The dawn of a new research and development (“R&D”) tax credit era arose when President Obama signed the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act” or “Act”) into law on December 18th. The law finally makes the R&D credit permanent and provides capability for some U.S. taxpayers to utilize the credit against the alternative minimum tax (“AMT”). It also allows qualified small businesses to utilize the tax credit against payroll taxes.
Since the inception of the U.S. R&D tax credit in 1981, commentary regarding the effectiveness of the R&D tax credit has included discussion as to the inability of start-up companies to utilize it. Start-up companies produce some of the most impactful innovations in the U.S. economy, but they usually do not have income tax liability to offset in the early years of business. Moreover, they generate significant net operating losses that they can carry forward to offset income tax liability in future tax years. Although some start-up companies have claimed the credit to generate a deferred tax asset on their books in order to attract investors or acquirers, many have not claimed it due to the lack of a near-term tax benefit. Rather, established companies with plentiful capital reserves and commercially viable products have claimed the credit as they can immediately utilize it to offset income tax liability. As a result, a credit aimed at inciting innovation has provided more benefit to existing business rather than new and emerging business.
The PATH Act addresses this issue by amending Section 41 of the Internal Revenue Code (“IRC”) to allow qualified small businesses to utilize the R&D tax credit against payroll tax liability. It defines a “qualified small business” as a corporation, partnership, or person with gross receipts of less than $5M in the taxable year and no gross receipts prior to the five taxable years ending in the taxable year. A taxpayer that meets this definition may utilize the R&D tax credit against the employer portion of the FICA excise tax imposed by IRC § 3111(a).  The Act does limit the portion of the R&D tax credit to be utilized against the FICA excise tax to $250,000. However, a company would have to generate $2.5M of qualified research expenditures (“QREs”) before it would reach this limit.
The mechanics of the law provide that a taxpayer must make an election under IRC § 41(h) that specifies the amount of the R&D tax credit to which the election applies. The election must be made on or before the due date of the taxpayer’s applicable income tax return, including extensions. A taxpayer that makes the election can then utilize the credit against the FICA excise tax imposed by IRC § 3111(a) for the first calendar quarter which begins after the date on which the taxpayer files the return. If the allowed credit exceeds the tax imposed by IRC § 3111(a) for any calendar quarter, then the unused credit may be carried forward to the succeeding calendar quarter. A person may not make such an election for more than five years.
Start-up companies often face a scarcity of capital as they undertake economic risk to develop new technology or new applications of existing technology. Consequently, they incur significant QREs that can generate a R&D tax credit. Prior to the PATH Act , a start-up company could generate the credit and carry it forward for up to 20 years, but the inability to utilize the credit in the near-term meant it had a deferred tax asset that it could not monetize to drive additional capital into development activities. Since many start-up companies will meet the “qualified small business” definition set forth in the PATH Act, they will now have near-term utilization of the R&D tax credit as they use it to reduce payroll tax expenses. This change will not only provide a direct financial benefit but will produce indirect financial benefits as venture capital firms and investors integrate the utilization and monetization of the credit into their investment models. The result should produce a cycle of prosperity as the credit’s impact on investment models will free-up additional capital for investment into start-up companies that they can use to increase technical innovation and hire additional employees.
As with any tax law, there are several technical and legal nuances that taxpayers must consider as they evaluate the utilization of the R&D credit. Consequently, they should consult with their tax advisors before claiming the credit on a return to be filed with the IRS or a state tax agency. For additional information and a complimentary assessment of the impact of the R&D credit on your company or investment model, please contact Tax Credit Co. (http://taxcreditco.com).
 While credit utilization against AMT is effective for tax years beginning after December 31, 2015, taxpayers may potentially be able to utilize the credit against 2015 tax liability due to one-year carry-back provision of IRC § 39.
 IRC § 41(h)(3)(A).
 “[T]here is hereby imposed on every employer an excise tax, with respect to having individuals in his employ, equal to 6.2 percent of the wages (as defined in section 3121(a)) paid by the employer with respect to employment (as defined in section 3121(b)).”
 Per the newly amended IRC § 41(h), the limit equates to the least of the amount of the calculated R&D credit, $250,000, or in the case of a qualified small business other than a partnership or S corporation, the amount of business credit carryforward under IRC § 39 carried from the taxable year prior to the application of IRC § 41(h).
 This threshold would apply for a start-up company filing a gross credit under IRC § 41(c)(3)(B)(ii)(I). If the company files under the Alternative Simplified Credit per IRC § 41(c)(5)(B), the QRE threshold would be $4,166,667. While most start-up companies would have little incentive to make an IRC § 280C(c)(3) election for a reduced credit, the QRE threshold rises to $3,846,154 or $6,410,256, respectively, if the election is made.
 Additional credit to which the election does not apply may continue to be carried forward for use against future income tax liability.
 IRC § 41(h)(4).
 IRC § 41(h)(4)(A)(ii).
 IRC § 3111(f)(3).
 IRC § 41(h)(4)(B)(2).
 IRC § 39(a).
 Since the provisions related to use of the credit against payroll tax liability apply for tax years beginning after December 31, 2015, the earliest calendar quarter for companies to utilize the credit will be Q2 of 2017.
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