On-Demand: The New R&D Credit Rules

So in terms of agenda, there's three certainties. There's death, taxes and updates to the R&D credit. We get one just about every year now, so I figured I'd start with that. So today we'll go through updates to the credit, very important changes to the deductibility of R&D expenses. Allie will talk about some of the financial statement considerations of these impacts, and then we'll close with some potential substantiation requirements that might be coming down the pipe.

So just a quick background, the credit is governed by section 41 of the revenue code. The deductoin is governed by section 174. The credit was originally acted in 1981 as a general business credit, and it can be carried forward for 20 years and carried back one year. Historically, the credit could only be used against income tax liability, but that changed in 2016 under the Path Act. And starting in 2016, qualified small businesses could elect to use the credits against future payroll tax liability.

So this was a huge deal for startup companies, where previously loss companies could only carry forward the credit and they didn't know whether or not they were going to use it or not. Now there's an opportunity for companies to claim up to $250,000 against payroll tax liability, and they can do that for up to five years, and we'll get into the definition of what a qualified small business is and some of the updates to it. Just a quick note on just a credit and how it works. The work has to be done in the US it's activity based and the credit is incremental over a base amount.

So in terms of the major update, the first and most important update was the increase of the credit from the inflation reduction act. So starting in 2023, the amount of credit eligible to be used against payroll tax liability has increased from 250,000 to 500,000. So this is a very big deal for larger startups and life science companies that have significant R&D spend. To put it in perspective, using the gross credit, a company would have to spend about $5 million in R&D to get that $500,000 of credit. Obviously you don't need to max out the $500,000 to take advantage of this incentive. So in terms of who is eligible for the payroll offset this 250,000 in 2022 and the 500,000 in 2023, we go through this question. Or I probably go through this question at least twice or three times a week.

The qualified small business must have less than five million of revenues of any kind in the current tax filing year. So last year that would've been for 2021. And the second element is there needs to be zero receipts of any kind prior to five years from the tax filing. So the count of the five years includes the tax year as well. So to illustrate the criteria here, just because the way that the wording of the rule is, people typically just don't understand it correctly. So for 2022, we have our current filing year, so we need less than five million of receipts of any kind in that current filing year. And then the count starts for 2022. So you'll see the five year count there. So we need zero receipts prior to 2018. So if we were formed in 2016 or '17 and we had $20 of interest in '16 or '17, we would be considered ineligible to claim the credits against future payroll tax.

You can still claim an R&D credit and carry it forward or use it against income tax liability, but you couldn't make that election. One other note on this table is tax years matter. The phrasing of the notice that interprets these rules includes tax years and not say calendar years. So if we had a couple of short tax years in say 2019, that would up the year and then we would need zero receipts prior to 2019. So it's just a quick note, if you have short tax years, that is a concern out there. So from a procedural perspective, how do you effectuate the election? On form 6765 section D, line 41, there's a little box there, that has to be checked. And then in the line item underneath, you have to put in the amount of credit that you're electing to use against payroll tax.

There is no relief available if you do not make this selection on your originally filed including extension return. So this is very important, especially as we go through busy season and everyone's reviewing tax returns and trying to figure out, or trying to get everything out the door, is making sure that the form is actually filled out correctly. And then after that, the way that you monetize the credits is you file a form 8974 in the quarter following the tax file. So say we filed tax return on October 15th, 2022 for the 2001 tax return, we made our elections, we start using the credits in Q1 of 2023. And so we provide either our PEO or our payroll provider an 8974. They include that in your 941 and then you save 50% of otherwise payroll tax due on a go forward basis. Every PEO and payroll provider, they have different processes on how to do this, so it is important to ask them what they need.

Some of them want the 6765 as well. For PEOs there's sometimes a lag time in terms of getting the money because they have to do it on your behalf. And I know some people have issues with some of their payroll providers, them sometimes delaying it, some delaying the payment. So it's something to keep in mind just talking to the sales rep or whoever your representative is, to make sure that you understand the process and what they need so they can get it done timely and make sure that you get the savings that you're really owed. And-

Allie Colman:My turn-

Tim Rankins:Sorry. Oh, yep sorry Allie.

