The chances of the now-expired business research and development (R&D) tax credit being revived before the midterm congressional elections in November are pretty slim.
A bill to extend the R&D credit – along with some 50 other tax breaks that expired at the end of 2013 – for two years has stalled in the Senate over a disagreement between Democrats and Republicans over amendments. The full House of Representatives already passed a bill early last month that would extend the R&D credit permanently, but the Obama administration threatened to veto the legislation because the estimated $156 million cost to revive the credit would not be offset.
If the Senate does pass its bill later this year, Congress will then have to determine which proposal will ultimately become law.
But despite the R&D credit’s current uncertainty in Congress, experts say that small business owners should continue to pay attention to lawmakers’ discussions because of the tax provisions each bill could provide their companies once a compromise is reached.
For example, under the House legislation, the rate of the Alternative Simplified Credit (ASC) – another method used to compute the R&D tax credit – would increase from 14 percent to 20 percent, while the Senate proposal would allow small business owners to take the R&D credit against their alternative minimum tax (AMT) liability.
“My view is that regardless of whether the R&D tax credit is made permanent, the better priority is to make it more accessible for small and medium businesses, and fortunately, that is what the Senate and the House have both done,” Dean Zerbe, national managing director of Houston-based specialty tax service provider alliantgroup, told AccountingWEB.
The R&D credit is provided as an incentive for US companies to make bold investments in developing new technologies. As David Wong, a senior director of R&D tax services at accounting firm BDO USA LLP, told AccountingWEB, “These attempts may fail, or they may result in the next great American innovation.”
Based on the most recent IRS data, nearly 13,000 companies claimed $8.5 billion worth of R&D credits in 2010. Of that $8.5 billion, $7 billion was claimed by corporations with more than $250 million in business receipts.
Wong said companies of all sizes can claim the credit, as long as they are "engaged in qualified research activities, and the amount is very much related to the amount of expense incurred."
Companies may be able to claim the credit provided that they are conducting research in the United States and if their qualified research activities meet the criteria of a four-part test (see sidebar).
“As a result, by virtue of their size, large companies receive the majority of credits claimed," Wong said. "Large companies also have the advantage of being able to allocate more resources to better scope the opportunity, identify the qualified expenses, and document qualified activities.
“With that said, small businesses seem to be more appreciative of the credit,” he continued. “Small businesses typically have very engaged owners and employees, and any assistance they can get to grow their business is welcomed.”
Pros and Cons of Each Bill
The Republican-led House is tackling the expired tax breaks – called “extenders” because they are revived by Congress every year or two – by considering individual provisions and passing legislation to make each permanent, the first of which was the R&D credit on May 9.
“The House is trying to tee up tax reform, and by taking those few extender provisions that they support and making them permanent, it changes the overall budget baseline for possible tax reform down the road,” said Zerbe, former senior counsel and tax counsel to the Senate Finance Committee.
According to Wong and Chad Paul, who is also a senior director of R&D tax services for BDO USA, the key aspects of the House’s R&D credit bill are:
- It makes the R&D credit permanent.
- It eliminates the regular credit computation method, which can have a look-back period to the 1980s, and replaces it with an enhanced ASC. The ASC is currently equal to 14 percent of the current-year’s qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years. The House bill would increase the ASC rate from 14 percent to 20 percent.
- It allows companies to claim the ASC on an amended return.
While congressional efforts to extend the R&D credit remain on hold, the US Treasury Department and the IRS issued new temporary regulations on June 2 that allow taxpayers to use the ASC method for computing the R&D tax credit on an amended return. That election was previously only allowed on a timely filed, original tax return.
In an article he wrote for Forbes on June 2, Zerbe called the new ASC regulations a “gamechanger” for small businesses.
“Even under ASC it is not a walk in the park for a business to qualify (requiring books, records, etc.) for the R&D tax credit. The reality is that for many small and medium business owners it’s not worth the candle to qualify for the ASC if they are only getting one year of benefit,” he wrote. “By allowing the ASC on amended returns, the Treasury and IRS have completely changed the math for thousands of small and medium business owners who will now see for the first time the benefits of the R&D tax credit.”
Wong and Paul noted the biggest detriment to the House bill is that it is perceived by some as not being revenue-neutral, with the Joint Committee on Taxation having estimated a reduction in revenue of approximately $156 billion over a 10-year period. Plus, President Obama would likely veto the bill over concerns that the cost would not be offset, even though he had included a permanent extension of the credit in past budgets.
