Shocking: Research Tax Credit Reform Saves Businesses Big

Eligible Qualified Research Expenditures: What’s Included and What’s Not

Eligible qualified research expenditures include taxable wages, supplies, computer lease or rental costs (including cloud computing), and third-party contractor costs. Taxpayers may also include costs for individuals directly supporting or directly supervising the performance of qualified research.

Eligible research expenses also include expenditures for developing internal-use software, as long as the software is not sold, licensed, or leased to others. Additionally, research expenses related to the development of patents, copyrights, and trademarks are also eligible for the research credit.

On the other hand, research expenses related to developing software or other intellectual property for sale, lease, or licensing to others are not eligible for the research credit. Similarly, research expenses related to developing products or processes for use in the taxpayer’s own trade or business, but not for sale, lease, or licensing to others, are also not eligible.

Moreover, research expenses related to developing products or processes for use in the taxpayer’s own trade or business, but not for sale, lease, or licensing to others, are also not eligible. Research expenses related to the development of existing products or processes for use in the taxpayer’s own trade or business, but not for sale, lease, or licensing to others, are also not eligible.

• Eligible qualified research expenditures include taxable wages, supplies, computer lease or rental costs (including cloud computing), and third-party contractor costs.
• Eligible research expenses include expenditures for developing internal-use software, as long as the software is not sold, licensed, or leased to others.
• Research expenses related to developing patents, copyrights, and trademarks are also eligible for the research credit.

Claiming the Payroll Tax Offset

Notice 2017-23 provides interim guidance on how QSBs can apply all or part of the R&D credit against their payroll tax liability. The notice provides guidance on the definition of a QSB and whether a business is eligible to elect to apply all or part of the R&D credit against its payroll tax liability instead of its income tax liability.

The notice also provides information on gross receipts, aggregation rules, and the time and manner for making the election to claim the payroll tax credit. As outlined in Notice 2017-23, the annual election must be made on or before the due date of the taxpayer’s income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities.

A taxpayer electing the payroll tax offset must complete Section D of the form as well as Section A or B, which reflects the R&D credit computation.

Time and Manner for Making the Election

The election to claim the payroll tax offset must be made on or before the due date of the taxpayer’s income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities.

The election is an annual election and must be made on or before the due date of the taxpayer’s income tax return (including extensions) for the taxable year for which the election is being made.

• The election to claim the payroll tax offset must be made on or before the due date of the taxpayer’s income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities.
• The election is an annual election and must be made on or before the due date of the taxpayer’s income tax return (including extensions) for the taxable year for which the election is being made.

Recent Court Cases and Implications

The Betz case provides insights regarding the IRS’s and the court’s recent interpretation of the Sec. 41(d)(4)(B) adaptation exclusion and its relationship with the Sec. 174 uncertainty test provided in Sec. 41(d)(1)(A).

Although the IRS and Tax Court independently analyzed the adaptation exclusion and the uncertainty test, the case opinion makes it clear that technical uncertainty factors into both analyses.

It is important for taxpayers to be mindful of the adaptation exclusion and how the Service may use it to challenge a research credit claim. This awareness is particularly crucial for taxpayers that perform development activities to meet customer specifications.

Betz and the Adaptation Exclusion

The petitioners in Betz were shareholders of Catalytic Products International Inc. (CPI), an S corporation that designed and supplied custom-built air pollution control systems, including catalytic and thermal oxidizers that eliminate harmful airborne manufacturing pollutants.

CPI often purchased components of the systems from third-party suppliers and engaged third-party subcontractors to construct the systems. CPI reported a research credit on its 2014 federal income tax return related to 19 projects and calculated the credit based on wages, supplies, and other expenses.

• The Betz case provides insights regarding the IRS’s and the court’s recent interpretation of the Sec. 41(d)(4)(B) adaptation exclusion and its relationship with the Sec. 174 uncertainty test provided in Sec. 41(d)(1)(A).
• Technical uncertainty factors into both analyses.

Practical Considerations and Observations

The Inflation Reduction Act, P.L. 117-169, increased the maximum amount that a qualified small business (QSB) can use from the Sec. 41 research credit (R&D credit) to offset certain payroll tax liabilities from $250,000 to $500,000 for tax years beginning after Dec. 31, 2022.

This can be particularly valuable for startup companies that currently have net operating losses for federal tax purposes and would like to monetize the R&D credit in the near term.

Opportunities and Pitfalls

The increased limit on the payroll tax offset creates opportunities for QSBs to use the R&D credit to offset payroll tax liabilities, potentially reducing cash flow burdens.

However, taxpayers should be mindful of the additional requirements and documentation necessary to support a valid Sec. 41 research credit claim, including the need to provide detailed information on business components, research activities, and individuals performing research activities.

• The Inflation Reduction Act increased the maximum amount that a qualified small business (QSB) can use from the Sec. 41 research credit (R&D credit) to offset certain payroll tax liabilities from $250,000 to $500,000 for tax years beginning after Dec. 31, 2022.
• The increased limit on the payroll tax offset creates opportunities for QSBs to use the R&D credit to offset payroll tax liabilities, potentially reducing cash flow burdens.