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A Message to Our Valued Clients

In the interest of public health and the safety of our community, and in compliance with Governor Cuomo’s executive order, Freed Maxick has suspended onsite client work and cancelled all office visits. Meanwhile, our team is working remotely to provide the same high-quality service you have come to expect. Utilizing the best technology at our disposal, we will continue to meet all of your audit, tax, and advisory needs and help you navigate the business implications of the pandemic as it unfolds. You can reach your Freed Maxick representative directly by email or phone, or contact our main line at 716.847.2651.

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Summing It Up

Keeping you ahead of the curve with timely news & updates.


How Tax Reform Created New Opportunities for R&D Tax Credits

R&D Tax Credit

Taxpayers everywhere were significantly impacted by the 2017 Tax Cuts and Jobs Act (TCJA). In particular, the Act impacted Research and Development (R&D) tax credits and deductions in ways large and small. The following summarizes the key changes to R&D tax credits in the wake of tax reform and offers takeaways for how these may affect you or your business.

Background

The Research and Experimentation (R&E) tax credit was first introduced in 1981 as a two-year incentive with the goal of increasing investments in research and development activities in the U.S. It was then made a permanent part of the Internal Revenue Code in 2015 under the Protecting Americans against Tax Hikes Act (PATH Act). Part of this credit is IRC Section 280C(c), which prevents taxpayers from receiving a double benefit for research-related expenses. Specifically, taxpayers must either reduce ordinary deductions by the amount of the credit or elect a reduced credit generally equal to the tax-effected amount of the research credit. As an alternative to the credit, IRC Section 174(a) provides immediate expensing of R&D expenditures and IRC Section 174(b) provides an election to amortize these costs over a period of not less than 60 months. Software development was included in such R&D expenditures under Rev. Proc. 2000-50.

Changes Affecting the R&D Tax Credit

One of the most significant changes of the TCJA was the reduction in the corporate income tax rate to a flat 21 percent from the top rate of 35 percent. Because Sec. 280C(c) requires taxpayers to reduce the amount of the R&D credit by the maximum tax rates, corporations can now benefit from an enhanced deduction. Whereas taxpayers previously only recognized a net benefit from this credit of 65 percent, the benefit has now increased to 79 percent.

Additionally, the TCJA repealed the corporate alternative minimum tax (AMT) and increased the exemption and phase-out amounts for individual AMT. Historically, the R&D tax credit could only be used to offset federal income tax liabilities and not AMT liabilities; eligible small businesses were already exempt from this provision. These credits can now be used to offset AMT in addition to federal income tax. However, corporate taxpayers are still subjected to IRC Section 38(c) which specifies “…a credit cannot exceed the excess of the taxpayer’s net income over 25 percent of the taxpayer’s net regular tax liability above $25,000.” For passthrough entities, more individuals will now be able to recognize a benefit from such credits as fewer individual taxpayers will be subject to the AMT provisions.

Another change comes in the form of net operating loss (NOL) deduction reform. Previously, a taxpayer could offset 100 percent of taxable income through utilization of NOLs. For tax years beginning after Dec. 31, 2021, NOLs can only be used to offset 80 percent of taxable income. This could enhance the need for the R&D tax credit to further offset any remaining tax liability. NOLs generated prior to 2018 are grandfathered in under the old law and can still be used to offset 100 percent of taxable income.

Changes Affecting Section 174

As previously mentioned, provisions under Section 174 permit taxpayers to immediately expense R&D expenditures, including software development. For tax years beginning after Dec. 31, 2021, this option is eliminated. Instead, taxpayers will be required to capitalize and amortize such expenses over a five-year period beginning with the midpoint of the tax year in which such expenditures are paid or incurred. This period is increased to 15 years for research expenditures conducted outside the U.S. Furthermore, the enhanced language under the provisions will now include software development as a specified research or experimental expenditure, thus eliminating the reliance on Rev. Proc. 2000-50. Taxpayers currently deducting such expenses will be required to file a Form 3115, Application for Change in Method of Accounting, to begin amortizing such expenses. This change is applied on a cutoff basis, eliminating a Section 481(a) adjustment.

