R&D Tax Credit Considerations in the Wake of New Legislation and COVID-19

November 19, 2020

UPDATED: 11/20/2020, 3:30 PM

By Tim Rankins

Since its inception in 1981, the research and development (“R&D”) tax credit has been one of the largest tax benefits available to eligible taxpayers. Now that election night is over, the most popular question is: “How does (or will) this affect my company’s credit going forward?” This article will provide a brief summary of tax reform – especially the CARES Act – and the implications for R&D credits.

Biden Presidency/Tax Reform

As of today, it’s still unclear which party controls the Senate. If a “blue wave” were to occur and corporate tax rates were potentially increased, it would change the rate of return from qualified research expense (“QRE”) to credit. The reason is the IRC Sec. 280C election. IRC Sec. 280C(c)(3) allows for companies to take a “reduced credit.” This mechanism provides that companies don’t have to offset their deductions by the amount of the credit. The election is based upon the corporate tax rate and listed on lines 17 and 34 of Form 6765, depending on the credit method claimed. To illustrate how a rate change affects the credit, let’s look at the change in ROI as a result of the Tax Cuts and Jobs Act.

The credit is incremental over a base amount, so let’s assume company A is claiming the regular credit method. It has $10,000,000 of qualified research spend in the tax filing years and 50% of current year QRE is less than the incremental QRE (e.g., low base amount). 

Pre-TCJA (Corporate tax rate of 35%) –

Current Year QRE $10,000,000
50% of current year QRE $ 5,000,000
Gross Credit at 20% credit rate $ 1,000,000
Reduced credit after 280C election $ 650,000
ROI (credit to QRE) 6.5%

TCJA (Corporate tax rate of 21%) –

Current Year QRE $10,000,000
50% of current year QRE $ 5,000,000
Gross Credit at 20% credit rate $ 1,000,000
Reduced credit after 280C election $ 790,000
ROI (credit to QRE) 7.9%

In summary, the taxpayer’s credit above went from $650,000 to $790,000, an approximately 20% increase based solely on the corporate tax rate reduction. Which leads to the ramifications of tax reform in a post-2020 election.

Biden Plan (Corporate tax rate of 28%) –

Current Year QRE $10,000,000
50% of current year QRE $ 5,000,000
Gross Credit at 20% credit rate $ 1,000,000
Reduced credit after 280C election $ 720,000
ROI (credit to QRE) 7.2%

As shown above, if the corporate tax rate is increased to 28%, the above taxpayer’s credit will decrease from $790,000 to $720,000.

An important note – the IRC Sec. 280C election is a function of the corporate rate. Therefore, although pass-through entities and individuals may have different rates, the reduced credit is still computed by the corporate tax rate. Taxpayers should analyze whether it’s more beneficial to not utilize the IRC Sec. 280C election, claim the gross and credit and adjust their deductions.

COVID-19 Implications

The business disruption caused by COVID-19 is immense. There are some obvious and not-so-obvious ramifications on company’s R&D tax credit going forward. Let’s start with the obvious.

Layoffs/Furloughs/Reduced R&D investments

The research credit is a function of qualified research spend, mainly wages. Companies undergoing large layoffs in 2020 will undoubtedly see a corresponding reduction in their research credit. Furloughs were also heavily used. Generally, furloughs will result in a reduction of overall wage pool for the credit. However, taxpayers should be cognizant that wages as a QRE are a function of total work hours, not total hours in a given year. For example, an employee working 40 hours per week less holiday and paid time off may work a total of 1900 hours. Now if that employee was also furloughed for two weeks, that would decrease total hours worked to 1,820. If the taxpayer neglects this adjustment in their calculation it can have dramatic effects on the credit depending upon the size of the organization.

CARES Act

For taxpayers who received PPP loans and receive forgiveness of those loans, it could have implications on their research credit in the year in which the loans were forgiven. First, for loans to be eligible for forgiveness, at least 60% of those loans must have been spent on payroll. As noted above, most company’s research credit is from the wages paid to personnel to perform qualified research. If the company receives the forgiveness, those wages paid to perform qualified research would be considered “funded research” and therefore not eligible for the credit. It’s important for companies to track the loans and identify what those funds were used for. If the funds were used for non-eligible expenses, such as rent or utilities, those will not affect the credit.

In conclusion, research credits claimed in the 2020 and 2021 tax years will have increased variability due to the items discussed above. Taxpayers should consider these issues proactively.

UPDATE – On November 18, the IRS released Rev. Ruling 2020-27, which states that taxpayers cannot deduct expenses funded with PPP loans where they have a reasonable expectation of forgiveness. In this scenario, the CARES Act will most likely impact taxpayers 2020 R&D tax credit calculations. If companies cannot deduct salaries or wages covered under PPP, they will not be eligible as a qualified research expense.

About Tim Rankins

Tim Rankins is a Senior Tax Manager with over 10 years of experience with focus on Research and Development Tax Credit.