RESEARCH AND EXPERIMENTAL EXPENSES
Research and experimentation can be much broader than we are accustomed to. It is not just scientists in a lab with white coats devoted to experimenting.
Starting January 1, 2022, research and experimental (also known as R&E or R&D) expenses cannot be 100% deducted in the year incurred but are required to be capitalized and amortized (½ year of amortization is allowed for the first year) over a five-year period for domestic research and fifteen years for foreign research. Note the five-year amortization rule also applies to software development costs. There is no early write-off for abandoned, disposed, or retired R&E permitted; full amortization is required. For the first time since 1954, companies are no longer able to immediately expense their R&E costs. Taxable income will be increased compared to financial income since R&E is expensed for books but capitalized for tax.
Internal Revenue Code (IRC) Section 174 requires capitalization and amortization of all direct and indirect research or experimental expenditures.
Capitalization is required for research categories such as direct wages, direct supplies, and direct outside service providers. Capitalization is also required for research funded by a third party, allocable rent, utilities, and overhead (indirect costs), as well as foreign research, patent expenses, and software development. The capitalization requirement is broad and there are other research categories not listed in the prior examples.
RESEARCH AND DEVELOPMENT TAX CREDIT
A research and development (R&D) tax credit under IRC Section 41 can provide a significant income tax reduction for many companies, reducing the negative impact of the increased taxable income that results from R&E capitalization. Some of the amortized R&E expenses may qualify for the R&D tax credit.
QUALIFYING FOR THE RESEARCH CREDIT
Many businesses are surprised to learn they qualify for the research and development (R&D) credit. New formulas, new material manufactured, new software creation, innovation, and other expenditures may qualify as R&D.
The four concepts below should be explored to help identify activities or expenses for the R&D credit.
ABBREVIATED R&D CREDIT BRAINSTORM
- Permitted purpose. Developing or improving a product, process, formula, or software?
- Technology. Performing work within physical, biological sciences, engineering, or computer sciences?
- Uncertainty elimination. Encountering questions such as “Can we develop it?” or “How do we develop it?”
- Experimentation process. Evaluating one or more alternatives?
For an activity to qualify for the research credit, the taxpayer must show that it meets the following four tests, commonly referred to as the four-part test.
IRC R&D CREDIT REQUIREMENTS
- The activity must rely on the principles of engineering, computer science, biological science, or physical science.
- The activities must aim to create or improve a new or improved business component of the taxpayer, defined as an existing product, process, technique, formula, invention, or software in the areas of functionality, performance, reliability, or quality.
- Technical uncertainty must exist at the outset of the development activities. Uncertainty exists if the information available at the outset of the project does not establish the capability or methodology for developing or improving the business component or the appropriate design of the business component.
- Substantially all (80%) of the qualified activities must involve a process of experimentation to eliminate technical uncertainty. This process includes testing, analysis, evaluation, and design iterations – for example, assessing a design through modeling, proof-of-concept, computational analysis, or trial-and-error methodology. An evaluative process is required that includes analyzing one or more alternatives.
R&D QUALIFYING EXPENSES
The R&D tax credit is available to taxpayers who incur incremental expenses for qualified research activities conducted within the United States. The R&D tax credit is restricted to U.S.-conducted, direct research expenses with certain expense categories limited or disallowed for R&D credit inclusion.
The credit is primarily composed of the following qualified research expenses:
- Wages paid to employees for performing or directly supporting or supervising qualified research activities.
- Supplies consumed in experimentation or for building prototypes.
- Sixty-five percent of contract research expenses provided the taxpayer assumes the financial risk and has substantial intellectual property rights in the products or processes under development.
- Basic research payments made to qualified educational institutions and various scientific research organizations.
RESEARCH AND DEVELOPMENT PAYROLL TAX CREDIT
While the R&D tax credit is traditionally viewed as requiring federal income tax liability, a business with an operating loss (no taxable income) can frequently benefit from the R&D tax credit.
A relatively unknown item is the availability in 2023 (double the 2022 amount) of up to $500,000 yearly, a $2.5 million maximum federal R&D payroll tax credit for a Qualified Small Business. A Qualified Small Business (QSB) has less than five million gross receipts (annualized) for the current tax year and is allowed gross receipts for the five-year period ending with the tax filing year but has no gross receipts for a tax year that is six years previous or older than six years previous to the tax filing year. An example would be a business formed in 2012 but had no gross receipts until 2018, which potentially qualifies as a QSB for 2022, and if its first gross receipts were 2019, 2020, 2021, or 2022, it possibly qualifies as a QSB for 2022 or 2023.
Gross receipts are defined as sales net of returns and allowances, amounts received for services, investment income such as taxable and tax-exempt interest, OID, dividends, rents, royalties, annuities, and capital asset transaction receipts reduced by property adjusted basis. Sales tax and other similar state and local taxes have exclusion and inclusion rules which vary.
The payroll tax credit is first used to reduce the employer’s share of social security tax up to $250,000 per quarter, and any remaining credit reduces the employer’s share of Medicare tax for the quarter. The credit cannot exceed the tax imposed for any calendar quarter, with unused amounts of the credit carried forward for up to twenty years.
Identifying activities and projects for capitalization and documenting the projects and activities as required by the IRS can increase compliance and reduce audit risk.
PKF Mueller can help identify and categorize activities, business plans, and expenses to determine which expenses require R&E capitalization and corresponding amortization and the subset of those expenses that qualify for the R&D tax credit.
If your business had its first receipts (income) in the years 2018 to 2023 and has less than five million gross receipts for 2022 or expects less than that for 2023, it may qualify as a QSB. A QSB is allowed up to $500,000 yearly and a $2.5 million maximum federal R&E payroll tax credit.
Questions? Please contact your PKF Mueller representative or:
Kelly Jordan, CPA, JURISPRUDENCE IN INTERNATIONAL TAX LAW, MBA, MBA, CFS, CITA, CTPS
+1 847 350 1504
Jean Petrik, CPA, MST
+1 708 745 3516