Key Points
A new legislative proposal to update the Research and Development (R&D) Tax Credit is garnering bipartisan support. The new legislation would increase the number of companies eligible to claim the credit, double the amount these companies can claim, and secure annual deductions for established businesses.
Key Legislative Changes Proposed:
- Immediately doubles the credit limitation for startups and qualified small businesses claiming the payroll tax offset from $250,000 to $500,000, and ultimately raises it to $750,000 over ten years.
- Allows companies with less than $15M in gross receipts to utilize the Credits against social security tax; currently only companies with less than $5M in gross receipts are eligible.
- Increases the period that startups can elect the payroll tax offset from five to eight years.
- Establishes the first year of eligibility as the earlier of the first year the election is made, or the first year in which revenue exceeds $25,000.
- Increases the value of the alternative simplified credit for qualified small businesses by up to 67%.
- Rolls back limitations imposed on IRC Section 174 by the Tax Cuts and Jobs Act of 2017, which stipulates that beginning in 2022, companies must spread the deduction over a five-year period.
Background:
The R&D Tax Credit (formally known as the Credit for Increasing Research Activities) was enacted in 1981 to spur economic growth and innovation in the U.S. Initially slated as a two-year credit, it has been extended several times and was made permanent in 2015. The credit allows companies to claim qualified research expenses (QREs) for research and innovation performed in the U.S. These include employee wages, raw materials and supplies, computer rental/cloud storage costs, and third-party contractor expenses. The credit has been instrumental in allowing companies to offset their tax burden and use that money to reinvest in growth and further innovation. For a full overview of the R&D Tax Credit, see our FAQs.
Increasing the Payroll Tax Credit and Other Benefits
The new bill proposed by Senators Hassan (D-NH) and Young (R-IN) is called The American Innovation and Jobs Act. It expands current R&D Tax Credit eligibility and benefits, setting larger caps that particularly favor small businesses and startups. One of the key changes proposed is increasing the payroll tax offset allowed under Section 41.
Currently, Qualified Small Businesses (QSBs) can elect to use the R&D Tax Credit to offset payroll taxes. Under the current law, QSBs must meet the following criteria: 1) have less than five million in gross receipts in the credit year; 2) have no gross receipts (including interest income) in any year prior to the five-year period ending with the credit year; and 3) have Qualified Research Activities and Expenses (QRAs and QREs). A QSB or startup that meets these criteria can elect to apply up to $250,000 in available credits to offset payroll tax liability each tax year.
The new law would immediately double the cap on the payroll tax credit election to $500,000, and raise it gradually to $750,000 over the next ten years. Additionally, the new bill would increase the gross receipt limitation from $5M to $15M. This allows growing small businesses to continue claiming the payroll credit. Finally, the changes would allow companies to claim the credit for eight years rather than five.
Additionally, the bill increases the alternative simplified credit (ASC) for QSBs from 14% to 20%. The ASC is an alternative method of calculating the R&D Credit by comparing current year R&D expenditures to the average expenditures in the three prior years.
As an example, let’s look at a startup that steadily increases its annual R&D expenses, and by year four has $1M in QREs (Year 1: $400,000; Year 2: $600,000; Year 3: $800,000). With the current 14% ASC calculation, the company would receive $98,000 in credit.
$1,000,000 - 50%*(1,800,0003)* 14%=$98,000
The new proposed credit of 20% increases that amount to $140,000.
$1,000,000 - 50%*(1,800,0003)* 20%=$140,000
Importantly, this bill stops detrimental changes to the R&D Tax Credit that are scheduled to take effect in 2022 as a result of the Tax Cuts and Jobs Act (TCJA) of 2017. Under the TCJA, companies that were able to claim the full amount of their R&D deductions annually will have to spread the deduction over a five-year period beginning in 2022. This change dilutes the immediate benefit of the R&D Tax Credit, and adds unnecessary complexity to already difficult tax filings.
Conclusion
The R&D Tax Credit is an important incentive for companies. It not only encourages businesses to keep high-tech R&D jobs in the U.S., it rewards companies for thinking outside of the box to develop new technology, software, and processes. The support for the American Innovation and Jobs Act is bipartisan. Both sides can agree that increasing tax incentives for businesses investing in R&D grows local economies while simultaneously maintaining the U.S.’s competitive edge in the global economy.
There are many exciting changes in the pipeline for the R&D tax credit, which has been rewarding U.S. risk and innovation for more than four decades. These proposed changes to the current tax code would increase the number of companies that can take advantage of these credits. It will also secure yearly deductions for established companies, allowing them to immediately recoup a portion of their costs associated with R&D. We will provide an update on our website as soon as additional information becomes available. Contact one of our R&D Tax Credit Experts for an in-depth discussion about your tax situation.
