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PATH Act changes make research credit creditable against other taxes for small businesses

The 2015 year-end legislation that retroactively extended and made the popular research tax credit permanent was welcome by many business taxpayers. But the “Protecting Americans from Tax Hikes Act of 2015” (the 2015 PATH Act) also included additional unexpected taxpayer-friendly bonuses: beginning in 2016, eligible small businesses (i.e., those with $50 million or less in gross receipts) may claim the credit against alternative minimum tax (AMT) liability, and the credit can be used by certain even smaller “start-up” businesses against the employer’s Social Security portion of the employer’s payroll tax (i.e., FICA) liability.

Research credit. The 2015 PATH Act retroactively extended the research credit (which had expired at the end of 2014) and made it permanent. In general, the research credit equals the sum of: (1) 20% of the excess (if any) of the qualified research expenses for the tax year over a base amount (unless the taxpayer elected an alternative simplified research credit); (2) the university basic research credit (i.e., 20% of the basic research payments); and (3) 20% of the taxpayer’s expenditures on qualified energy research undertaken by an energy research consortium. (Code Sec. 41)

The base amount is a fixed-base percentage of the taxpayer’s average annual gross receipts from a U.S. trade or business, net of returns and allowances, for the 4 tax years before the credit year, and can’t be less than 50% of the year’s qualified research expenses. The fixed base percentage for a non-startup company is the percentage (not exceeding 16%) that the taxpayer’s total qualified research expenses are of total gross receipts for tax years beginning after ’83 and before ’89. A 3% fixed-base percentage applies for each of the first five tax years in which a startup company (one with fewer than three tax years with both gross receipts and qualified research expenses) has qualified research expenses..

A taxpayer can elect an alternative simplified research credit equal to 14% of the excess of the qualified research expenses for the tax year over 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined. If a taxpayer has no qualified research expenses in any one of the three preceding tax years, the alternative simplified research credit is 6% of the qualified research expenses for the tax year for which the credit is being determined.

Under pre-2015 PATH Act law, the research credit wasn’t a specified credit (as defined under “Offset against AMT,” below) with respect to any taxpayers.

RIA recommendation: Because the extension of the research credit is retroactive to include amounts paid or incurred after Dec. 31, 2014, taxpayers, such as fiscal year corporations that already filed returns for a fiscal year that includes part of 2015, or any other taxpayers that have filed returns for tax years ending after Dec. 31, 2014, should consider filing an amended return to claim a refund for the amount of any additional tax paid because of not claiming amounts now eligible for the credit.

Offset against AMT. For credits determined for tax years that begin after Dec. 31, 2015, eligible small businesses (generally, those with $50 million or less of gross receipts, see below) may claim the credit against their AMT liability. (Code Sec. 38(c)(4)(B)(ii))

Specifically, the provision provides that, in the case of an eligible small business (as defined in Code Sec. 38(c)(5)(C), after application of rules similar to the rules of Code Sec. 38(c)(5)(D)), the research credit determined under Code Sec. 41, is a specified credit. As a specified credit, the research credits of an eligible small business may offset both regular tax and AMT liabilities.

Under Code Sec. 38(c)(5)(B), for tax years beginning in 2010, an eligible small business was allowed to offset both the regular and AMT liability with the general business credits determined for the tax year (eligible small business credits). For this purpose, an eligible small business was, with respect to any tax year, a corporation, the stock of which was not publicly traded, a partnership, or a sole proprietor, if the average annual gross receipts did not exceed $50 million. (Code Sec. 38(c)(5)(C)) Credits determined with respect to a partnership or S corporation were not treated as eligible small business credits by a partner or shareholder unless the partner or shareholder met the gross receipts test for the tax year in which the credits were treated as current year business credits. (Code Sec. 38(c)(5)(D))

RIA observation: A calendar year corporation meets the $50 million gross receipts test for eligible small business qualification (see background above) for calendar Year 4 if its average annual gross receipts beginning for calendar Years 1, 2 and 3 do not exceed $50 million. Similarly, a fiscal year taxpayer meets the $50 million gross receipts test for its tax year beginning in calendar Year 4 if its average annual gross receipts for its tax years beginning in calendar Years 1, 2 and 3 do not exceed $50 million.
RIA illustration ABC Corporation, a calendar year taxpayer, had gross receipts of $75 million in Year 1, $45 million in Year 2, and $36 million in Year 3. ABC’s average annual gross receipts for the three-tax-year testing period are $52 million [($75 million + $45 million + $36 million) ÷ 3]. Since ABC’s gross receipts for the three-tax-year testing period exceed $50 million, ABC isn’t an eligible small business, and so, for Year 4, its research credits can’t offset the AMT.

