One year ago, on Dec. 22, 2017, President Trump signed the Tax Cuts and Job Act of 2017 (TCJA) into law. This legislation provided the most sweeping changes to the U.S. tax code since The Tax Reform Act of 1986. The TCJA preserved the research and development (R&D) tax credit under tax code Section 41, which was made permanent in the Protecting Americans from Tax Hikes (PATH) Act of 2015. While there were no direct changes to the R&D tax credit, the centerpiece of the tax law, a permanent reduction in the federal corporate tax rate, has had a significant impact in making the R&D tax credit more valuable for taxpayers.
The TCJA permanently reduced the federal corporate tax rate from 35 percent down to 21 percent for tax periods after Jan. 1, 2018. How does this change impact companies claiming the R&D tax credit? At first glance, it might not be obvious. The calculation for taxpayers claiming the gross R&D tax credit will not see a change. However, it’s the taxpayers that claim the reduced R&D credit under Section 280C(c) that will see an overall increase.
Section 280C Election
Taxpayers claiming the R&D tax credit are precluded from claiming their full Section 174 research and experimental expenses (R&E) and claiming the gross R&D tax credit. The tax law requires these companies to reduce the total of their Section 174 expenses by the gross credit amount to avoid a double tax benefit. However, Section 280C(c) provides taxpayers with the ability to make an election, on an originally filed return, to take a reduced credit without having to make the adjustment to R&E expenses. Many companies choose the reduced credit option to avoid state tax issues or impacting taxable income borne from the requirement to reduce current deductions.
Prior to the TCJA, the rate at which the R&D tax credit was reduced under Section 280C was 35 percent, directly related to the maximum corporate tax rate under Section 11(b)(1) (Section 280C(c)(3)(B)(II)). Therefore, the final benefit with the reduced credit election was 65 percent of the gross credit amount. As a result of the permanent reduction to the corporate rate, taxpayers electing the reduced credit will see an overall benefit of 79 percent of the gross credit amount starting in 2018—a 21.5 percent increase.
Fiscal Year Taxpayers
Fiscal year taxpayers with tax years that ended in 2018 have already noticed an increase in their R&D tax credit calculations. Section 15 provides that when there is a change in the tax rate, fiscal year taxpayers must use the tax rate corresponding to the rate in effect during each tax period. The IRS has provided guidance for calculating a blended tax rate using the pre and post TCJA corporate tax rates for taxpayers electing the reduced credit under Section 280C.
Below we explore the two methodologies used to calculate the R&D tax credit, the traditional method and the alternative simplified credit method, as well as examples showing the mechanics of the pre-TCJA corporate tax rate and the post-TCJA tax rate change.
Traditional (or Regular) vs. ASC R&D Calculation Methodologies
Currently, there are two ways to calculate the R&D tax credit—the traditional credit method and the alternative simplified credit (ASC) method. The traditional or “regular” method relies on a base period of expenses and gross receipts from the mid-1980s which can prove unreliable and cumbersome to many companies. It equals 20 percent of a taxpayer’s qualified research expenses (QREs) that exceed a base amount. The base amount is the product of the fixed-base percentage and the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being determined (Section 41(c)(1)). However, the base amount can never be less than 50 percent of the QREs for the credit year. The fixed-base percentage is computed as the aggregate QREs for tax years beginning after Dec. 31, 1983, and before Jan. 1, 1989 (i.e., the base period), divided by the aggregate gross receipts for the same period (Section 41(c)(3)). The base amount cannot exceed 16 percent (Section 41(c)(3)(C)).
For companies defined as start-up companies, meaning any company whose first tax year with both gross receipts and QREs begins after Dec. 31, 1983, or any company that has fewer than three tax years between Dec. 31, 1983, and Jan. 1, 1989, with both gross receipts and QREs, the fixed base percentage is 3 percent for the first five years where QREs exist and then a moving average formula of gross receipts to QREs (Section 41(c)(3)(B)).
The ASC equals 14 percent of the excess of QREs for the current tax year over 50 percent of the average QREs for the three preceding tax years, also known as the taxpayer’s “base period.” If a taxpayer had no QREs in any one of the three preceding tax years, the ASC equals 6 percent of the QREs for the tax year for which the credit is being determined. Despite the difference in the credit rates, the ASC method can be a less burdensome methodology to compute the credit where recordkeeping for historical data is an issue.
Example 1—Pre TCJA and Post TCJA Traditional Method Calculation With Section 280C(c) Election:
Example 2—Pre TCJA and Post TCJA Alterative Simplified Credit Calculation With Section 280C(c) Election:
Additional Legislative Changes Impacting the R&D Tax Credit
Limitations on Net Operating Losses and Excess Business Loss Limitations
In addition to reducing the corporate tax rate, the law changed the rules for utilizing net operating losses (NOLs). For NOLs arising in tax years beginning after Dec. 31, 2017, NOLs can only be used to offset 80 percent of taxable income. The law also eliminated the ability to carryback NOLs to the preceding two taxable years. Prior to the TCJA, businesses could offset up to 100 percent of taxable income, for regular tax purposes, in a given year (or 90 percent for alternative minimum tax).
The TCJA also imposed new limitations on the deductibility of business losses that are incurred by taxpayers, other than corporations. Under the new rules, a taxpayer’s loss from a non-passive trade or business is limited to $500,000 for married individuals filing jointly or $250,000 for other taxpayers. This limitation applies to tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026.
Businesses that expected to end the year with zero tax liability may find themselves in a taxable position due to these new loss limitations. This may present an opportunity for companies to utilize the R&D credit to offset some of that unexpected tax burden.
Elimination of Corporate Alternative Minimum Tax
The TCJA also repealed the corporate alternative minimum tax (AMT) for tax years beginning after Dec. 31, 2017.
Previously, corporations could only use the R&D tax credit to offset ordinary income tax liability, and not their AMT liability. Starting in 2016, the PATH Act of 2015 allowed eligible small businesses—privately held businesses with $50 million or less in average gross receipts for the three preceding tax years—to utilize the credit against their AMT.
By eliminating the AMT for corporations, the law essentially allows the R&D tax credit to reduce a corporation’s liability subject to the limitations imposed by Section 38(c).
Taxpayers are required to maintain documentation to illustrate the nexus between qualifying research expenses and qualifying research activities (Treasury Regulations Section 1.41-4(d)). Assembling appropriate documentation may require changes a company’s recordkeeping processes because the burden of proof regarding all R&D expenses claimed is on the taxpayer. With the increased value of the R&D tax credit, taxpayers should ensure that adequate data retention policies are in place to support the benefit claimed.
The increased value of the R&D tax credit stemming from the decreased corporate tax rate, limitations on the utilization of losses, and the elimination of the corporate AMT should incentivize both corporate and non-corporate businesses that are not currently claiming the R&D credit to reevaluate doing so. The more than 21 percent increase in the value of the credit may now be worth taking on the task of computing and documenting the R&D tax credit for many companies. Eligible businesses that anticipated minimal or no tax liability may find themselves in a taxable situation that can potentially be offset by the tax credit. Taxpayers that are still undecided would benefit from making a protective Section 280C election to reserve the right to claim the reduced credit on an amended return.
Yair Holtzman is a Tax Partner at Anchin, Block, and Anchin, R&D Tax Credits and Incentives Practice Leader, and is also the leader of the Chemicals & Energy and Life Sciences Practice Industry Groups. Sharlene Sylvia, CPA, MST, is a Senior Manager in the R&D Tax Credits and Incentives practice group at Anchin, Block, and Anchin.