The Research and Development Credit Applies to Banking
In these times of economic uncertainty, companies are looking into many different means of increasing cash flows. Reducing income taxes is a great way to achieve that goal and can often be accomplished by taking advantage of available tax credits. The focus of this article is going to be an often overlooked incentive called the Credit for Increasing Research Activities, or more commonly known as the R&D Credit. The R&D credit was originally enacted back in 1981 and exists to incentivize companies to pursue innovation. It is described in section 41 of the Internal Revenue Code.
First, a word about tax credits in general. A “credit” is a more efficient way of reducing tax liability because it serves as a dollar for dollar reduction to the calculated income tax liability. The more common “deduction” also reduces tax liability but does so by offsetting income before subjecting it to the applicable tax rates. To illustrate the difference, a $1,000 credit will reduce taxes by $1,000 whereas a $1,000 deduction will result in a $210 tax break using the current 21% tax rate in effect for C-Corporations. From a GAAP perspective, as a direct reduction of tax expense, a credit would reduce a business’s effective tax rate.
You may be wondering why you are reading about this credit within the pages of a banking newsletter. This mindset is what has led this to become an overlooked and often ignored tax credit. There is a common misconception that the type of research that is eligible for the R&D credit is performed inside of a laboratory and that a new, patentable invention must result. While these types of activities would certainly qualify, they are far from necessary.
Four Part Test
The IRS has prescribed a four part test that can help determine whether a business is engaging in qualified research activities. And while one of those tests requires the involvement of hard sciences, those sciences extend beyond those typically performed in a lab to engineering and computer science as well.
The other three tests indicate that there needs to be:
- An intent to develop or improve a business component – a business component would include a product, process, formula, or software and improvement would be demonstrated by increased performance, reliability, or quality though there is no requirement that the endeavor be a success
- An attempt to eliminate uncertainty – there must be an attempt to eliminate uncertainty around the development or improvement of a product or process
- A process of experimentation – the company must demonstrate that they have evaluated alternatives through trial and error, modeling, or some other means of experimenting
Banking Activities that May Qualify
Bringing it back to the banking industry, a financial institution could qualify for the credit through the development or improvement of its software system. While there are some “innovation” hurdles that need to be overcome to qualify internal use software for the credit, other software development activities could qualify. Whether it be expenditures related to the enhancement of security to prevent cyberattacks, the development of mobile banking technology that allows customers to pay bills, deposit checks, or perform other online banking transactions, or the creation of software that leads to the automation of previous manual processes, these activities could qualify. In particular, mobile banking has been an increasing trend in recent years and even more so in the current environment of social distancing and contactless transacting. One important thing to keep in mind is that a company’s research does not need to lead to anything new to the industry, just something new to the company.
If engaged in a qualifying activity, an R&D credit up to 20% of qualified research expenditures (QREs) in excess of a base amount may be allowed to offset federal income tax. There are typically three types of qualified expenditures: salaries and wages, supply costs, and contract research expenses. It is important to keep good documentation of which expenses went toward research and development activities. This is especially true for salaries where employees perform services beyond those that are research in nature.
Limitations and Alternatives
Those with some familiarity of the credit are aware that there is a requirement that the R&D credit producing activity generate income in order to be claimed. For many businesses, 2020 is not on pace to be a very profitable year. This should not lead you to abandon hopes of benefitting from the credit because a credit can be carried forward up to 20 years if not available for use in the current year. Further, companies with less than $5 million in revenue may be able to make an election to offset up to $250,000 of payroll taxes in lieu of income taxes during the first five years in which they have gross receipts.
Others may have heard reports of the alternative minimum tax hindering the ability to fully benefit from the R&D credit since businesses were not always able to offset the AMT portion of their tax liability with the credit. The PATH Act of 2015 created an exception that allowed eligible small businesses to use the credit to offset their AMT but then the Tax Cuts and Jobs Act did them one better and repealed the corporate AMT entirely. With that, many businesses whose credits were previously subject to the AMT limitation are now able to utilize significantly more of the credit in a given year. There is still one limitation that businesses with over $25,000 in tax liability must be aware of. They are not able to offset more than 75% of their tax liability with the R&D credit.
From a timing perspective, there are a couple of items that should be considered. First, if research and development activities were performed during years prior to the current tax year, amended returns may be filed to recover the credits as long as the applicable statutes of limitation have not expired.
In addition, under current law that went into effect with the Tax Cuts and Jobs Act, beginning in 2022 businesses will not be able to immediately deduct their research and development expenses, as is currently the case. Instead they must be charged to a capital account and amortized over a 5-year period (15-years if the research was performed outside of the US). The delay in the deduction of the research and development expenses will effectively raise the cost of the investment which, in turn, will diminish the economic benefit of the R&D credit. While this requirement could end up being eliminated by 2022, it is currently the law and should have businesses thinking about ways that they can accelerate research and development activities into 2020 or 2021.
Each state has its own rules surrounding the R&D Credit. One local state worth calling attention to is Massachusetts. While a credit will be allowed to offset corporate excise tax, a bank is not allowed to use the credit to offset the financial institution’s excise tax.
The R&D credit could provide a nice source of cash flow for businesses engaged in research & development activities. If you think you have or will be incurring expenses that could qualify, we strongly recommend reaching out to your tax advisor to discuss.
If you would like to discuss these matters further contact your BNN advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.