Promising Tax Legislation for Technology Start-Ups
The recently enacted Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) provides significant tax incentives for technology startups. The law, signed by President Obama in December 2015, makes the research and development (“R&D”) credit permanent and affords certain taxpayers the ability to use the credit against the alternative minimum tax (“AMT”). Most importantly for technology startups, the new legislation permits qualified small businesses (“QSBs”) use of the R&D credit to offset payroll taxes. This “game-changing” facet of the legislation permits technology startups -- naturally encumbered with significant research and development expenditures coupled with no income tax liability in their formative years -- the opportunity to avail themselves of the credit in the near term.
The R&D credit was first introduced in 1981 as a temporary measure in the Internal Revenue Code (the “Code” or “IRC”). The R&D credit has expired 8 times and been renewed 15 times since its original appearance in the Code. With the long-awaited permanency of the R&D credit and its applicability to payroll taxes, small technology companies are finally able to achieve a near-term tax benefit that larger entities with tax liabilities have long utilized. Prior to the PATH Act, technology startups, which generally have no tax liabilities in their early years, found no immediate ability to use the credit. Alternatively, this important and vital group of taxpayers would have to settle with the long-term prospect of net operating losses (“NOLs”) that could be carried forward to offset future tax liability or claim the credit in order to create a deferred tax asset (“DTA”) for book purposes that may be utilized in the future. The PATH Act has partially eliminated this incongruity between emerging technology companies with no tax liability and profitable technology companies with annual tax obligations.
The PATH Act amends IRC § 41 (R&D Credit) by permitting QSBs to use the credit to offset taxes imposed by § IRC 3111(a), the old-age, survivors and disability (“OASDI” aka “social security”) portion of an employer’s FICA taxes. While the exact amount of credit taken is dependent on a number of factors, the credit cannot exceed $250,000 in any year. In general, under the PATH Act, a QSB is now a corporation (including an S corporation), partnership or person if:
- its gross receipts are less than $5 million; and
- it did not have gross receipts (as so determined) for any taxable year preceding the 5-taxable-year period ending with such taxable year.
Hence, the definition of QSB should capture a large spectrum of newer technology companies.
To use the credit, the taxpayer must make an election under § 41(h) specifying the amount of credit sought and it must be made on or before the due date of the taxpayer’s income tax return, including extensions. Once elected, the taxpayer may offset its FICA taxes with the R&D credit in the first calendar quarter after the return is filed. If the FICA taxes are less than the credit for a particular quarter, the excess is allowed as a credit against the FICA taxes for the following calendar quarter. A taxpayer is limited to making the election for 5 years.
In terms of who is considered a taxpayer for purposes of the credit, certain aggregation and allocation rules under IRC § 41 are applicable. For example, members of the same controlled group of corporations are treated as a single taxpayer; and trades or businesses, whether or not incorporated under common control, are treated as a single taxpayer. In instances where multiple taxpayers are treated as a single taxpayer for purposes of the credit, the aforementioned $250,000 limitation is allocated pro rata according to each member’s applicable research and development expenditures.
Readers should note that the credit described herein does not impact the deductibility of the taxes imposed under IRC § 3111(a).
Near-term tax benefits always improve the appeal of technology startups to investors eager to provide capital. Further, the credit affords technology startups the opportunity to innovate and focus on projects they may have not considered prior to the change. The benefits of the PATH Act for technology startups are clear and significant.
This aspect of the PATH Act will undoubtedly receive further guidance as the IRS has been mandated to issue regulations in this area. Readers are encouraged to contact a tax advisor in the interim to understand how the R&D credit may benefit their company and the mechanics of the election discussed above.