Planning Opportunities

Taxpayers now have some interesting planning opportunities to maximize the benefit of research and experimental expenditures. With the elimination of the AMT provisions and changes to the NOL deductions, more taxpayers may realize benefits from the research tax credit. To generate the greatest benefit, taxpayers may seek to expedite R&D expenditures before the Section 174 changes are implemented in 2022. The ability to expense these as incurred is available only until Dec. 31, 2021. Additionally, due to the longer amortization period, taxpayers should also evaluate the location of future R&D activities. For individual taxpayers, the Section 174 changes may be more beneficial. The capitalization requirements would increase qualified business income, which would also increase the Section 199A qualified business income deduction available to individual taxpayers. Although the top income tax rate is at 37 percent, the individual tax rates are not permanent like the corporate tax rate. If the rates revert to pre-2018 rates, individuals would recognize a higher tax benefit from the amortization of such expenses rather than expensing them currently.

Key Takeaways

  • The credit is more valuable now that the tax rates have decreased.
  • The credit can now be used to offset AMT. With the elimination of corporate AMT and increased limits for individuals, the credit is now more valuable to more types of taxpayers.
  • NOL deductions can only offset up to 80 percent of taxable income, so this credit could provide additional tax shields.

Now is the time to analyze current research expenditures and devise a plan to maximize tax benefits going forward for all types of taxpayers.

Contact Freed MaxickDo you have questions about the R&D tax credit or other tax planning issues? Please contact Freed Maxick at 716.847.2651, or click on the button for a contact form. 

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Driving Innovation and Investments With R&D Tax Credits

R&D Manufacturing

As a business owner, you recognize the importance of continuous investment in your manufacturing business. But, as the manufacturing landscape becomes increasingly competitive and globally inclusive, you may ask yourself: “Where can I find the extra capital I need to drive my business forward?” One relatively straightforward way to do this is to take advantage of the Research and Development (R&D) tax credit, a dollar-for-dollar tax credit that may be applied against taxes for the generating business.

Less than one-third of eligible companies realize they qualify for the R&D tax credit. For federal purposes, the R&D credit allows qualifying taxpayers to receive up to 14% of qualified research expenditures (QREs), such as in-house research expenses and contract research expenses. QREs can come from a wide variety of expenses but generally will include wages paid to qualifying employees and associated expenses used to develop a new product or process. Examples of manufacturing activities that may qualify include:

  • Designing manufacturing equipment
  • Optimizing manufacturing processes
  • Designing and developing tooling and equipment
  • Designing and testing prototypes

In addition to federal R&D credits, more than 30 states offer some version of an R&D credit. Planning accordingly can allow your business to reap twice the rewards on an investment you’re already making. Most states offer credits ranging from 2% to 6%, potentially allowing your business to return 6% to 14% of your original investment.

Freed Maxick Can Help

New call-to-actionNeed help creating an R&D tax credit survey to help determine which of your manufacturing activities qualify? Please contact Freed Maxick at 716.847.2651 or fill out our contact form.

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Brewing Up Tax Savings with the Federal R&D Tax Credit

Microbrew

Microbreweries often experiment with flavors and processes in ways that may qualify for a significant federal tax credit.

When craft brewing is done right, it often seems more like art than science. So it should come as no surprise that many craft-brewers overlook a tax-saving opportunity that is more closely associated with science-based industries like pharmaceuticals and tech companies.

The Federal Research & Development (R&D) tax credit provides a federal tax credit based on certain expenditures business spend on “qualifying research activities” (QRAs).  Additional incentives are available for certain startups and smaller breweries, such as credit against certain payroll taxes and not being limited by the alternative minimum tax.

