Many businesses fail to take a tax credit for their research efforts because meeting the criteria set by the IRS can be daunting. But businesses that fail to do so may be missing out on what could be a significant tax savings, says John Carey, CPA, JD, an associate director for the tax department at SS&G.
“The Small Business Jobs Act expanded the carryback period for many business tax credits arising in 2010 and beyond, including the research credit, from two to five years for eligible small businesses,” says Carey. “These are privately held companies with revenue under $50 million, many of which were profitable in the years before the recession. The longer carryback period opens up some of those years, and taxes paid then can be recovered by carrying back credits generated currently. That can be a huge boost to cash flow.”
Smart Business spoke with Carey about how to make the most of the tax credit for increasing research activities.
What is the credit for increasing research activities?
The credit, commonly referred to as the research and development tax credit, is a tax incentive designed to encourage businesses to take the risk of putting their resources into research to develop new products and technologies. That research must take place in the United States and has to meet four criteria. It has to involve technical uncertainty — it’s not a sure thing that you will be able to accomplish this, so there is an element of risk; there has to be an attempt to develop a new product or process, or to improve the functionality of an existing product or process; it has to be done through the process of experimentation, by trial and error; and it has to be technological in nature.
What barriers do businesses face with this credit?
Many companies, especially smaller ones, have faced a number of obstacles and have either shied away from taking the credit completely, or have failed to maximize its benefits. For one thing, there has been a great deal of uncertainty surrounding the credit, which has been set to expire a number of times. The provision of the law providing for the credit has been extended for only one year at a time, and more than once the extension has come at the last minute. This has made it hard to plan for using the credit. But the current administration favors making the credit permanent.
The calculation of the credit involves comparing current data to data from a base period, which is set at 1984 to 1988. A company that has been around since that time has to compare what it is doing today with what it did back then. It has to collect data from that period, including W-2 forms, documented detail of which employees did what and how much time was spent on research, and documentation of expenditures for supplies, computer usage and contracted services.
There is also an alternative simplified calculation method, which does not require the use of a base period from the 1980s. Instead, the base period consists of the three tax years immediately preceding the year for which the credit is being calculated. That credit is available at a reduced rate, but that rate was recently raised from 12 to 14 percent.
Also, the IRS has labeled this credit as a tier one audit issue. If the credit is taken on a return that gets audited, IRS policy is for the agent to refer the issue to the IRS technical specialists for a more in-depth review. Since all amended returns are reviewed by IRS personnel, any amended return that is filed to take the credit that was missed or just not taken on the original return will be referred to the technical specialists under IRS policy.
The requirements for contemporaneously documenting the data used in the calculation of the credit can also be intimidating, and many tax professionals have been leery about taking it for that reason, as well. The IRS has imposed stringent standards for documentation of the amounts of expenses included in the calculation. However, the courts have held against the IRS in some recent cases, and more reasonable standards can be applied under the law as it currently stands.
Finally, the credit for increasing research is a general business credit and, until recently, general business credits have not been available to offset the alternative minimum tax (AMT). This has particularly impacted flow-through entities, which may have some owners who are subject to the AMT and some who are not. A business may not even be aware of the AMT status of all of its owners, and therefore has had a hard time evaluating the true tax savings of the credit. However, the Small Business Jobs Act changed that. Going forward, for new credits arising in 2010, general business tax credits will now be able to offset the AMT. That’s huge for businesses — smaller businesses, in particular.
What would you say to a business owner who says pursuing the credit seems too complex?
It is time-consuming, but the biggest thing is documentation of what was done. Much of the time involved is in pulling data together, but many companies already do that. If there is a project the company is working on, it tracks the costs going into that project and the time spent working on it. Often companies are not aware that they have already compiled the documentation they need to take advantage of the credit.
Can businesses sort out the intricacies of this tax on their own?
With the complexity of the calculations and the nuances of the credit, it is more than most businesses can handle on their own. An experienced adviser can help sort it all out by being aware of the technical points of the credit and knowing where to draw the line in taking a position. An adviser who is knowledgeable about the mechanics and the components of the credit, and who knows the current state of the law, can advise a client when to take a credit without taking on undue risk.
By talking to an adviser, you can determine whether the credit makes sense for your business and, if it does, what steps you should be taking to document your expenditures.
John Carey, CPA, JD, is an associate director for the tax department at SS&G. Reach him at (330) 668-9696 or JCarey@SSandG.com.