Limitations, Exceptions, R&D Expense Reporting: Claiming the R&D Credit
Individuals’ Limitation under IRC § 41(g):In general, for individuals who are shareholders in a partnership or S-corporation, or beneficiaries of a trust or estate, the allowable passed-through R&D tax credit benefit utilized in an applicable tax year cannot exceed the amount of tax attributable to that portion of the individual’s income that is allocable or apportionable to the individual’s interest in that partnership or S-corporation (see IRC§41(g)(2) and (4); Treas.Regs. § 1.41-7(a)(1) and (3)).
Because the R&D credit is a expenditure driven benefit, generally it must be allocated among the shareholders in the same proportion that their IRC §174 (R&D expense deductions) are allocated for that year, as the passthrough of credits are applied in accordance with the principles set forth in Treas. Regs. § 1.53-3. If an individual’s share of the passthrough entity’s R&D credits exceeds his or her regular tax liability, the apportioned credit may be carried forward 20 years, but the limitation on general business credits (GBCs) under IRC § 38 and § 39, which apply to R&D tax credits, may still apply (see also Treas. Regs. § 1.41-7(a)(5)).
Example:
In 2018, Shareholder X received a Schedule K-1 with $200,000 of taxable income and $50,000 of R&D credits from an S-corporation in which he is a shareholder.Shareholder Xalso has $5,000 of interest income related to his personal portfolio and $50,000 of W-2 wages from the S-corporation.
In calculating the amount of R&D credits he can use on his 2018tax return,Shareholder X must first calculate what portion of his total income is attributable to the activity that generated the credit.Shareholder X achieves this by dividing the net income from the activity that produced the credit (numerator) by the total gross income from all activities (denominator).
The ratio calculated based on the facts above is as follows: $250,000 ($200K S-Corp taxable income & $50K S-Corp wages) ÷ $255,000 ($200K S-Corp taxable income & $50K S-Corp wages & $5K unrelated interest income) = 98.04%.
Next, assuming that all deductions are allocated to these two categories in the same proportions,Shareholder X would multiply his total tax by 98.04% to determine how much of his 2018tax liability can be offset by the credit. Assuming his total tax after deductions and exemptions is $50,000,Shareholder X would be able to apply $49,020 ($50,000 × 98.04%) of the $50,000 in R&D credits against the tax liability before any limitations imposed under IRC§ 38(c).
Note that an additional step would need to be taken ifShareholder X has deductions on his K-1 that are not directly attributable to the activity or if another IRC section limitationapplies (i.e. charitable contributions). In this situation, the deduction must be prorated among the items taken into account in computing the deduction. See Treas. Regs. § 1.53-3(d)(1) for more information.
General Business Credit Limitation under IRC § 38(c):IRC § 38(c) imposes a limitation that applies primarily to individuals owning interests in passthrough entities. This limitation states that General Business Credits (e.g. R&D tax credit)for any tax year may not exceed the excess (if any) of the taxpayer’s net income tax over thegreaterof
(1) the taxpayer’s tentative minimum tax for the tax year,or
(2) 25% of the amount by which the taxpayer’s net regular tax liability exceeds $25,000.
Regarding the first limitation, a passthrough entity’s R&D tax credit can reduce its tax only by the amount equal to the difference between the taxpayer’s regular tax liability and tentative minimum tax, not by the full amount of the taxpayer’s R&D tax credit. Any remaining R&D credit may be carried forward 20 years. As such, shareholders with ownership interests in passthrough entities may not fully utilize the full benefits of their R&D credit claim the same year their qualified research expenses (QREs)were incurred.
Alternative Minimum Tax (AMT) Limitation - Taxpayer Friendly Exceptions under Protection Americans from Tax Hikes (PATH) Act & Tax Cuts & Jobs (TCJA) Act
The PATHAct of 2015provides a key incentive to eligible small businesses for taxable years beginning on or after Jan. 1, 2016 that certain taxpayers ("eligible small businesses") can utilize the federal R&D credit to offset their alternative minimum tax (AMT) liability. In prior years, companies and shareholders facing Alternative Minimum Tax (AMT) liability could not utilize R&D credits against AMT liabilities. However, the PATH Act now provides for eligible small businesses and shareholders to utilize the R&D credit against AMT liabilities.
An eligible small business is defined as a non-publicly traded corporation, partnership or sole proprietorship withan average of $50 million or less in gross receipts over the prior three years. Gross receipts are defined under IRC § 448(c)(3) and the related Treasury Regulations. Accordingly, gross receipts include total sales (net of returns and allowances) and all receipts received for services, as well as income from investments, including interest, dividends, rents, royalties and annuities. Gross receipts also includes proceeds from the sale of property (IRC § 1221(2)) used in a trade or business, reduced by the adjusted basis in the property.Partnerships, LLCs, and S-corporation shareholders must separately satisfy the gross receipts test in order to be eligible for the AMT liability offset.Any for-profit company meeting the above criteria and that is performing qualified research defined under IRC §41 may be eligible for R&D credits and this provision.
For tax years beginning on or after Jan. 1, 2018, theTCJA of 2017 also increased the AMT exemption for individual taxpayers, as well as the phaseout amount, for tax years beginning after Dec. 31, 2017, until 2026. These changes, coupled with the new IRC § 164(b)(6) limitation on deducting state and local taxes (preference item for AMT), may provide non-corporate taxpayers additional ways to use the credit.As such, the research credits of an eligible small business may now offset both regular tax and AMT liabilities.
Moreover, theTCJA of 2017, eliminated the federal corporate alternative minimum tax (AMT) pursuant to IRC § 55and amended IRC § 38(c)(6) for corporate taxpayers as having zero tentative minimum tax. These amendments removed a prior constraint that prevented some corporate taxpayers from using credits under IRC § 41(a), due to the IRC § 38(c) tentative minimum tax limitation.