Qualifying Research Activities for Breweries and Microbreweries

That phrase “Qualified Research Activities” is the heart of the argument for applying the credit to certain microbrewery expenditures. Costs related to an activity that meets the four-part test to qualify for the R&D credit, regardless of the industry in which the business operates.

Examples of qualified activities for Breweries and Microbreweries include, but are not limited to:

  1. Developing new or improved hopping techniques, including testing new varieties or combinations of varieties. In fact, according to gardeningknow.how.com, there are about 80 different hops types commercially available. It’s not unreasonable to think that many others are in development.
  2. Develop new or improved malting, lautering, fermenting, or conditioning processes.
  3. Developing new or improved bottling processes to improve shelf longevity, lower cost, or other functional improvements,
  4. Improvements to your brewing process to reduce waste, improve water recycling throughout the process, improve filtration, reduce cycle time, or other functional aspects,
  5. Development related to new product formulations, including use of different ingredients or preservatives.

Deductibility is in the Details

Tax Situation ReviewThe potential benefits of the R&D credit are significant, so the government requires thorough documentation. If you’re planning to claim the credit, you’ll want to set up your accounting system to track QRAs in separate accounts. Time allocations for employees engaged in R&D are an important part of your records.  Actual timesheets and payroll records are the strongest support.  These can be supplemented with post-completion analyses of resources used, design drawings for proposed developments/improvements, meeting notes, and testing documentation.

Extra Benefits for Start-Ups and Small Businesses

The IRS rules don’t go into specifics about what constitutes sufficient documentation for any particular claim, but they do express a strong preference for contemporaneous documentation. If you’re planning to claim the R&D tax credit for your brewery or microbrewery, it’s important to consult with a knowledgeable professional at the outset (or as soon as possible after starting!) to build the system that will document your costs accurately as you go.

The PATH Act of 2015 made the R&D credit permanent and even more valuable to microbrewery start-ups and small businesses. If you are a brewer with less than $5 million in current-year gross receipts and no gross receipts for any tax year that precedes the fourth preceding tax year, you can elect to claim up to $250,000 of the credit against your employer portion of Social Security tax. Partnerships, sole proprietorships and privately held corporations whose average annual gross receipts for the last 3 years that do not exceed $50 million, can also claim the credit against an alternative minimum tax liability. 

State Incentives for Brewers in New York

The Empire State also offers several incentives for brewers operating within its borders. Credits for investment in buildings and equipment apply to brewers, as do income and property tax credits for manufacturers. New York also provides an alcoholic beverage production credit and, for locally sourced beers, some reduced permit requirements. In addition, breweries can qualify for the state’s START-UP NY business incentive program, depending on their location.

Brewing Up Your Credit

Securing both Federal and New York State credits and incentives requires detail analysis and documentation.  In some cases this will require presentation to tax authorities in an audit to defend your position.

That’s why you’ll want to work with a team of experts with impeccable credentials in helping businesses of all types and sizes use the R&D Credit -and other tax minimization strategies – to lower their tax burden.

For more information about how your microbrewery could benefit from the R&D tax credit, please contact Freed Maxick at 716.847.2651.

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

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Tax Reform and the Federal R&D Tax Credit for Corporations

Tax Credits R&D

Tax Cuts and Jobs Act of 2017 didn’t change the R&D Tax Credit, but the repeal of the corporate Alternative Minimum Tax (AMT) expanded the potential benefit to all corporations that were in AMT.

The Tax Cuts and Jobs Act (TCJA) enacted at the end of 2017 did not make specific changes to the research and development (R&D) tax credit, but one significant change to the corporate tax system could benefit businesses that claim the R&D credit on their returns.

TCJA repealed the corporate alternative minimum tax (AMT) for taxable years beginning after December 31, 2017.  As a result, the new law could make all corporate tax credits and carry forwards, including the R&D credit, more valuable in the next few years. 

