research and development deductionsHowever, Startups Need to be Mindful About Future Changes to Research and Development Deductions.

Most tax experts would agree that the recently enacted Tax Cuts and Jobs Act of 2017 was generous to businesses of all types. One of the most anticipated events was what Congress was going to do with the very popular Research and Development Tax Credit.

Even though this new tax legislation made sweeping changes to the tax code, the good news is that the R&D tax credit was largely unaffected by this legislation, with the exception that start ups may have to pay income tax in earlier years than they have in the past.

Here’s a summary of Freed Maxick’s R&D Tax Credit Team’s perspective on the new legislation and its consequences for the credit:

Section 174 Costs

The most pervasive and taxpayer unfavorable provision related to research and development activities does not directly relate to IRC Section 41 (Credit for Increasing Research Activities), but rather, IRC Section 174 (Research and Experimental Expenditures).  

New call-to-action

Currently, taxpayers have the option to immediately expense R&D costs or elect to capitalize and amortize them, but starting in 2022, companies will no longer be able to immediately expense costs allowed under IRC Section 174 related to research activities.  At that time, taxpayers will have to capitalize US-based research expenses to a capital account and deduct them over a five-year period.  

If such expenses relate to research performed outside of the United States, they will be capitalized and deducted over a more protracted 15-year period.

IRC 280C Reduction

The definition of qualified research activities & qualified research expenses did not change, nor did the methods to calculate the credit (regular credit or alternative simplified credit).

Many taxpayers will generate larger credits as the maximum corporate tax rate decreased from 35% to 21%, thus reducing the reduction under IRC Section 280C (“280C”) or the impact of the expense addback if the 280C reduction is not elected.  As you may know, you can’t claim both the credit and the deduction for research expenses.  The 280C election, if made, reduces your credit by the maximum corporate rate so you don’t have to add back the deductions.  

However, with the corporate rate decreasing, the benefit will decrease and the net effect on the effective rate for corporations may remain similar. Here’s an example:

Under the old rules owner’s of pass-through entities taxed at the highest individual rates and large corporations simply elected the IRC Section 280C reduction because the difference in rates was not that great for the owners (39.6% individuals; 35% corporations) and the percentage reduction (35%).

Research and Development Tax Credit Calculation

An example in the case of a large Corporation:

   

2017 Rates

 

2018 Rates

 

Difference

 
 

Taxable Income

20,000,000

 

20,000,000

 

-

 
 

Corporate tax rate

35%

 

21%

 

-14%

 
 

Corporate tax

7,000,000

 

4,200,000

 

(2,800,000)

 
               
 

R&D tax credit gross

615,385

 

615,385

 

-

 
 

R&D tax credit after 280C reduction

400,000

 

486,154

 

86,154

 
               
 

Net tax

6,600,000

 

3,713,846

 

(2,886,154)

 
 

Effective rate

33%

 

19%

 

-14%

 
               
 

% benefit of R&D credit (Effective rate - Corporate tax rate)

-2%

 

-2%

 

0%

 
               

A more careful analysis may be needed on individualized bases as the credit is reduced by 21% under IRC Section 280C, but the top rate could be 29.6% (assuming a full 20% QBI deduction & ignoring any affordable care act taxes).  

Corporate AMT

As part of the 2015 PATH Act, President Obama exempted most taxpayers from the AMT limitation that hindered many businesses from claiming R&D credits.  With the removal of the Corporate AMT starting in 2018, all corporate taxpayers will now only be limited by the regular tax limitations (taxpayers with over $25,000 in regular tax liability are limited to offsetting no more than 75% of their regular tax liability using the credit).

It is important to note that the individual alternative minimum tax was not repealed.  On the bright side, with the higher exemption amount and phase-out income levels, potentially fewer individuals and pass-through entity owner/taxpayers will be subjected to the individual AMT.

Section 59A Base Erosion and Anti-Abuse Tax

The research credit is one of the very few general business credits that can be claimed to offset the new Section 59A Base erosion and anti-abuse tax (“BEAT”) tax through 2025.  This tax will only impact multinationals with gross receipts over $500,000.  However, those companies are highly likely to generate research credits and the R&D credits they generate can help offset this additional tax imposed upon them.

A Word of Caution for Startups on the R&D Tax Credit

After 2021, start-ups claiming the R&D Tax Credit could be in for a rude awakening.  A combination of changes to the limitation on usage of net operating losses and capitalization of previously deductible IRC Section 174 costs for R&D expenditures could result in startups having to pay income tax in earlier years than they have in the past.  See the discussion above related to the new Section 174 rules.

We strongly suggest that you connect with us to see how tax reform affects you or your company. The year 2022 is only a few years away, so starting to plan now may help reduce your taxable income in the future.

Connect with Our R&D Tax Credit Experts for More Information

Tax Situation ReviewThe Research and Development Tax Credit experts at Freed Maxick are standing by to help review your situation and provide guidance on both your eligibility for the credit, and the scope and processes necessary for its capture and claim.

To schedule a complimentary review, call me at 716-847-2651, reach me via email at joe.burwick@freedmaxick.com, or simply click on the button to complete and submit a meeting request.

For more insight, observations and guidance on the new Tax Cuts and Jobs Act, visit our Tax Reform webpage.