Like Arnold Schwarzenegger’s character in The Terminator, the research credit is back. This valuable tax break, which had officially expired and been restored more than a dozen times in the past, was extended again by the Protecting Americans from Tax Hikes (PATH) Act, retroactive to the beginning of 2015. What’s more, the credit has been made permanent, with certain modifications, by the new PATH Act.
Background: The research credit is generally equal to 20% of the amount of qualified research expenses for the year exceeding a base amount. The base amount is a fixed-base percentage (not to exceed 16%) of average annual receipts for the prior four years. In no case, however, can it amount to less than 50% of the annual qualified research expenses.
Alternatively, businesses can elect to use a simplified credit based on 14% of the amount by which qualified expenses exceed 50% of the average for the three previous tax years. Although an earlier version of the PATH Act included an increase in the 14% figure to 20%, this change ultimately was not included in the final law.
But the research credit is not automatic. The following three requirements must be met for the credit to be claimed.
- The expense must qualify as a research and experimentation expenditure under Section 174 of the tax code. Such expenses include in-house wages and supplies attributable to qualified research, certain time-sharing costs for computer use in qualified research and 65% of contract research expenses (i.e., amounts paid to outside contractors in the United States for conducting qualified research).
- The expense must relate to research undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in developing a new or improved business component.
- Substantially all of the activities of the research must constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality.
Note that the same or similar expenses may qualify for a research and experimentation deduction under Section 174. However, any Section 174 deduction must be reduced accordingly if you claim the research credit for the same expenses.
As with other tax extender provisions, the research credit officially expired after 2014. But now the PATH Act brings it back to life for 2015 and thereafter. Depending on the circumstances, filing an amended return may be warranted.
Other new law changes: The PATH Act also enhances the research credit for certain companies for tax years beginning after 2015.
- A small business may claim the credit against alternative minimum tax (AMT) liability. For this purpose, a small business is one with an average of less than $50 million of gross receipts over the prior three years.
- A startup company may annually claim up to $250,000 of the credit against its FICA tax liability for up to five years. To qualify, the company must have less than $5 million in gross receipts.
The research credit is an important tax incentive for businesses of all sizes. Coordinate your efforts to maximize the tax benefits that may be claimed under the new law. Your tax advisers can provide assistance.