2020 Tax Strategy Update: Get the Most Out of the R&D Credit
As we near the end of a very tumultuous 2020, we wanted to bring you up to date on several current developments that may have an impact on your Research and Development (R&D) Tax Credit for 2020 and beyond. While the year has brought many challenges and changes in our tax laws, the R&D Tax Credit remains a highly valuable tax planning strategy.
Paycheck Protection Program (PPP) Loans
Congress has stated that they intended to allow for the deductibility of the expenses related to PPP loan forgiveness. However, in May 2020, the IRS released Notice 2020-32, which cited existing tax law and eliminated deductibility. Since then, Congress members have continued to state this was not their intent but have failed to take action to restore the deductibility. On November 18, 2020, the IRS issued further guidance in Revenue Ruling 2020-27 and Revenue Procedure 2020‐51. These pronouncements further confirmed that the expenses are not deductible and clarified that, in most cases, this would mean an increase in 2020 taxable income. While we now know that without action from Congress, the deduction of these expenses will be disallowed, there is still no guidance on the impact of the non‐deductibility of these expenses on credits or other tax items.
Should the PPP loan expenses remain non-deductible, the total taxable income will be increased. Here is where we see some nice benefits from the R&D Tax Credit, as it can be used to offset the resulting additional tax. Another benefit would include a look back period of the prior three years if the R&D Tax Credit has not been utilized in the past. Prior year credits can be generated to either result in immediate refunds of prior year taxes or be used as a carryover to offset 2020 taxes.
If guidance is received, which states that the non‐deductible wages cannot be utilized in generating the R&D Tax Credit, the current year credit may decrease. However, due to the credit’s incremental nature, the disallowance of the wages for 2020 credit will actually increase the credit for the next three years.
There are also potential impacts on the Qualified Business Income (QBI) deduction for pass-through entities (S Corporations, Partnerships, etc.). The QBI deduction has some limits based on the company’s wage levels. If PPP forgiveness wages are not allowed for the QBI test, the resulting deduction could be reduced.
You should strongly consider the tax impact on how you complete your PPP forgiveness application before submitting it to your lender. Strategically utilizing allowable non-wage costs and those wages not associated with your R&D activities could create significant tax savings.
TJCA and Other Tax Proposals
The Tax Cut and Jobs Act of 2017 (TCJA) will require businesses to amortize research and development expenses under IRC § 174 over 5 years, which is set to start in 2022. Several new proposals introduced in the House or Senate would repeal the amortization requirement and reinstate the immediate deductibility of the Section 174 expenses.
One of those acts is the American Innovation and Jobs Act (AIJA). The AIJA is a bipartisan bill introduced by Senators Maggie Hassan (D-NH) and Todd Young (R-IN) to repeal the Section 174 amortization requirement and allow businesses to deduct 100% of the R&D expenses in the current tax year. The AIJA would increase research and development efforts in the United States in many industries, with special appeal to start-ups and small businesses. The new bill would fuel growth and technological advancements and create more jobs. The AIJA would also immediately double the credit and raise the cap overtime for the refundable R&D tax credit.
In reaction to the COVID-19 pandemic, there has been an emphasis on increasing economic growth and creating jobs. Similar to the American Innovation and Jobs Act, several additional bi-partisan bills were introduced to legislation that would double the R&D credit benefit, increase eligibility, and benefit start-ups and small and mid-sized businesses.
The most significant of those acts is the FORWARD Act, which carries sponsorship from several senators’ on both sides of the aisle. The FORWARD Act responds to COVID-19 and recognizes the United States lagging investment in research, workforce training, and domestic supply chains. This Act would improve access to the credit for small-sized businesses and medium-sized businesses, and it would expand the credit to include expenses related to workforce training. Start-up firms with up to $20 million in gross receipts will be eligible to use the credit to reduce their payroll tax obligation during a span of 8 years—up from current thresholds of $5 million and 5 years. A new de minimis threshold delays the start of the 8-year window until gross receipts exceed $25,000.
While none of these proposals have yet been signed into law, it is evident that the R&D Tax Credit has bi-partisan support, and we are optimistic that enhancements are on the way to make the credit even more valuable.
LB&I / Audit
While Congress has shown its support for the R&D Tax Credit, the IRS continues to be the watchdog to prevent abuses. In addition to the recent activity described above regarding the PPP Loan program, the IRS has stepped up audit activity regarding the credit.
In 2020, IRS created the Large Business and International (LB&I) campaign to ensure compliance for the Research and Development Tax Credits under IRC § 41 and Research and Development expenses under IRC § 174. This campaign included issues-based exams, form updates, and requests for guidance. The LB&I exam team, comprised of engineers and other highly technical specialists, participates in the R&D Credit review, including documentation, project information, and employee titles and job descriptions. Focused on the highest risk, the LB&I team researches issues and the consistency of examinations. The examination trends focus on the availability of contemporaneous documentation, meeting the higher innovation tests for internal-use software, and performing a formalized experimentation process. Other issues that might be raised include providing documentation of innovation, uncertainty, and business component.
While the R&D Tax credit is an extremely valuable tax planning strategy, we recommend that you always utilize a firm with experience in your industry to perform your study. The firm should maintain thorough documentation to support your credit and their conclusions, all of which should be shared with you in a study report. Most reputable firms will also provide you with audit support should your credit be challenged.
Election Results/ State and Local Tax (SALT) Impacts
As we look ahead to 2021, our overall tax landscape looks very uncertain. The Biden team has proposed an aggressive tax plan, which includes raising the individual tax rate from 37% to 39.6% for individuals with income over $400,000. The corporate tax rate would be increased from 21% to 28%, and impose a 15% minimum tax on book income over $1 million. This tax proposal would eliminate the 20% QBI deduction under IRC § 199(a) for incomes over $400,000 for S corporations, partnerships, and sole proprietorships. The ultimate tax proposal will likely vary somewhat and may contain some provisions not yet revealed.
The fate of Biden’s tax plan likely falls in the hands of the Georgia Senate runoffs scheduled for early January. Should the Republican candidates win at least one of the two open seats, the Republicans will retain control of the Senate and will likely make sweeping tax reform more difficult. On the other hand, should the Democrat candidates win both seats, the path toward significant tax changes will be much easier.
Any potential tax increases will continue to highlight the value of the R&D Tax Credit. As noted above, there is bi-partisan support for the credit, so it will remain a key strategy for offsetting federal income taxes regardless of the outcome of tax reform.
States also continue to face declining tax revenue stemming from the pandemic. In reaction, recovery efforts could include more aggressive tax collection measures and almost certain tax hikes. There are R&D Tax Credits available in several states that should be utilized to offset the increased income tax liability.
We realize that this situation is complex and ever-changing. Stay up to date and take a deeper look at your firm’s tax strategies. Watch Stambaugh Ness’s on-demand webinar, R&D Tax Credits: Year-End Savings Strategies.