The Tax Cuts and Jobs Act of 2017 (TCJA) set the stage for the most sweeping update to the U.S. tax code since 1986. We’ve covered many of these changes in depth. Today, we’ll look at the impact on the research and development (R&D) tax credit. And, before you think your business may not qualify for the credit, check here. Far more businesses qualify than actually claim the credit.
As expected, the TCJA preserved the R&D tax credit, which was made permanent in the Protecting Americans against Tax Hikes (PATH) Act of 2015. While there are no direct changes to the R&D tax credit as a result of tax reform, there are four major ways that this new legislation affects taxpayers claiming R&D tax credits.
The changes outlined are effective for tax years beginning after December 31, 2017.
Reduced Tax Rates and Section 280C Elections
The drop in the corporate tax rate (from 35% to 21%) can potentially amplify the net benefit pass-through taxpayers see from the R&D tax credit.
IRC Section 280C(c) states that no deduction shall be allowed for that portion of the qualified research expenses (as defined in section 41(b)) or basic research expenses (as defined in section 41(e)(2)) otherwise allowable as a deduction for the taxable year which is equal to the amount of the credit determined for such taxable year under section 41(a). What that means is that taxpayers filing on time (including those who received extensions) have the option of either modifying their deductions or taking a reduced credit. The amount of the reduced credit is the product of the calculated credit and the top corporate tax rate (again, now 21%). While C-Corporations are likely to receive the same amount of benefit regardless of whether they make the election or not, pass-through entities whose partners are expected to be in the top individual rate can benefit greatly from making this election.
Amortization of Research and Experimental Expenditures
Previous law allowed taxpayers to elect to expense reasonable R&D expenses paid in connection with a trade or business in the year they occurred. Alternatively, they could capitalize these research expenses and amortize them over the useful life of the research, but no less than 60 months. These rules stay in place until tax years beginning after December 31, 2021, but thereafter will change significantly.
After December 31, 2021 “specified Research & Experimentation expenditures” must be capitalized and amortized over a 5 year period (15 years in the case of expenditures for activities performed outside of the U.S.). Amortization of these capitalized expenditures begins at the midpoint of the tax year in which the specified R&D expenses were incurred or paid.
Under the TCJA, “specified R&D expenses” include expenses for software development. Expenses for land, depreciation property and depletion property used in the course of research and experimentation are not included, however, the depreciation and depletion expenses associated with such property are. If a project is abandoned before the end of the amortization period, the remaining unamortized basis of the R&D expenditures may not be recovered during disposal, retirement, or abandonment; the basis continues to be amortized over the remaining amortization period.
Alternative Minimum Tax
AMT has been a limiting factor in the effectiveness of the R&D tax credit for many years. With the PATH Act, Congress addressed some of the challenges associated with AMT and the R&D credit by allowing qualified small businesses (those that averaged less than $50 million in revenue for the previous three tax years) the ability to use the R&D Credit to offset AMT tax liabilities. TCJA takes things one step further by repealing corporate AMT.
Individual AMT was not repealed; however, exemption amounts were increased. Additionally, limitations pertaining to the state-local tax deduction make it so there are fewer taxpayers in AMT. If you feel the individual AMT applies to your personal return, please reach out for assistance.
Orphan Drug Credit
Congress passed The Orphan Drug Act in 1983 to provide a more lucrative incentive for companies that are willing to embark on the development of orphan drugs -- drugs developed to specifically target diseases that affect only a small percentage of the U.S. population (less than 200,000 people), also known as orphan diseases. Instead of calculating the benefit for orphan drug development using the rules under IRC section 41 for the R&D tax credit, the Orphan Drug Act provided for a tax credit of 50% of clinical testing expenses (“CTEs”) under IRC Section 45C. Under the new tax law, the OD tax credit will be dramatically reduced to 25% of a company’s costs related to clinical trials for developing rare disease treatments.
With all the changes associated with the TCJA, the preservation of the R&D tax credit is welcome. While you can continue to rely upon the R&D tax credit for savings, new features of the tax code present some interesting considerations. Reach out to your BGW team member for assistance, as always.