Allie Colman:That's okay. You can talk about financials if you want. But so the R&D credit, when you are using your R&D credit as it was historically intended to be used against income taxes, nothing's really changed in this area. So just some things to note that might not necessarily seem logical or intuitive, is that if you are generating an R&D credit in 2022 and you are not utilizing that credit, so you're creating a credit carry forward to be used against income taxes, you're creating a deferred tax asset. Sometimes people are inclined to think that if you have a deferred tax asset, that there would be no impact to your income tax expense or your rate rec in your financial statements. But the R&D credit is an exception to that, because in the year that you generate an R&D credit, if you're not utilizing it, you're creating a deferred tax asset with no current period benefit and you're not saving current year expense.

So you'll see the creation of an R&D credit carry forward sitting within your tax footnote within your deferred tax table and also on your rate rec. If you're utilizing a current year credit that you're generating, you're also going to see that on your rate rec, but going the other way because you're having a current period savings but no offset to your deferred taxes. So just something to throw that out there. I know people think deferred tax asset and assume don't need to worry about it not going on my rate rec, but that's not the case for R&D credit.

When you're electing to offset your payroll tax with R&D credit, it no longer becomes an item that's governed by ASC 740. So to the extent that you're taking a portion of your tax credit and offsetting it against payroll taxes, that is going to get reclassed to above the line. You're going to create a payroll tax receivable and a reduction to your payroll tax expenses above the line, and then when you collect the cash, you're just going to reverse the receivable. So just some little things, tips and tricks that I wanted to point out. And in our little 30 minute webinar today, I would say that the R&D credit is the protagonist, it's the good guy. Now we're going to jump into the antagonist. We're going to talk about the bad guy related to R&D. So back to you Tim.

Tim Rankins:Yeah, I did some online CPEs in December and I was doing some of the online Becker ones and this one guy Stan Pollock who I enjoyed, he would say "The IRS giveth and the IRS taketh away." And so we have this nice tax incentive that's been doubled for new small businesses. Well now we have tax treatments that actually disincentivizes R&D investments. So as part of the tax cuts and Jobs Act back in 2017, there was a provision that starting in 2022 requiring taxpayers to capitalize and amortize their R&D expense over five years if it's incurred in the US. And 15 years if outside the US. And there were several attempts to either delay the implementation of this provision that was in the original Build Back Better bill, or remove the provision entirely with the Omnibus bill. Obviously that didn't happen. So the current law of the land is this capitalization, what I call regime. And you had over 60 years, the tax treatment was to deduct R&D expense and most companies weren't concerned about it to account for it because they could deduct it as an ordinary necessary business expense anyway.

Now they're required to figure out what their R&D expense is. And to give you the definition of R&D and the way it's phrased in the internal revenue code is R&E, research or experimental expenses. So you have the historical, standard definition of R&D, which is expenses related to the development or improvement of a business component where there's uncertainty involving capability method or design. And so this definition right here, they layer it down or kind of peel back the onion a little bit in the regulations, but at the end of the day what they say is laboratory or experimental sense. And then they get down to all right, development or improvement where there's uncertainty. And then it's capability method or design. Now what we'll see here is they added this phrase specified research, specified R&E expense in here in. What that does is, it gives you the standard definition and then it's essentially in addition, they say a specified R&D expense also includes any amount paid or incurred in connection with the development of any software shall be treated as R&E

So by picking out software development, it removes the flexibility or the wiggle room of say, a technology company that wants to be out of this regime that doesn't want to capitalize to say, well there was no uncertainty related to the development of our software. We felt fairly certain of it, therefore we didn't think that we needed to capitalize it. Well, this line item here brings it all in. And I was on a call right before this webinar explaining that to a software development company in how it works. So it does in my opinion, create some issues. And for as long as I've been in this arena, the IRS has been coming in and arguing that what you do is not R&D, it's not uncertain. Now it's the opposite where they're coming in and they could potentially argue that you should be under this capitalization regime. You should be amortizing these costs rather than expensing them because there is uncertainty that exists.

So this is that definition that I was just mentioning. Activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. And then we have our uncertainty related capability method or appropriateness of design. In terms of some of the differences, and I get these questions a lot between section 41 with the credit and section 174 with the capitalization. In order to be eligible for the credit with section 41, you needed to have been eligible for 174. So if you're claiming an R&D credit on your tax return, you need to make sure that you're capitalizing at a minimum those expenses for 174. The 174 is also broader than section 41. So 41 with the credit, you have wages, supplies, contract research is eligible costs.

