The Research and Development (R&D) credit is a business tax credit that generates substantial savings for companies of all sizes and industries, yet is one of the most underutilized tax saving strategies in business today. Entrepreneurs are constantly seeking to increase cash flow to build and scale their businesses, but too often forget that this reduction in taxes can be a key component of that strategy. Chances are good that you are doing something in your business that qualifies you for the R&D credit (and if you don’t know, ask us). But even more exciting news is this: potential changes to the credit are looming in Congress and could prove highly beneficial to startups and small and medium-sized businesses. Here’s what you need to know.
Payroll tax election for startups
Currently, startups that qualify for the federal R&D tax credit but aren’t yet paying taxes have the option to carry forward the credit to use in later years when they do have a tax liability. The new proposal would allow qualified small businesses to elect to use a portion of their R&D tax credit now to offset payroll taxes instead of waiting to use the credit.
The election to use the R&D tax credit against payroll taxes would be available to qualified small businesses for a period of 5 years, and the annual limit of credit that could be used would be $250,000. Here, a qualified small business is a corporation or partnership that had less than $5 million in gross receipts for the taxable year and that did not have gross receipts for any period preceding the five taxable-year period ending with such taxable year.
Alternative Minimum Tax (AMT)
This proposal would allow eligible small and medium-sized pass-through entities (e.g., S corporations and partnerships) who have an AMT liability to use the R&D tax credit to offset the AMT. Businesses in this category have previously been unable to claim the credit.
This long-awaited set of proposed regulations would make it easier for companies using proprietary software in the delivery of their products or services to qualify for the R&D credit.
The proposed regulations would change the definition of internal-use software. Prior IRS guidance generally suggested that software developed for purposes other than to be commercially sold, leased, licensed, or otherwise marketed to third parties was classified as “internal-use software” and therefore ineligible for the R&D tax credit (in most cases).
Under the 2015 proposed regulations, the definition of internal-use software would no longer include software developed to enable interactions with third parties or to allow third parties to initiate functions or review data. This type of software would therefore not be required to satisfy the most stringent high threshold of innovation test in order to qualify for the credit.
Despite a bill passed by the House of Representatives in May that would make the credit permanent, the general expectation among lawmakers and accountants is that the credit will remain in its current, temporary form. Despite its temporary nature, the credit has been consistently renewed since its original expiration in 1985. It offers a substantial potential for savings, so keep yourself abreast of the changes and don’t miss out on it.