Corporate AMT and R&D Tax Credits

Before TCJA, a corporation that was subject to the AMT in one year could take an offsetting AMT credit in subsequent years only to the extent that its regular tax liability exceeded its tentative minimum tax. Some corporations were perennially subject to AMT tax and the AMT credits increased over time and were unusable.

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Refund of AMT Credit Carryforwards. Under the new law, any AMT credit carryforwards that weren’t used before the AMT was repealed can now be used to offset the corporation’s regular tax liability. The credit carried forward can be refunded in an amount equal to 50 percent of the excess of the credit for the tax year over the amount of the credit allowable for the year against regular tax liability. (That increases to 100 percent for tax years beginning in 2021.)

Corporations that have AMT credit carryforwards may now get an additional benefit from the R&D tax credit. To the extent the R&D credit reduces the regular tax liability, it could also accelerate the amount of AMT credit carryforwards that could be refunded during the “50 percent” years.

R&D Tax Credit Application for All Corporations and Not Only Eligible Small Businesses

In a previous blog, we discussed provisions of a 2015 law change that allowed only certain “eligible small businesses” (ESBs) to apply the R&D tax credit against their AMT due. Under current law, it appears that this benefit would apply to all corporations, regardless of whether they previously qualified as ESBs for purposes of deducting the R&D tax credit from their AMT liabilities. In effect, the elimination of the AMT under the TCJA has expanded the benefit to all corporations. The availability of the R&D credit to ESB would still apply to individual partners or S corporation shareholders who are subject to the AMT on their personal returns.

Connect with a Freed Maxick R&D Tax Credit Expert

Calculating and claiming the R&D credit for a corporation is a complicated process, and it’s made even more challenging if your business is carrying forward AMT credits from prior years.

If you have any questions or concerns about how the AMT and the R&D credit affect your personal or business taxes, connect with us by clicking on the button or please call the Freed Maxick Tax Team at 716.847.2651 to discuss your situation.

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Why You Might Want to Wait on an R&D Tax Credit Study… Even if You Pass the 4-part Test

BlogBefore spending, consider these 2 additional R&D tax credit tests from the experts at Freed Maxick

New call-to-actionWe’ve written a lot about how the Research and Development (R&D) Tax Credit delivers tax savings for businesses with qualifying activities. 

It’s important to know that claiming the Credit involves preparing a detailed study, documentation, and interactions with the IRS. Most firms engage a professional to help them claim the credit and consider the fees they pay as an investment. 

In our work helping businesses identify costs and calculate the credit, we’ve noticed that even though some businesses may have expenses that meet the 4-part test, they may still not benefit from the credit because of circumstances that limit its applicability. 

That’s why our R&D Tax Credit Team does a Situation Assessment prior to an engagement. That includes performing two initial additional “tests” complementing the 4-part test that can identify factors limiting your company’s ability to claim the credit. 

If the company does not pass these tests, we may recommend deferring activities pursuant to claiming the credit until a later date. These include: 

Additional Test 1: Do You Own the Risks and Rewards of the R&D Activity? 

If a business is hired to conduct qualified research activities by another business, the claim for the credit will generally flow to the business that bears the risk of failure and owns the rights to success. Businesses may be hired to develop a product or process by another company. These contracts often call for the researching business to receive a fixed fee for the work regardless of result and it transfers the rights to the results to the hiring business. 

Even though research costs might qualify for the credit, the company that hired the research business would be the one to claim it. 

The determining factor in a situation like this will be the contract between the two companies. If your company performs research on a contract basis for other businesses, it’s important to consider the value of the R&D tax credit when negotiating a contract. 

Your business might still end up in a better position if you are paid regardless of result, but understanding the value of the tax credit foregone can lead to more equitable pricing for both parties. 

Additional Test 2: Do You Owe Taxes? 

In addition to the ownership of risks and rewards, businesses sometimes find that they qualify for a credit but can’t claim it in the current year because they aren’t making money, and therefore have no tax liability.  For individuals, alternative minimum tax (AMT) limitations could prevent one from claiming credit, but recent tax changes significantly increased the AMT exemptions and therefore reduced the likelihood that AMT would limit credit on an individual taxpayer level. 