Section 174 is any amounts in connection with. So that would include your wages, supplies, contract research, but it would also include other indirect costs. And then you have your 15 year for non-US. So you wouldn't be able to claim any costs outside the US as part of the credit, but now you actually have to amortize them over 15 years. For 2022, it's under mid-year convention. So for 2022, taxpayers are only going to allow an amortization deduction of one 10th of US expenses and one 30th of non-US expenses. So this is a very, very big deal for five years. I told clients not to worry about it. It's a bipartisan issue that Congress is going to figure out a way to fix this and we're not going to have this capitalization regime, and we are now in 2023 and I have to finally admit that I'm wrong.

We'll see if it sticks around because there is still an appetite on one side of the aisle to get it into some bill. But the Omnibus bill was large and it didn't make it in that. And at a certain point, I think taxpayers are going to have started to account for this and in my opinion, kind of move on with their lives and not lobby congress as much for this and find something else to ask for in my opinion. So one note on this is there was a rev proc that came out recently in December saying that there is no form 3115 change of accounting method is required. So that that's nice, at least taxpayers don't have to file that. But in terms of financials, we'll kick it back to Allie.

Allie Colman:Thank you. Yeah, so just recently finding out that no 3115 requirement was definitely a surprise and a good one, something going our way. But a few things I want to mention. So the capitalization of R&D expenses is a temporary item. You're still going to be able to deduct the full amount of your R&D spend, just not all in the year that you incur it. So as Tim mentioned, to the extent that the R&D is incurred in the US and performed in the US, it gets capitalized over a five year period. To the extent that the R&D is performed overseas, it's a 15 year period. Something that we have been discussing a lot with my clients that I've seen is, just because you're paying a US CRO to do your R&D, if the actual R&D is not being performed in the United States and it's being performed somewhere else, you need to look through to determine where the R&D is being performed.

Just looking at the entity and the billing address of who you're paying isn't going to cut it. But anyway, so because you are going to eventually deduct the same amount of R&D expenses for book and tax purposes, it's a temporary item. I've already talked about deferred tax assets and this is another one of them. So we'll have a new deferred tax asset on our tax footnote that is going to be called likely R&D expenses. We expect to see obviously the biggest hit to your tax return and to your taxable income, assuming you have a consistent R&D spend, is going to be in 2022. Because as Tim mentioned in 2022, you're only going to be able to deduct 10% of the current year costs. Then next year in 2023, you'll be able to deduct 20% of your 2022 costs along with 10% of your current costs.

So the year before you were only able to deduct 10%, in year two, you're essentially getting to deduct 30%. 20% of the year before and 10% of the current year. We need to look at how the capitalization of these R&D expenses is going to impact your 2022 taxable income. And that then can lead to us discussing things such as your valuation allowance. If you know that you're going to be utilizing net operating loss carry forwards, you likely should be removing the... You should do the analysis to see if evaluation allowance on the full amount of your net operating losses is necessary. Same thing with a lot of companies that are pre-revenue, that are pre profit, have just been carrying forward their R&D credits and net operating loss carry forwards, not tracking things like ownership changes for 382. So we need to make sure that if you're utilizing NOL, that those attributes are valid because if you have a greater than 50% ownership change in a three year period, everyone looks at NOLs under 382 to know that they're limited.

But 383 is there also. And that says that there's a limitation on your R&D credits as well. So if this regulation, if this law is putting you into taxable income, there's a lot of areas that it's a domino effect, a lot of other areas that you need to consider. 163J carry forwards as well of course. One thing that I would be remiss if I did not acknowledge is states. So do states all conform to the capitalization of R&D? And they good news, they don't. So California, for example, as of today, California does not conform. So you'll have a state modification, a good guy in California that's going to reduce your California taxable income. And the other thing, we could have mentioned this when we did the R&D credit, but remember that the R&D credit most often does not bring your tax liability to zero, unless your tax liability is pretty minimal.

It usually only offsets 75% of your tax liability. And because of the lovely TCJA, we have the 80% limitation on net operating losses from 2018 and after. So if you're a new company, Fred that began in 2018 to now, and you have NOL carry forwards, you have R&D credits and you're thinking to yourself, "I'm going to be fine. This isn't going to impact me. I have hundreds of millions of dollars of NOL carry forwards." Unfortunately that's not the case. So just make sure that we're running the numbers, that you're putting pen to paper because sometimes what you think in your head, where you're covered, you may not be when you actually do the compensation. So Tim, to you.

