Beginning in 2015, the “Protecting Americans from Tax Hikes Act” permanently instituted what is commonly known as the R&D credit — allowing businesses to claim credit for some of their Research and Development costs through Section 41 of the Internal Revenue Code.
The 2015 law also made it possible for small businesses (especially start-ups) to use the credit to offset some of their social security taxes for up to five years. However, the IRS has now instituted new requirements for R&D credit claims to combat fraud.
For now, the new requirements apply only to taxpayers filing amended returns using the R&D credit to request a refund for previously paid taxes. But there are concerns the agency might eventually expand these requirements to include R&D credits filed as part of regular tax filings.
Under the new requirement, which goes into effect January 10, 2022, a company filing a refund claim based on the R&D credit will need to submit a statement that details and documents the research activities each business component performed, the individuals who performed each activity, and the specific information each individual sought to discover. This new requirement is in addition to other claim information such as the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses.
R&D Credit Limitations and Exclusions
IRC Section 41 requires companies to perform a series of complex calculations to determine a base amount and other limitations on the credit. In addition, only certain types of research are eligible. To qualify, research activities must satisfy a four-part test:
- Expenses must be connected to the company’s trade or business and must represent R&D costs “in the experimental or laboratory sense,” as defined under IRC Section 174.
- The research must seek to discover technological information that “relies on principles of the physical or biological sciences, engineering, or computer science.”
- The information discovered must be “useful in the development of a new or improved business component.”
- Substantially all research activities must involve a “process of experimentation that relates to a new or improved function, performance, reliability, or quality of the business component.”
Some types of research are specifically excluded from the R&D credit. These include research conducted after the beginning of commercial production; research to adapt an existing product to a particular customer; duplication of an existing product or process; surveys or studies; research relating to certain internal-use computer software; research funded by another organization; research in the social sciences, arts, or humanities; and research conducted outside the United States, Puerto Rico, or a U.S. possession.
Deductibility of Research Expenses
Another long-standing tax incentive to encourage innovation could also be changing soon. Since the 1950s, companies have been able to deduct certain qualifying research expenses from their taxable income under IRC Section 174. But the 2017 Tax Cuts and Jobs Act (TCJA) changed that, calling for the direct deductibility of R&D expenses to end after 2021.
Instead, the TCJA requires that such expenses be capitalized and amortized over five years (15 years for research conducted outside the U.S.). The Build Back Better legislation currently pending in Congress includes a provision to delay this mandatory amortization for four more years, but for now it is scheduled to take effect in January 2022.
For now, businesses with significant R&D expenses should prepare for more tax exposure and adjust their bookkeeping to keep those expenses separate. As always, the ever-evolving tax code means that businesses must always be ready to adapt in order to minimize their tax exposure and keep compliance costs to a minimum.
The tax issues around research and development costs have changed multiple times in the last six years alone — highlighting just why it’s so crucial to work with an experienced tax advisor who can keep track, position your firm for success, and allow you to focus on your business. Contact Dembo Jones today for an evaluation of what these changes in the tax code mean to your business and how best to prepare.