The R&D Tax Credit is not a refundable credit—it can reduce the balance of taxes that you owe, but if you don’t owe taxes it will not generate a refund. The PATH Act, passed in 2015, allows certain start-up businesses to apply the credit against payroll taxes owed, but if you don’t qualify for that break your business will have to carry the credit forward until a year in which it owes taxes. 

So, it may not make sense to invest in having an expert conduct an R&D study and prepare the documentation for claiming the credit.  However, at the time when you have taxable income, claiming the credit may be a prudent strategy … assuming the tax benefit you’ll receive is greater than the cost of the study that needs to be performed!  Regardless of when you do the study, you will want to maintain good internal documentation.  If you do multiple years of R&D credit claims together it is important to have good R&D tax credit documentation so you aren’t “recreating” records and reduce audit risk. 

Connect with a Freed Maxick R&D Tax Credit Expert

New call-to-actionThe important thing to remember is that a claim for the R&D Tax Credit requires careful planning. If you’re looking to hire research on a contract basis or to perform research for hire, your agreements should reflect an understanding of the value of the credit and who will have the right to claim it. 

If your business performs R&D activities but isn’t yet profitable enough to claim the credit now, you need to understand how soon you will get the value of those expenditures back on your tax return. 

These can be complicated issues, and it’s our recommendation that before pulling the trigger on a R&D Tax Credit Study, you look at applicability issues in detail. 

We can help. 

In a 30-minute phone call we can identify whether you’re eligible for the credit and if it makes sense to proceed with a claim. 

To discuss your situation contact us by clicking the button or call us at 716.847.2651.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

 

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Tax Reform and the R&D Tax Credit for Corporations

tax-reform-potential-state-taxation-impactTax Cuts and Jobs Act of 2017 didn’t change the R&D Tax Credit, but the repeal of the corporate Alternative Minimum Tax (AMT) expanded the potential benefit to all corporations that were in AMT.

New call-to-actionThe Tax Cuts and Jobs Act (TCJA) enacted at the end of 2017 did not make specific changes to the Research and Development (R&D) tax credit, but one significant change to the corporate tax system could benefit businesses that claim the R&D credit on their returns. 

TCJA repealed the corporate alternative minimum tax (AMT) for taxable years beginning after December 31, 2017.  As a result, the new law could make all corporate tax credits and carry forward, including the R&D credit, more valuable in the next few years.  

Corporate AMT and R&D Tax Credits 

Before TCJA, a corporation that was subject to the AMT in one year could take an offsetting AMT credit in subsequent years only to the extent that its regular tax liability exceeded its tentative minimum tax. Some corporations were perennially subject to AMT tax and the AMT credits increased over time and were unusable. 

Refund of AMT Credit Carryforwards. Under the new law, any AMT credit carry forwards that weren’t used before the AMT was repealed can now be used to offset the corporation’s regular tax liability. The credit carried forward can be refunded in an amount equal to 50 percent of the excess of the credit for the tax year over the amount of the credit allowable for the year against regular tax liability. (That increases to 100 percent for tax years beginning in 2021.) 

Corporations that have AMT credit carryforwards may now get an additional benefit from the R&D tax credit. To the extent the R&D credit reduces the regular tax liability, it could also accelerate the amount of AMT credit carryforwards that could be refunded during the “50 percent” years.

Application for All Corporations 

In a previous blog, we discussed provisions of a 2015 law change that allowed only certain “eligible small businesses” (ESBs) to apply the R&D tax credit against their AMT due.

Under current law, it appears that this benefit would apply to all corporations, regardless of whether they previously qualified as ESBs for purposes of deducting the R&D tax credit from their AMT liabilities. 

