The Short Story
Businesses historically have not been able to use the Section 41 research credit in tax years where there was no regular income tax liability. However, on December 18, 2015, then-President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015, which includes favorable changes to the research credit that help mitigate the impact of this limitation.
In particular, the PATH Act of 2015 allows certain small businesses to offset their alternative minimum tax (AMT) or payroll tax liability with the research credit. As a result, small businesses in an AMT or loss position that otherwise would not have claimed the research credit should now consider doing so.
Background on the R&D Tax Credit
The research credit under Section 41 was enacted in 1981 to stimulate research and development in the United States by helping businesses offset some of the costs associated with increasing their qualified research activities. Over its lifetime, the research credit has been subject to various ‘sunset’ provisions, but regularly extended (often retroactively), resulting in year-to-year uncertainty about its future.
However, the PATH Act of 2015 made the research credit permanent after December 31, 2014. The credit, as permanently extended, retains both the regular credit and the alternative simplified credit (ASC) options. Therefore, businesses will continue to have the opportunity to compare the two methods and choose the more favorable one by making an annual election on a timely filed federal return.
Businesses that have not claimed a regular credit in a prior year may make the election on a timely filed amended return for that year. The PATH Act of 2015 also opens the door for a new mix of businesses to utilize the research credit. For tax years beginning after December 31, 2015, the research credit is expanded to allow certain small businesses to benefit from the credit in tax years where there is no regular income tax liability (a regular income tax liability normally is a requirement of Section 38, related to the general business credit, of which the research credit is a part).
Offsetting the AMT Liability
Businesses in an AMT position may now be able to offset their tax liability with the research credit, a new category of ‘specified credit’ under Section 38(c)(4)(B). In order to offset its AMT liability with the research credit, a business must be an ‘eligible small business’ (ESB).
Qualification as an ESB An ESB is defined in Section 38(c)(5)(C) as a sole proprietorship, partnership, or non-public corporation with average annual gross receipts of $50 million or less for the three preceding tax years.
For this purpose, rules similar to those found in Section 448(c)(2) and (3) are applied in determining gross receipts:
- All persons treated as a single employer under Section 52(a) or (b), or Section 414(m) or (0), are treated as one person (i.e., gross receipts are aggregated).
- If the entity was not in existence for the entire three-year period, then the gross receipts requirement is based on the period during which the entity was in existence (i.e., a period of less than three tax years).
- For any short tax year, gross receipts are annualized (i.e., gross receipts for the short period are multiplied by 12 and the result is divided by the number of months in the short period).
- Gross receipts for any tax year are reduced by returns and allowances made during that same year.
- Predecessor entities are taken into account in determining gross receipts.
With respect to an S corporation or partnership, the gross receipts requirement must be met both by the entity and its various shareholders or partners. Therefore, one shareholder or partner may qualify to use the research credit to offset an AMT liability while other shareholders or partners may be ineligible.
EXAMPLE: Partners A and B (Albert and Betty) each own 50% of Partnership Z, an ESB. In 2016, Partnership Z generates a research credit of $4 million. For the three preceding tax years, Partner A had average annual gross receipts of $40 million and Partner B had average annual gross receipts of $55 million. Because Partner A’s gross receipts did not exceed $50 million, Partner A can use his distributive share of the research credit to offset his AMT liability. Partner B cannot use her share of the research credit to offset her AMT liability because she did not meet the gross receipts requirement. If Partnership Z had not qualified as an ESB, neither Partner A nor Partner B would be able to offset his or her AMT liability.
Claiming the Benefit
No election is required in order to offset an ESB’s AMT liability with its research credit. ESBs simply complete the applicable research credit forms, including the new line items. An ESB may offset any amount of AMT with its research credit, subject to the general limitation applicable to specified credits. Any unused credit generally may be carried back one tax year and carried forward 20 tax years. However, it is not clear whether an unused research credit from the 2016 tax year may be carried back to the 2015 tax year in order to offset AMT paid in that year since this new provision was not effective until the 2016 tax year.
Offsetting Payroll Tax Liability
Businesses in a loss position (e.g., start-ups) may now be able to monetize their research credit by applying it against their payroll tax liability. In order to offset its payroll tax liability with the research credit, a business must be a ‘qualified small business’ (QSB). Qualification as a QSB A QSB is defined in Section 41(h)(3) as a partnership, corporation, or person with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year. A tax-exempt organization cannot be a QSB.
EXAMPLE: Partnership Z generates $4 million of gross receipts in 2016. It had $7 million of gross receipts in 2015, 2014, 2013, and 2012. It had no gross receipts in 2011 and earlier tax years. Partnership Z is a QSB in 2016 and may elect to offset its payroll tax liability with the research credit. Partnership Z is a QSB because it had less than $5 million in gross receipts in the year of the election and no gross receipts in any of the tax years preceding 2012. It is irrelevant that Partnership Z did not have gross receipts of less than $5 million during the four tax years immediately preceding the year of the election. In 2017, Partnership Z would not be a QSB because it had gross receipts in 2012.
Gross receipts are determined under Section 448(c)(3), without regard to Section 448(c)(3)(A). As a result, gross receipts are annualized for short tax years, are reduced by returns and allowances, and are adjusted to account for predecessor entities. In addition, entities or persons treated as a single taxpayer under Section 41(f) are treated as a single taxpayer for Insights 3 pwc Section 41(h), meaning in this context that gross receipts must be aggregated for a controlled group of corporations, or for trades or businesses under common control.