How to handle the current R&D Tax Credit situation

Benjamin Franklin famously wrote, “In this world, nothing is certain except death and taxes”.

We all know that one day we’ll die. The uncertainty lies in when, where, and how it will happen.

We all know that as employees and corporations, we must pay taxes. The uncertainty lies... well, just about everywhere!

Laws, rules, and regulations surrounding taxes, credits, deductions, and the like are everchanging and complicated. Sometimes seemingly purposefully so. What is one to do? Get help!

Even if you have an amazing accountant or even a full team of accountants and other financial pros, it’s not likely that their expertise lies in tax credits. It’s even less likely that they can keep up with everything going on at all times. You may need guidance from outside. More on that at the end of this post.

Recent changes to Research and Development (R&D) Tax Credit rules have posed challenges for businesses across the state of Utah and the U.S. Despite the potential benefits of this credit, uncertainties persist as the IRS refines guidance, and Congress deliberates further modifications.

It is a complicated subject for sure but we’re going to do our best to demystify the R&D tax credit, debunk prevalent misconceptions, analyze recent legislative changes, and outline potential outcomes.

Understanding the R&D Tax Credit

Before delving into fresh developments, let's establish a basic understanding of the R&D tax credit. Introduced in 1981, the R&D Tax Credit serves as a general business tax credit designed to incentivize companies to engage in research and development activities within the United States. Initially conceived as a temporary measure, the credit was made permanent in 2015, cementing its importance in tax planning strategies for businesses.

The R&D tax credit allows eligible companies to reduce their tax liabilities by approximately $0.13 for every dollar spent on qualifying R&D endeavors. Despite its enduring significance, a considerable portion of the available credits goes unclaimed each year. In 2019, an estimated $60 billion of the $92 billion in R&D tax credits remained unutilized, primarily due to lack of awareness and misconceptions surrounding eligibility criteria.

Myths Surrounding the R&D Tax Credit

One of the most pervasive misconceptions surrounding the R&D tax credit lies in its definition. Contrary to popular belief, R&D activities are not confined to traditional laboratory settings with scientists in lab coats. Instead, the tax definition of R&D encompasses a broad spectrum of endeavors characterized by technical uncertainty, technological innovation, experimentation, and the pursuit of new or improved functionalities.

To qualify for the R&D tax credit, activities need not yield successful outcomes but they must demonstrate a genuine commitment to innovation and advancement. By digging deeper and clarifying eligibility criteria, businesses can realize the expansive applicability of the R&D tax credit across diverse industries. Particularly in engineering and manufacturing.

Recent Legislative Changes

Over the past five years, the R&D tax credit landscape has undergone significant transformations, particularly with the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). A pivotal provision of the TCJA, in Section 174 of the tax code, altered the treatment of R&D expenses for businesses.

From the 2022 tax year forward, companies deducting R&D expenses became required to capitalize and amortize (spread out) such costs over a five-year period. Previously it would have been an immediate deduction. This rule change has profound implications, particularly for startups and small businesses invested in R&D endeavors. While the amendment underscores the importance of claiming the R&D tax credit, many businesses adopted a cautious approach, anticipating legislative reversals that failed to materialize in 2023.

What’s wrong with the current law?

Critics suggest that today’s setup discourages domestic innovation and promotes offshoring of research and development in several ways:

·??????? It Reduces the Immediate Benefit. Prior to 2022, companies could deduct their R&D expenses from their taxes in the year they were incurred, now they must amortize the costs over five years. This reduces the immediate financial incentive for domestic R&D projects.

·??????? It Increases the Compliance Burden. The new law added complexity to claiming the credit. Companies now need to track and document their R&D expenses more carefully, leading to increased administrative costs. This can be particularly challenging for small businesses and startups, potentially discouraging them from pursuing R&D entirely.

·??????? Again, the Benefit is Limited for Startups. The current structure is not helpful for startups with limited tax liability in their early years. They may not be able to fully utilize the tax credit until (or IF!) they become profitable. Proposed legislation aims to address this by increasing the credit amount for startups and allowing them to claim it against payroll taxes.

·??????? It Incentivizes Offshoring R&D. The 2022 law allows companies to claim the R&D credit for qualified research conducted outside the US, but with a longer amortization period (15 years). This could make it more attractive for companies to conduct R&D in countries with lower labor costs, potentially leading to job losses in the US R&D sector. Other companies may choose the immediate gratification of saving money by offshoring over the lengthy process of getting the tax break.

Potential Outcomes & Future Strategies

In early 2024, the introduction of the Tax Relief for American Families and Workers Act offered a ray of hope for businesses seeking relief from the TCJA's provisions. However, progress on the bill has been sluggish and the outcome is still uncertain.

Should the bill pass into law, businesses would have the option to fully expense R&D expenditures, potentially reducing income tax liabilities or offsetting future tax losses.

If the bill does not pass, current requirements will remain in effect.

The outcome of the Tax Relief for American Families and Workers Act holds significant implications for businesses navigating the waters of R&D tax credits. Businesses are urged to engage with tax experts to assess their options carefully.

For businesses yet to achieve profitability, promptly claiming the R&D tax credit may prove advantageous, given the uncertain legislative landscape. Conversely, profitable businesses may opt to file for extensions until the bill's fate is clarified, ensuring informed decisions aligned with their financial goals.

By understanding the nuances of the R&D tax credit, dispelling common myths, and staying informed about legislative developments, you too can optimize your tax planning strategies and harness the full potential of this invaluable incentive to drive innovation and fuel growth in the years ahead.

Fingers crossed!

If you’re looking for practical advice from experts in specialty tax credits, please reach out to our friends at?Leaf Specialty Tax Consultants . Adam Farnsworth ([email protected] ) and his team are keeping a close eye on all legislative developments surrounding the R&D Tax Credit and are well-equipped to set your company up for success.

If you’re looking for engineering and manufacturing recruitment experts to help you fill out your team with the best of the best, you know where to find us!

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SOURCES:

https://www.thomsonreuters.com/en-us/posts/tax-and-accounting/section-174-expenditures/#:~:text=Section%20174%20requires%20companies%20to,relate%20to%20qualified%20research%20activities .

https://gusto.com/resources/articles/taxes/section-174-changes

https://www.forbes.com/sites/jessicaledingham/2024/01/22/companies-with-domestic-rd-need-to-keep-a-close-eye-on-the-rd-credit/?sh=4e2112496820