“There is effectively no chance this bill will be approved, and whatever research credit legislation ultimately gets approved will most likely be closer to revenue-neutral,” Paul said. “That being said, a 2011 study by the Treasury Department found that the credit was in fact revenue-neutral. It found that each dollar of credit reported would generate a dollar of additional research spending. A more recent study by the Information Technology and Innovation Foundation suggested that for every dollar of credit reported, another $1.30 would be spent.”
Another shortcoming of the bill, according to the BDO tax professionals, is that the credit cannot be used to offset AMT or payroll taxes, leaving only those with regular income tax liability to immediately receive a cash benefit.
In early April, the Senate Finance Committee voted to revive about 50 of the 55 tax breaks, including the R&D credit, as part of a two-year, $85 million legislative tax extenders package. If approved by Congress, the Senate’s package of tax breaks would be extended through December 31, 2015.
However, the bill has stalled in the Democratic-controlled Senate because of a dispute over which Republican amendments would be allowed. House Majority Leader Harry Reid (D-NV) said recently that the legislation would likely be deadlocked until after the November congressional elections.
Under the Senate bill, eligible small businesses – those with receipts averaging less than $50 million for the preceding three tax years – can apply unused 2014 and 2015 research credit amounts exceeding income tax against their AMT liability, according to Wong and Paul.
Qualified small businesses – those with less than $5 million in gross receipts in the current taxable year, and zero gross receipts in any year preceding the five-year period ending with the current taxable year – can apply unused research credit amounts exceeding income tax to their payroll taxes, subject to a $250,000 limit.
“A company of any size that claims a credit but does not utilize it in the current year may carry it back one year. If it can’t be used in the prior year, the credit can be carried forward up to 20 years,” Paul said. “This means, in general, it makes sense for any company that is engaged in qualified research and that incurs eligible expenses as a result of that research to claim the credit.”
He added that unlike the House bill, the Senate’s proposal does not include language exempting the legislation from revenue-neutral requirements and “is more likely to garner support.”
Among the shortcomings of the Senate bill is that the R&D credit could be held hostage by more controversial incentives. This proved to be the case on May 15 when GOP senators blocked the package of tax extenders over frustration with Reid, whom they believe is preventing them from offering amendments to the bill.
According to an article from The Hill, Republicans wanted to offer amendments to repeal the Affordable Care Act’s medical device tax and strike the wind production tax credit from the Senate package, but Reid filed cloture on the bill after using a procedural move known as “filling the amendment tree” that blocks the minority party's ability to call up amendments.
Wong and Paul said another drawback of the Senate bill is it does not make any changes to the computation of the research credit, meaning taxpayers who want to use the regular credit may need to maintain records from as far back as 1984 to 1988 to support their credit calculation. Without increasing the rate for the ASC, there is less incentive for taxpayers to switch methods and rely on more current – and likely more auditable – books and records, they added.
Finally, the Senate bill would not make the R&D credit permanent, something the BDO tax professionals believe could have a material positive effect on how companies budget, plan, and allocate their resources.
“Many states, including California, have already enacted permanent legislation for a research credit. It’s past time that the federal government followed suit,” Wong said.
Lack of Education is an Issue
In an article he wrote for Forbes last year, Zerbe noted that only one out of 20 eligible small businesses in the United States took advantage of the R&D credit. He told AccountingWEB the reason why so many don’t is because of a lack of education.
“Thousands of small and medium companies that are eligible for the R&D tax credit don’t take it because they aren’t aware they qualify,” he said. “The R&D credit is available for a huge range of industries, including manufacturing, software, engineering, architecture, chemistry, biology, agriculture, and food processing. The R&D credit isn’t just about lab costs and test tubes; it’s about applied science – what you are doing on the factory floor or modeling on the computer to make not only a new product, but also to make an existing product better, quicker, cheaper, or greener.”
If a small or midsized business engages in activities that meet the test's four criteria, "that business is likely engaging in qualified research and should consult their tax practitioner to determine if the business is eligible to claim a research credit," Paul noted.
Zerbe emphasized another possibility for small business owners: investigating whether their state offers a research tax break.
“Nearly 40 states now have a permanent R&D tax credit,” he said. “Often, a company can wipe out its state tax bill by utilizing its state’s R&D tax credit.”
If any or all of these R&D credit provisions are included in a final tax extenders package passed by Congress later this year, Zerbe said small business owners “should be dancing in the streets.”
“If the House and Senate will agree to the improvements to make the R&D tax credit more available for small and medium businesses, that will make a big difference in making our manufacturing more competitive internationally and encouraging R&D work in this country,” he concluded.