warady, CFP has been consulting on the R&D tax credit for more than 10 years.  For the past 6 years, Michael has worked with SourceHOV|Tax clients and their CPAs to help them understand the value the credit offers.

SourceHOV | Tax has helped CPA firms and their clients maximize specialized federal and state tax incentives for more than 30 years. We’ve helped thousands of companies save billions of dollars through these lucrative tax strategies.

With the March 15 deadline looming for many of your clients, now is the time to consider any necessary tax elections for clients who plan to evaluate or take the R&D tax credit.

When a company claims a research credit, it can either elect the GROSS credit or the REDUCED credit.  When electing the reduced credit, the company makes a 280C election on the original return. This election cannot be made on an amended return.

The benefit of the 280C election is that there is no AMT impact if the company later goes back and amends the return for this credit.  If the gross credit is elected, the company must reduce its deductions by the amount of the gross credit thereby increasing taxable income.

AMT income also increases by the same amount, so companies closer to the AMT threshold may get pushed further into AMT if they go back and claim a credit under the gross credit method.   While the reduced credit is the preferred method for most companies, some (generally those with NOLs) may benefit from the gross credit method.  So an assessment should be made before making the election.

In order to make the 280C election, a company needs to determine if this election is made using the Regular Credit calculation or the Alternative Simplified Credit calculation.  To make the proper 280C election, an assessment as to which credit method will be most beneficial must be made when making the election.

For 2014, the box on Form 6765 line 17 or 34 must be checked depending on the credit calculation method chosen.

SourceHOV | Tax can analyze the benefits of the 280C election for your clients and recommend which method is most beneficial for those claiming or looking to claim the R&D tax credit.

There is still time to conduct the proper evaluation to meet the March 15 filing deadline for your clients who anticipate claiming the credit and want to make the proper election, but time is of the essence. I welcome the opportunity to discuss further how we might work together to help reduce your clients’ tax burden.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

In today’s fast-paced marketplace, software has become an integral part of doing businesses for companies of all sizes and across all industries. Congress recognized the vital role software now plays in day-to-day operations, and on January 20, 2015 the Internal Revenue Service published proposed regulations to address issues regarding the treatment of research expenses related to the development of internal use software (IUS) for purposes of claiming research and development (R&D) tax credits.

Because IUS must meet the more onerous 7-part test to qualify for R&D tax credits, it is often excluded, preventing many companies from claiming the credit. However, under the proposed regulations, the definition of IUS is narrowed.  Software that is developed to enable a taxpayer to interact with third parties or allow third parties to initiate functions or review data on the taxpayer’s system is now considered external use software and subject only to the less restrictive 4-part test. Narrowing the definition of what constitutes IUS versus external use software opens the door for many non technology-based taxpayers, especially service-based companies, to now successfully claim R&D tax credits.

The proposed regulations limit the definition of IUS to software developed for general and administrative functions that facilitate or support a taxpayer’s trade or business. This includes any system used to run the business such as financial management, human resources management or support services software. For software that may serve a dual function (i.e. be used for both internal purposes and also by third parties), a taxpayer may classify certain components of an integrated system as non-IUS if they can demonstrate that an objective and reasonable method was used to determine the components of software that would be used by third parties.

The 3-part test for IUS is also clarified.  The “unique or novel” standard that was introduced in the 2001 regulations is eliminated, and the original definition of “innovative” is confirmed in these proposed regulations.  The regulations provide that the high threshold of innovation test is satisfied if:

  • The software is innovative, meaning that the software results in a reduction in cost or improvement in speed that is substantial and economically significant.
  • That the software development involves significant economic risk, meaning that the taxpayer commits substantial resources to the development and there is substantial uncertainty because of technical risk and that such resources would be recovered within a reasonable period.
  • That the software is not commercially available for use by the taxpayer without modifications that would satisfy the first two requirements.

These regulations are applicable for tax years ending on or after the publication date of the Treasury decision adopting these rules as final regulations in the Federal Register.  However, the IRS will not challenge positions consistent with the proposed regulations for taxable years ending on or after January 20, 2015.

For more than 30 years, SourceHOV | Tax has helped companies properly identify and sustain tax incentive strategies including R&D tax credits, cost segregation studies, 179D tax deductions and LIFO inventory accounting.  For more information, please call 800-806-7626 or visit www.sourcehovtax.com.

Deb Roth, Managing Director, R&D Tax Consulting

Deb Roth, Managing Director, R&D Tax Consulting

This $65 million HVAC/sheet metal engineering firm was engaged to create the design and manage construction of a ventilation system for an underground parking facility at an historic site. The facility was the main entrance for buses, trucks and other vehicles visiting the site and was to include x-ray devices and other high-security systems to detect explosives or other potential security risks.

In this case, the design was to effectively ventilate exhaust fumes from the facility rather than provide consistent, fresh breathing air as is typical when ventilating a building. The job was made more complex due to the facility having 70 purge zones, each with its own control.

There was uncertainty as to how technical personnel could most efficiently design and install the ventilation system while the concrete contractor was simultaneously building walls in the same area. The underground facility consisted of an exterior slurry wall that was designed to hold back soil from the river bank. Inside the slurry wall was a four to five foot cavity and then a second, interior wall. The second wall was three feet thick and required interior and exterior metal forms to hold everything in place during construction. In some places, steel was placed over the second wall as an added blast-proofing security measure. As a result, there was little room for the ductwork to be installed between the walls.

Through the use of computer aided design, the teams experimented with multiple ductwork designs. In the process of calculating the most efficient way to install the ductwork, the initial design called for the technical team and the concrete contractor’s team to alternate going first in either pouring walls or hanging ductwork. However, this design was deemed to be ineffective because the concrete contractor would have difficulty removing the wall forms and steel rebar after the ductwork was in place.

An alternative CAD design included pouring the walls first and then installing the ductwork. This required technical personnel to design various sizes of duct to fit in the crevices left after the walls were formed. The CAD designers created numerous alternative designs in an attempt to achieve optimal layout of the ventilation system. Technical personnel were required to resize and rebuild various pieces of ductwork to accommodate the new designs. And, production staff worked with project management and CAD designers to redesign the shape and size of numerous key components of the ventilation system.

SourceHOV | Tax has worked with the firm and its CPA to claim R&D tax credits for tax years beginning in 2007. Over the past seven years, the firm has claimed annual credits of $135,000.