Prior to the PATH Act and TCJA, the R&D credit could not reduce a taxpayer’s tax liability below the AMT. Previously, many taxpayers (e.g. partnerships and S-corporationshareholders in AMT), did not claim an R&D credit on their original, timely filed tax return, as there were issues utilizing the R&D credit currently and/or within the foreseeable short term. However, under the PATH & TCJA, taxpayers should now re-examine their eligibility for the R&D credit benefits to improve cash flow, lower future tax liabilities, and take advantage of a federal and/or state incentive intended to benefit businesses and shareholders such as yourself.
AMT Adjustment for IRC § 174 Expenses
Prior tothe enactment of the TCJA, taxpayers had the following options on treatment and reporting of research and experimental expenditures as listed below. Note, the regardless of the recent enactment of the TCJA, the current accounting methods under IRC § 174 and Rev. Proc. 2000-50 listed below will remain effective for tax years beginning before Jan. 1, 2022.
Currently deductas immediate R&D expenditures under IRC § 174(a);
Amortize over a period of not less than 60 months (beginning the first month benefits are realized) under IRC § 174(b);
Amortize over 10 years pursuant to § 174(f)(2), IRC § 59(e), and IRC § 174(a); or
For applicable software development costs under Rev. Proc. 2000-50
Current deduction in full or
Amortize over a period of not less than 60 months.
Taxpayers that paid or incurred expenses for software development may also rely on Rev. Proc. 2000-50 to determine R&D expenditure reporting. Because of the similarity between expenditures identified under IRC § 174, Rev. Proc. 2000-50 provides that the IRS will not disturb a taxpayer's consistent treatment of these costs if deducted in full (similar to those under IRC § 174(a)) or consistently capitalized and recovered through amortization deductions under rules similar to those under IRC § 174(b).
However, for tax years beginning after Dec. 31, 2021, the TCJA amended the available reporting options per IRC § 174 for research and experimental expensesto the following:
Amortizationover 60 months (5 years), beginning with the midpoint of the tax year when said specified research or experimental expenditures are paid or incurred per IRC § 174(a) as amended by the TCJA;
The revision enabling taxpayers to deduct an research and experimental expenditure beginning with the midpoint of the tax year in which the specified research expenditure is paid or incurred is favorable compared to current IRC § 174(b), which does not allow a deduction until the first month that a taxpayer realizes benefits from R&D expenditures.
For foreign research, the amortization period is extended to 15 tax years;
For retired, abandoned, or disposed property,expenditures must continue to be amortized over its remaining time period aspaid or incurred (immediate deduction no longer permitted)per IRC § 174(d); and
Modified the language in IRC § 174 from "research or experimental expenditures" to "specified research or experimental expenditures."
Special rule under IRC § 174(c)(3) that providesany amount paid or incurred in connection with the development of software is treated as a "specified research or experimental expenditure."
As a result, the TCJA eliminates taxpayers' ability to leverage Rev. Proc. 2000-50 to deduct software development expenditures.
Note, the TCJA modifications above for the 2022 tax year and subsequent years may require certain taxpayers to modify their accounting methods. Moreover, the accounting method change will be applied on a cutoff basis, thus taxpayers may not have a IRC § 481(a) adjustment (IRC § 13206(b) of the TCJA). Taxpayers that have used IRC § 174(a) or Rev. Proc. 2000-50 to expense costs related to research or experimentation or software development, respectively, should consider the temporary timing differences resulting from the future IRC § 174 modifications. Lastly, the different amortization period requirements for domestic and foreign research or experimentation starting in 2022 tax year should prompt taxpayers to reconsider the tax cost of performing R&D activities outside the United States.
Regardless of taxpayers' selection of accounting method for IRC § 174 expenditures, for purposes of the R&D tax credit, IRC § 41(d) defines "qualified research" in part as "research with respect to which expenditures may be treated as expenses under IRC § 174." However, many taxpayers may still be eligible to claim expenditures for the R&D tax credit under IRC § 41 that are deduct elsewhere on their tax return (e.g. IRC § 162, ordinary and necessary business expense).
As such, thepresent option to expense and deduct expenditures in the current tax year under either IRC § 162 or IRC § 174(a) may not be a significant concern. However, generally passive shareholders of pass-through entities who pay AMT, must amortize research or experimental expenditures under IRC § 59(e)(2) or amortizing them under IRC § 174(b) over 60 months. Nevertheless, the TCJA amended language of IRC § 174 for tax years beginning after Dec. 31, 2021 may create timing difference considerations when determining classification of a deduction under IRC § 174 or IRC § 162.
The creation of the timing difference in classification of expenditures is a critical issue that taxpayers should consider when analyzing the R&D tax credit for tax years beginning after Dec. 31, 2021. Since the TCJA makes a corresponding amendment to IRC § 41(d)(1)(A) to define qualified research, in part, as "specified research or experimental expenditures under IRC § 174," taxpayers will have to consider the impact to the timing of deductions if they pursue the credit. The IRS is more likely to analyze taxpayers' classification of expenditures for deductions, if they claim the R&D tax credit. Thus, taxpayers will have to validate the expenditures claimed as IRC § 41 expenditures as "specified research or experimental expenditures" under IRC § 174, and will have to amortize those costs over 5 tax years, or 15 tax years for foreign research.
R&D Tax Future Planning Considerations
Due to the delayed effective date of the modifications to IRC § 174 and IRC § 41, taxpayers may continue to take advantage of the current expensing of research or experimental expenditures under IRC § 174(a), while also claiming a reduced credit under IRC § 280C (claiming 79% of the credit). Moreover, taxpayers with expected R&D expenses and activities should evaluate expediting those expenditures to before 2022.