In effect, the elimination of the AMT under the TCJA has expanded the benefit to all corporations. The availability of the R&D credit to ESB would still apply to individual partners or S corporation shareholders who are subject to the AMT on their personal returns. 

Connect with a Freed Maxick R&D Tax Credit Expert

New call-to-actionCalculating and claiming the R&D Tax Credit for a corporation is a complicated process, and it’s made even more challenging if your business is carrying forward AMT credits from prior years. 

If you have any questions or concerns about how the AMT and the R&D credit affect your personal or business taxes, connect with us by clicking on the button or please call the Freed Maxick Tax Team at 716.847.2651. to discuss your situation.

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

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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Good News: No Changes to the Research and Development Tax Credit

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).  

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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.

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Does Filing for R&D Tax Credits Raise an Audit Red Flag?

Does Filing for R&D Tax Credits Raise a Red Flag?New call-to-actionIf your company relies on the hard sciences or uses technology to create or improve products or processes, then you may be eligible for the federal Research and Development Tax Credit. Fear of being audited makes certain taxpayers (generally smaller companies, with limited resources) choose not to claim the R&D tax credit even if they may qualify.

IRS or state audits can certainly take an extraordinary amount of time and resources to handle. However, misconceptions abound about attempting to claim the R&D tax credit and the likelihood of a future audit, possibly stemming from the credit being a Tier 1 issue (i.e. top priority for review) in the IRS old “tiered” system for tax examinations and enforcement. The IRS discontinued the tiered system in 2012 and now leaves the choice to audit R&D tax credits to the discretion of field auditors. Further, recent taxpayer-friendly law changes and announcements clearly identify the importance of the credit as a matter of tax policy and global competitiveness. This in turn suggests that the IRS will not view R&D credit claims with the same level of skepticism as they did historically.

Bogus R&D Tax Credit Claims

There’s no doubt that some taxpayers that don’t qualify still claim fictitious or egregious credits. If a company that researched Van Gogh’s life tried to claim R&D credit, they would be denied because research in the social sciences (economics, business management, and behavioral sciences), arts or humanities is excluded from the definition of qualified research. However, a company that developed new formulation of artists’ paint would not be excluded, however.

Factors Considered by the IRS to Audit a Taxpayer

Certain factors can increase the likelihood of your R&D credit claim being audited:

  • The overall size of your credit claim. The larger your credit claim, the higher the likelihood of audit.
  • The credit you claim versus your industry average.
  • Filing an amended return that claims the R&D credit can also increase your chances of an audit, as all amended returns routinely receive additional attention from the IRS.
  • The industry you are in.  If IRS perceives potential abuse within an industry, you may have a higher likelihood of audit.
  • If your NAICS business code is one that indicates you may not be eligible, then you probably have a higher likelihood to get audited. Examples of such businesses include hair salons and restaurants.

How to be Successful on an R&D Tax Credit Audit

One secret: documentation, documentation, documentation. Regarding the quantitative aspects of claiming the credit, it is important to substantiate the amounts of your qualified expenses with proper records that clearly demonstrate the nexus between the activities performed and amount of credit you’re claiming. Regarding the qualitative aspects of the credit, it is important to provide documentation and/or create a narrative that addresses the IRS criteria to validate the eligible nature of qualifying R&D activities. Establishing the proper framework for supporting the R&D tax credit significantly increases the likelihood the claimed will be accepted on audit for both original and amended returns.    

Other tips for a successful audit:

  • Don’t go at it alone or rely on your deliverable alone. Bring in an experienced R&D tax credit specialist.
  • Respond timely to information document requests (“IDR’s”).
  • Know the IRS audit techniques guides, which the IRS publishes to inform field agents of areas to focus on.
  • Treat your IRS agent with respect.  

New call-to-actionThe R&D credit can provide a tremendous benefit to the right companies. Simply filing an R&D credit claim won’t cause an audit. However, working with tax experts familiar with the R&D tax credit and audit process will help to: (1) ensure the R&D tax credit claim will survive an audit (2) to identify efficient processes for supporting the R&D tax credit claimed every year.   

