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The PATH Act of 2015 Makes Research and Development Tax Credit an Immediate Tax Benefit for Start-up Companies

Why It Matters
Since being enacted in 1981, the Research and Development (“R&D”) Tax Credit has been rewarding businesses for conducting research activities in the U.S. A great incentive, but not a perfect provision, the Credit had long been criticized for favoring more established businesses. Often, new, small companies (frequently the country’s most innovative) could not realize an immediate benefit from claiming the R&D Credit because they did not generate a tax liability. We are happy to say that this has now changed due to the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 bringing awaited changes into place. The PATH Act not only permanently extended the R&D Tax Credit, but it has also made it even bigger and better.

What Has Changed
The PATH Act boosted the number of companies that can now be instantly rewarded for performing qualified R&D activities in the U.S. Under the pre-PATH Act legislation, companies were allowed to claim the R&D Credit against income tax only - preventing businesses yet-to-become profitable to monetize the credit when they were in the most need for additional capital. However, effective January 1, 2016, certain companies can apply the R&D Credit - regardless of profitability – against the employer portion of the Federal Insurance Contributions Act (“FICA”) payroll tax, if they:

  • Meet the definition of a Qualified Small Business (“QSB”)
  • Conduct qualifying research activities in the U.S. and incur allowable costs

Who Can Benefit
Under the PATH Act, payroll tax offset is only available for a QSB. A company is deemed QSB by legislation, if:

  • It is a corporation (public entities, non-public entities, and S corporations are considered qualified corporations) or a partnership
  • It has gross receipts of less than $5 million during the tax year
  • It has gross receipts for 5 years or less. Hence, a company will not be deemed an eligible QSB for the 2016 credit year if it generated gross receipts before 2012. Thus, a QSB must be less than five years old or, if older, have no gross receipts in any tax year before the five-year lookback period

What Is the Benefit
The refundable payroll tax credit is limited to the lesser of:

  • $250,000 – the maximum benefit allowed by this provision
  • The R&D Credit calculated for the tax year
  • The amount of business credit carryforward accumulated after January 1, 2016 (if not a partnership or S Corporation)

What You Should Do
Eligible companies should take the following steps each year in order to claim the payroll tax credit:

  • Calculate the allowable R&D Tax Credit for qualified research activities conducted in the U.S. after January 1, 2016
  • Calculate your estimated and eligible FICA taxes for a tax year subsequent to a credit year (e.g. 2017 tax year for 2016 credit year). The R&D Credit cannot offset the entire employer portion of the FICA tax. The R&D Credit can only offset the Social Security, or old-age, survivors and disability insurance (“OASDI”), portion of the FICA tax. Thus, the Credit cannot be taken against Medicare, or hospital insurance (“HI”), portion of the FICA tax
  • Make a payroll tax credit election within the above noted dollar limitation on a timely and originally filed business tax return (including extensions). Please note, this election is irrevocable and cannot be made on an amended tax return or be claimed for more than five consecutive years
  • Calculate the refundable payroll tax credit (Form 8974) and report it on a quarterly payroll tax return (Form 941). The payroll tax offset is available during the first quarter after the QSB tax or information return is filed. Hence, assuming a calendar year-end, the earliest your company can realize a benefit is October of 2017, if your tax return is filed on April 15, 2017, or January of 2018, if it is filed on September 15, 2017. The refundable payroll tax credit cannot exceed OASDI liability for the quarter with any excess being carried forward to the following quarter
  • Substantiate the R&D Credit claimed. Historically, the credit has been a hot and controversial issue during IRS examinations. Up to this point, unprofitable companies had been receiving little or no attention from federal and state tax authorities regarding credit claims. Lack of tax benefit usually translates into a lack of attention. The PATH Act has changed this. With the new legislation turning the R&D Credit into actual cash savings, companies will surely be subjected to greater scrutiny in this area. Therefore, ensuring the Credit is calculated correctly and is properly documented is key to later defending the credit claimed. Now is the right time to find a team of specialists with deep technical knowledge in this complicated area

How It Works in Practice
The concept of payroll tax credit can be better understood through an illustrative example. Let’s play the same scenario under both the pre-PATH and the PATH Act legislation.

“ZZZ” is a Boston-based robotics company founded in 2016. Being a lucrative investment option for its visionary ideas and stunning growth, the company just raised a Series A round at $35 million from “Friendly VC”. ZZZ has a federal research credit of $150,000 for developing human-like helper robots. Under the old provision, as a company with losses-to-date, ZZZ is not able to instantly monetize its R&D Credit and, instead, carries the Credit forward until it becomes taxable.

However, with the legislative changes brought by the new PATH Act, ZZZ is able to derive some tax benefit for its development efforts. The company’s 2017 payroll is at $2 million, hence, its social security tax to be paid is $124,000. ZZZ meets the legislative definition of a QSB. Therefore, it can take a payroll tax credit of $124,000 with $26,000 becoming subject to the credit carryforward rules. ZZZ can now invest its before-tax savings of $124,000 in accordance with its current business needs.

Talk to Us
The R&D Tax Credit has a well-deserved reputation of being a controversial and subjective matter among taxpayers, tax authorities, and tax professionals. Now, in the light of the new legislation, even more issues can arise. If you have questions, would like additional information, or want us to talk you through how this new legislation impacts and can benefit your business, please, do not hesitate to reach out to:

Joseph Burnett, CPA, Tax Senior Manager, at 617-428-5494 or jburnett@wolfandco.com, or
Hanna Mialik, CPA, Tax Staff, at 617-933-3359 or hmialik@wolfandco.com.