Since its first introduction in 1981, R&D Tax Credit has expired eight times but was continuously extended fifteen times for its apparent benefits for encouraging innovation for American businesses. The Congress finally made the credit permanent in December through 2015 PATH Act. What should excite are two specific changes that came with the bill. The new R&D Tax Credit can be (1) used against payroll tax and (2) reduce the Alternative Minimum Tax (“AMT”).
A Brief Introduction of the Credit and its Previous Limits
R&D Tax Credit, along with many policies offered by the American government, encourages corporations to invest in research and development by providing incentives- a tax break. To be specific, organizations with active research and development activities in the U.S. can receive tax credits which can offset their income taxes. Companies are motivated to invest more resources in research and development knowing they can balance extra spending through tax credit.
The biggest limitation however was the R&D Tax Credit could only be used against income taxes, meaning that a company with no income simply couldn’t reap the benefit because it paid no income taxes that the tax credit could offset. As a result, R&D Tax Credit became a luxury tax break for established corporations that posted a consistent net income. Startups, arguably the most innovative companies, and smaller companies, even though they poured in a huge amount of resources to research and development, weren’t able to receive the benefits of R&D Tax Credit because of the lack of income. The government policy that was intended to encourage innovation, in reality, has not been achieving its goal to reach a wide range of companies. However, now that the new tax bill allows the credit to be used against even the companies’ payroll taxes, startups can now receive R&D Tax Credit and enjoy the benefits without having any income as long as they have paid employees.
R&D Tax Credit to be used against Payroll Tax
By law, American companies are obligated to pay payroll taxes, the amount equivalent to almost eight percent of the entire employee payroll. For example, if a company employed ten researchers each with a $100,000 yearly salary, the company will have to pay $80,000 a year as a payroll tax to the IRS. The payroll tax applies to all American companies, and it even applies to the salary of the founder himself/herself.
Previously, R&D Tax Credit couldn’t be used to offset such payroll tax; however, the new bill allows the credit to relieve companies’ payroll tax obligations. This is a very realistic benefit for all startups and smaller companies. Many early stage companies often invest a large sum of money into research projects and researchers to carry on projects, so in terms of expenses, project expenses, salaries, and payroll tax are responsible for the majority of their budget. With the new revisions to R&D Tax Credit, early stage companies with no current yearly income can directly benefit by receiving credits to decrease their payroll tax obligation.
R&D Tax Credit to Decrease AMT
Alternative Minimum Tax (“AMT”) is a tax policy under which companies are required to pay a certain amount of taxes even when the companies received multiple tax breaks to reduce their tax obligation. Therefore, even if R&D Tax Credit reduced the amount of the company’s yearly regular income taxes, in some, or many, cases the company still had to pay the AMT because the R&D credit could not be used against it. The new bill allows qualified companies to reduce the amount AMT, so in theory, a company that received the full benefit of R&D Tax Credit could end up paying no income tax, neither the regular income tax nor the AMT.
R&D Tax Credit Made Permanent and the Importance of Quality Analysis
Interestingly enough, the R&D for tax credit purposes are defined quite broad in the U.S. tax code, and the government takes a rather relaxed interpretation of research and development, compared to the typical perception that people generally have about it (i.e. professional scientist, laboratories, equipment, and etc.). The definition is certainly not limited to basic research, and therefore, R&D credit should be a consideration to many companies willing to understand and justify the qualification for the credit. On the other hand, it should be noted that the R&D Tax Credit is among the biggest tax benefit the U.S. government offers to businesses, and thus it comes with government’s strict supervision to prevent any inappropriate system abuse. For that reason, the IRS generally audits companies receiving R&D Tax Credit and imposes a hefty penalty when caught with an intentional or reckless violation. The point is, companies should well be aware of the importance of a proper, quality analysis for both maximum tax benefits and tax compliance purposes. They should never shy away consulting with experienced tax experts specializing in this area of tax law because the new bill truly opened up R&D Tax Credit to a wide range of companies.
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