Please call us today at 716.847.2651 if you would like to speak with us in more detail about the audit process or to evaluate whether your company may be eligible for the R&D tax credit.  

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

 

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New IRS Directive Provides R&D Tax Credit Audit Protection

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New call-to-actionThe federal Research & Development (R&D) Tax Credit can mean tremendous tax savings for companies that fund research and development activities to create new or improved products or processes. Now, a new IRS Directive issued to its examiners aims to streamline the approach to determine the amount of qualified research expenses (QREs) for Large Business and International (LB&I) Taxpayers (i.e. assets equal to or greater than $10 Million).

The Directive applies to LB&I Taxpayers that have Certified Audited Financial Statements (CAFS) prepared in accordance with U.S. GAAP. The CAFS must show QREs calculated in accordance with ASC 730 as a separate line item on the income statement or as a separately stated note.

The Directive may involve some additional work in the first year to establish a framework and schedules to break out certain costs, but should facilitate claiming this valuable tax credit in future years. Under the Directive, IRS examiners are instructed to accept the amount of R&D tax credits claimed by LB&I Taxpayers (based on ASC 730 QREs as adjusted per the Directive) who choose to follow the procedures outlined in the Directive.

The Directive applies to original returns timely filed (including extensions) on or after September 11, 2017. It can also apply to years under an IRS audit if, at the start of the audit, the company indicates that it intends to follow the Directive.  

Get a copy of the new R&D Tax Credit Directive here.


Optional Methods for Claiming Research & Development Tax Credits

LB&I Taxpayers now have the option to have a traditional R&D tax credit study performed to support the tax credits claimed, or to follow the procedures outlined in the Directive which should provide IRS audit protection, but may reduce the amount of the tax credit claimed.

The Directive effectively provides a “safe harbor” methodology when claiming R&D tax credits. In addition, the LB&I Taxpayer may increase the amount of the R&D tax credit claimed by including additional QREs allowed under the IRC that are not included in the Directive.  These QREs are subject to IRS examination and therefore, this portion of the R&D tax credit claimed may constitute an uncertain tax position impacting the CAFS. A limited scope R&D tax credit study can be performed for any QREs that don’t fall under the safe harbor.

Given the optional methods to substantiate R&D tax credits, LB&I taxpayers should consider having a feasibility analysis performed by an R&D tax credit expert to compare the potential tax benefit and related costs under both methodologies.  In addition, LB&I Taxpayers may realize cost savings in time and effort to compile and substantiate QREs, particularly where the QRE identification process is time consuming or complex.

Eligible QREs under the Directive

The eligible QREs under the Directive focus on wages and supplies.  For instance, generally 95% of the taxable wages of “qualified individual contributors” and “first-level supervisors” (i.e., those with only one level of employees directly below them) whose wages are charged to R&D cost centers and expensed as ASC 730 R&D costs are included in the safe harbor under the Directive.

W-2 wage and supply expenses excluded from the Directive include costs incurred to perform R&D under third-party contracts and other agreements, patent costs, severance pay, and expenditures not otherwise allowed as QREs for income tax purposes such as efficiency surveys, wages used in computing the work opportunity credit, and foreign research.

LB&I Taxpayers who choose to follow the Directive will need to establish the organizational reporting levels and structure of employees whose costs are expensed as ASC 730 R&D costs, as well as identify appropriate financial information. This involves extracting, organizing and validating data needed to breakout the eligible ASC 730 R&D costs for use in calculating the R&D tax credit.  

LB&I Taxpayers who don’t currently disclose ASC 730 R&D costs may find it beneficial to identify, compute and report these costs in their CAFS.