Tim Rankins:Thank you. One note that I wanted to make is on that 3115, in 2022 it doesn't have to be filed. But if you did not capitalize R&D for 2022 and it's the same types of expenses and you're going to for 2023, or if you change your method from 2022 and start expensing it, a 3115 is required in that following year. I did think that's a noteworthy point. So substantiation concerns. So there was a directive that came out a couple of years ago requiring additional disclosures if the company was amending a prior year tax return for R&D credit refund. That's currently on hold, but those disclosure requirements that are a part of it are now being considered as part of the standard filing of the 6765. I think this could be a very, very big deal. The disclosure requirements is listing of a business component, a description of the business component, and then qualified research expenses by business component.

So there's a lot of companies where we have a list of employees, let's say 20 employees, and they say these five people, 80% are eligible for R&D. These people are 50, these people are 20. We add up the box for W2 wages and we have a credit. These disclosure requirements are going to require time allocated and cost allocated by business component. So it's essentially requiring taxpayers to put together the information that would've been asked under exam. And it's more of a compliance fee cost and a time cost on taxpayers to have to put this information together just to get the R&D credit. This is something that's being discussed. It's not there yet, but if it is, it would be for 2023 or later than that. But the way that it's going, it appears that this will become part of the R&D credit at some point and part of the filing process.

In my opinion, it's a little unfair to taxpayers. I think there's just what I would call bad apples in the marketplace. And the IRS and the treasury don't trust them. And so what they want to do is essentially pre-exam and pre-review these credits before everything's actually processed, or have some information to be able to select it for further examination. So it's a pretty big deal because I know a lot of clients that their credit's say $50,000, they're using against payroll and they don't want to spend $10,000 to $15,000 putting together all the documentation for a $50,000 credit. So it's still uncertain if this is going to go through, I think it will end up going through, it's just whether or not it's 2023 tax year or 2024 tax year.

Allie Colman:And Tim, I think it's also important that similar to NOL carry forwards, if you claim an R&D credit on your tax return, I believe the audit period doesn't start until the year you use the credit.

Tim Rankins:That's right.

Allie Colman:Not the year the credit is generated. So if you are carrying forward R&D credit for 17 years and then you use that credit in 2024 and the IRS comes in and questions it, if you don't have the documentation to substantiate your credit, I'm not going to do that math in my head right now from 17 years ago, then you might be in trouble. So that's why I always encourage my clients to make sure it's easier to put together the documentation in the year that you're incurring the expenses to recreate rather than recreate history and look through old time logs to figure out how the three CEOs before you figured out how much R&D to put on their tax return.

Tim Rankins:Yeah. The subject matter experts end up leaving and they're not around to justify it anymore.

Allie Colman:Right, exactly. So just wanted to throw that out there. And along with the documentation, I know a lot of public companies and private companies have uncertain tax positions against their R&D credit, and that's just if a company doesn't have a proper R&D study or a reputable firm putting together documentation, it's one of the highest items that's scrutinized under audit by the IRS. So most clients have an uncertain tax position. If you do one of those studies or have the proper documentation in house, you can argue that that uncertain tax position can be lesser.

Capitalization. If it's not something that you considered for your estimated tax payments, make sure it's something you consider before your extensions. Because remember extensions are extensions of time to file, not to pay. And if you don't have a certain amount paid in by April, assuming you're a calendar year end, then your extension may be invalid. If you have foreign forms, if you have 5471s or 5472s that come with the 10,000 or $25,000 penalties for late filing, that could be a big deal. So make sure that you're doing your due diligence to make sure you're capturing the appropriate amount of R&D spend into your taxable income.

And lastly, I'll skip over reading licensing agreements. Just if you're a CRO or if you're entering into a license agreement, make sure that you're reading who at the end of the day owns the R&D because that matters, of whether or not the expenses fall into 174 for you or the other party. And then also, of course, with the federal R&D credit, about two thirds of states have some sort of state R&D credit. I know Pennsylvania has a refundable R&D credit and a few other states have refundable credits that you don't necessarily have to carry forward. So make sure that when you're doing your R&D analysis, you're including which states the payroll is, where the employees are working that are doing the R&D, where the contract research organizations are. Because all of those things could help you. The more information, your credit, the subject matter experts know the better. So Tim, you have anything else to add before we wrap up?

Tim Rankins:No, I was going to say we kept it brief, 30 minutes. Which I think, I hope it was helpful for people because it just touches upon, in my opinion, the most impactful topics as it relates to this. And if you have any questions, please feel free to contact me or be around.

Allie Colman:Yeah, we have some questions. We got quite a few questions coming in. We just didn't have time to get to them, but if you asked a question, we will send you an email and get back to you. I can promise you that.

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