Offset against payroll tax. For tax years that begin after Dec. 31, 2015, qualified small businesses may elect to claim a portion of their research credit as a payroll tax credit against their employer Federal Insurance Contributions Act (FICA) tax liability, rather than against their income tax liability. (Code Sec. 41(h) and Code Sec. 3111(f)) The FICA payroll tax that is imposed on employers and employees is each composed of two parts: (1) the Social Security or old age, survivors, and disability insurance (OASDI) tax equal to 6.2% of covered wages up to the taxable wage base ($118,500 for 2016); and (2) the Medicare or hospital insurance (HI) tax equal to 1.45% of all covered wages (with an additional 0.9% for employees on wages received in excess of certain threshold amounts).

That is, a qualified small business may elect for a tax year to claim a certain amount of its research credit as a payroll tax credit against its employer OASDI liability, rather than against its income tax liability. The payroll credit tax portion isn’t treated as a research credit (i.e., as a credit for income tax purposes) except for purposes of Code Sec. 280C (under which, generally, neither deduction nor capitalization are allowed for expenditures for which a research credit is allowed, unless the taxpayer elects to reduce the amount of its research credit). (Code Sec. 41(h)(1))

Taxpayers eligible for the credit. A qualified small business is one that, in the case of a corporation or partnership, with respect to any tax year:

1. has gross receipts (as determined under the rules of Code Sec. 448(c)(3), without regard to Code Sec. 448(c)(3)(A)) of less than $5 million, and
2. did not have gross receipts (as determined in (1), above) for any tax year preceding the 5-tax-year period ending with the tax year. (Code Sec. 41(h)(3)(A)(i))
RIA observation: Thus, the above rule disqualifies a taxpayer as a qualified small business if it has gross receipts in any year before the fourth preceding tax year and so generally limits qualified small business status to start-ups

An individual can qualify if he meets the above two conditions, taking account the aggregate gross receipts received by the individual in carrying on all his trades or businesses. (Code Sec. 41(h)(3)(A)(ii)) Special aggregation rules apply. And an organization exempt from tax can’t be a qualified small business. (Code Sec. 41(h)(3)(B))

For purposes of this provision, all members of the same controlled group or group under common control are treated as a single taxpayer. (Code Sec. 41(h)(5)(A)) The $250,000 amount (see below) is allocated among the members in proportion to each member’s expenses on which the research credit is based. Each member may separately elect the payroll tax credit, but not in excess of its allocated dollar amount. (JCS-1-16)

Amount of the credit. The payroll tax credit portion is equal to the lesser of:

…an amount specified by the taxpayer that does not exceed $250,000;
…the research credit determined for the tax year; or
…in the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under Code Sec. 39 from the tax year (determined before the application of Code Sec. 41(h) to the tax year). (Code Sec. 41(h)(2))
RIA illustration Corpco, a C corporation that is a qualified small business for the tax year, has a research credit of $120,000 determined for the tax year. However, Corpco’s business credit carryforward from the tax year, determined without regard to an election, is only $40,000. Thus, Corpco’s payroll tax credit portion for the tax year can’t exceed $40,000.

The payroll tax portion of the research credit is allowed as a credit against the qualified small business’s OASDI tax liability for the first calendar quarter beginning after the date on which it files its income tax or information return for the tax year. The credit can’t exceed the OASDI tax liability for a calendar quarter on the wages paid with respect to all employees of the qualified small business. If the payroll tax portion of the credit exceeds the qualified small business’s OASDI tax liability for a calendar quarter, the excess is allowed as a credit against the OASDI liability for the following calendar quarter. (Code Sec. 3111(f))

The credit allowed against employer FICA can’t be taken account for purposes of determining the amount allowable as a payroll tax deduction. (Code Sec. 3111(f)(4))

Electing the credit. For any tax year, the election must specify the amount of the credit to which the election applies, and must be made on or before the due date, including extensions, of:

…for a qualified small business that is a partnership, the return required to be filed under Code Sec. 6031 (i.e., the partnership information return);
…for a qualified small business that is an S corporation, the return required to be filed under Code Sec. 6037 (i.e., the S corporation information return); and
…for any other qualified small business, the return of tax for the tax year. (Code Sec. 41(h)(4)(A))

A taxpayer may not make an election for a tax year if it has made such an election for five or more preceding tax years. (Code Sec. 41(h)(4)(B)(ii))

In the case of a partnership or S corporation, an election to apply the credit against its OASDI liability is made at the entity level. (Code Sec. 41(h)(4)(C))

An election to apply the research credit against OASDI liability may not be revoked without IRS’s consent. (Code Sec. 41(h)(4)(A)(iii))

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