Talk to the R&D Tax Credit Experts

New call-to-actionCalculating your company’s adjusted ASC 730 R&D costs can be complex. If you’re an LB&I taxpayer with CAFSs and have QREs (even if you don’t currently claim R&D tax credits), you owe it to yourself to investigate whether this Directive identifies new QREs or can simplify the time and effort to compile and substantiate QREs.  This could provide the audit protection you desire and limit reporting the uncertain tax position in your CAFS.  

We can help.

Click here to schedule a 30-minute consultation regarding whether your company is eligible to claim R&D tax credits and the new Directive.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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3 Reasons That Small Businesses Overlook the R&D Tax Credit

Reasons-Small-Businesses-Overlook-the-R&D-Tax-Credit-LARGE-771845-edited.jpgThe R&D tax credit can deliver significant tax savings, but many small businesses don’t realize it’s available to them.

New call-to-actionYes, there is a tax credit available to all businesses, including small businesses, for R&D costs. The tax credit has been a part of the tax code in some form since the 1980’s, although for the vast majority of that time it was considered “temporary.” It had to be extended 16 times before being made permanent in the Protecting Americans from Tax Hikes (PATH) Act of 2015. Perhaps the on-again/off-again uncertainty of the tax credit’s availability has led to its underutilization by many of the businesses it was designed to help.  

Whatever the cause, so many eligible taxpayers are failing to claim the available small business R&D tax credit that some members of Congress have introduced legislation aimed at improving government efforts to educate small businesses on the topic. There are two bills currently in the Senate and House, S. 650 and H.R. 1543 that would require the IRS and the Small Business Administration to work in partnership to develop basic training sessions and related information relating to federal income tax credits, especially R&D tax credits that benefit small businesses and start-up companies.

Those efforts should focus on 3 main problems:  

  • Small businesses don’t know the R&D tax credit exists. In the early stages of a business, tax planning sometimes takes a back seat to tax preparation. Owners who prepare their own tax returns or rely on tax preparers with limited experience may fall into the trap of “doing it like last year” instead of analyzing each year’s income and expenses with a clean slate. A failure to recognize the availability of the R&D tax credit in one year can be compounded by repeating the mistake in future years.
  • Small businesses don’t think they have R&D expenses. Many taxpayers skim past the R&D tax credit because they assume it’s only available to companies “in the business” of research and development, like a pharmaceutical or technology corporation. In fact, the tax credit is based on the activity performed, not the industry of the taxpayer. Costs may qualify for the tax credit if the activity:
    • --Is designed to eliminate a technical uncertainty,
    • --Includes some process of experimentation,
    • --Is technological in nature, and
    • --Is intended to create a new or improved product or process.

Activities focused on improving or redesigning existing products, as well as designing new products, can qualify. Costs associated with creating or improving a manufacturing process or new software may be eligible. Recent IRS guidance even eased limitations on eligibility of R&D expenses related to the development of internal use software.

  • Small businesses don’t have an income tax liability against which to claim the tax credit. Until recently, this hurdle used to make many startups and small businesses ineligible for the tax credit at a time when they most needed support. As part of the PATH Act, Congress enacted provisions allowing certain qualifying startups and new small businesses to claim the tax credit against the employer’s share of Social Security taxes and to calculate the tax credit without regard to alternative minimum tax limitations. 

New call-to-actionNow that the R&D tax credit is a permanent part of the tax code and its applicability to small businesses has been expanded, many businesses are taking the time to learn more about the tax credit and find out if they qualify. The calculation of tax credits and the election to claim them can be a complicated process. If you’re wondering whether your business (small or large) may be missing out on these R&D tax credit savings, please contact us at Freed Maxick.

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Freed Maxick CPAs, P.C. is Western and Upstate New York’s largest public accounting firm and a Top 100 firm in the United States. Freed Maxick’s reputation and experience with business and tax issues has made us a go-to firm for businesses and individuals from all over the U.S. and Canada and around the world.

For more insight, observations and guidance on the R&D Tax Credit, visit our Freed Maxick Guide to the Federal Research and Development Tax Credit webpage.

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