The Tax Cuts and Jobs Act of 2017 eliminated many of the common credits and incentives that businesses relied upon to lessen their tax burden, but the research and development tax credit remains. In this episode, Mike Krajcer, CPA, JD, president of Tax Credits Group LLC in Cleveland, discusses the companies that are eligible to claim the R&D credit, the benefits a company could expect to receive, and more.
*Since this episode was recorded in January 2020, Mike Krajcer has provided an update on the relevance of the R&D credit in the wake of the COVID-19 pandemic.
By: Jim DeLuccia, Manager, Learning Content
Under the 2017 Tax Cuts and Jobs Act, many of the common credits and incentives that businesses had relied on were eliminated and/or had their value diminished. As taxpayers and tax preparers alike work to understand the impact of this legislation, they may find that the research credit is one of the primary permanent tax-planning tools still available. We’re joined on the phone today by Mike Krajcer, JD, CPA, president of Tax Credits Group LLC in Cleveland, Ohio, to talk about the R & D credit.
For purposes of setting up the discussion, what exactly is the R&D credit?
[Krajcer] The R&D credit is an incentive provided by the federal government to private industries and it's intended to stimulate spending on research and development for new and improved products and processes. Our government believes R&D is essential to America's economic progress, job creation, and global competitiveness. Thus, to promote an increased R&D activity in the United States, Congress enacted the R&D credit to reimburse companies for some of the related costs of their R&D. Now the incentive is provided via a tax credit, which offsets tax liability dollar for dollar and is in addition to the tax deduction for these same expenses. Basically, a double benefit. The credit generally offsets income tax, but in some cases may offset the alternative minimum tax or payroll tax for smaller businesses. The R&D credit is part of the general business credit, thus if not used in the tax year which it's earned, it may be carried back one year or carried forward for 20 years.
When we talked a little bit about some of the credits and incentives that have been eliminated or diminished, what are we referring to? And how exactly does the R&D credit help in these situations?
[Krajcer] Sadly for taxpayers we saw some elimination or reduction in advantages of other tax-savings tools. So, what I'd be referring to there is from the elimination standpoint, we have the domestic production activities deduction. The DPAD was eliminated all together, but also we saw diminishing impact or advantage of the IC-DISC, the net operating loss deduction, like kind exchange tax deferrals, all of those were diminished in their savings benefit by the Tax Cuts and Jobs Act of 2017.
How does the R&D credit actually help then with a loss or diminishing impact of those tax-savings tools is that it can connect as a replacement. What we've seen in my practice is many clients in the past may have been eligible for the R&D credit, but had no need for utilization of it because of those other tax-savings tools. Said simply, they already had decreased their tax liability to the lowest level it could go, say zero, if you will. So, why do we need to get another credit involved? They weren't even considering the R&D credit in the past because of that situation. Well, now with the loss of those tax-savings tools, they're faced with having to write potentially a big tax check to Uncle Sam at the end of the year, and not being used to that or maybe not wanting to do that, again, they're considering other tax-saving tools such as the R&D tax credit.
What type of companies are eligible to claim the R&D credit?
[Krajcer] The great news is that any company of any size in any industry may be eligible to claim the R&D tax credit. There is no just base exclusion for certain industries so that's a great start. But it's all going to depend on if they are conducting qualified research activity in that tax year where they would want to claim the credit. Certainly more industries than others have activity that would be eligible for the R&D credit.
In the Midwest, where my firm's located, we work mostly with manufacturers in the auto industry, aerospace, specialty equipment manufacturers and medical device industry. We also work with software developers. The IT group that is creating software applications for sale or maybe a hybrid of a hardware and software that they sell as a unit, but, again, sold to customers to be used in their operations. But also we work with financial institutions, such as banks, that are developing software applications not particularly for sale to another bank or someone on the outside, a third party, but which they're going to use in their operations to service their clients, to interact with their clients. Those kind of companies, that kind of industry, will qualify as well.
Wouldn't most companies who are eligible for it already be claiming the R&D credit?
[Krajcer] Actually not, and the reason for this is that the R&D credit was enacted for any industry, any company, within any industry to utilize. It's very broad in its terminology and can be very subjective in what can qualify or what can not qualify. Even though it's been around since 1981, there's been a lot of misconception and IRS controversy in this area that has resulted in many eligible companies still not taking advantage of it. Or if they are claiming the credit they have in the past, maybe they're not maximizing the benefit they should be claiming. Now fortunately in the last couple years we've had some very favorable legislation come out from Congress. We've had a very favorable regulation coming out from the IRS and the Treasury Department. Court decisions have come out in favor of the tax where they have cleared up the landscape in this area for taxpayers.
Now there's more certainty in what can qualify. There's more certainty in what expenses can be utilized in the calculation, the credit, and there's more certainty in just the actual technical calculation methodologies in what taxpayers are allowed to utilize and how they should be utilizing those different methodologies. Now we're seeing greater interest because of this in the R&D credit. Not just from those that have never taken it, but from those that have taken it that want to reconsider the methodologies they've utilized in the past. Are there optimal processes they can be putting in place to better document their credit activities and associated expenses so that they've been able to improve upon the substantiation and documentation of the credit that they are claiming going into the future?
What amount of benefit could a company expect to receive?
[Krajcer] Tough question to answer because it really depends on the eligible spending on research and development in that particular tax year. It is an annual calculation to where a taxpayer will gather the amount of allowable expenses, which would include wages of employees, supplies for prototypes and test materials, vendor costs for utilizing outside expertise, for using testing houses if that's what they need to conduct their R&D. All that's gathered up on an annual basis and then the actual credit calculation requires that we compare it to some historical spend information to see if we in fact are in excess for that particular year, which we can then apply the credit rate to.
Hard to give a rule of thumb there and I think I'd like to avoid it here at this point. But I do want to note that the credit calculation itself, although not impacted by the TCJA of 2017, was significantly improved upon just because of the reduced corporate tax rate for the maximum tax rate, which actually has made the R&D credit calculation more favorable and is going to return in and of itself that change a greater amount of credit each year after that enactment of that tax reform.
As we begin to wrap up this conversation here, are there audit risks associated with claiming it?
[Krajcer] There are. But the good news is that, although there are risks, this is a tax credit, so just like any item of income deduction or credit is subject to audit, the landscape here is improving. What we have is that the taxpayer has the burden of proof to show that they are eligible for the credit that they have properly substantiated the qualification documentation, the quantification of the amounts claimed. If they don't do that, they certainly are subject to a disallowance of their credit. Maybe all of it in an IRS audit. Currently, we're seeing that the IRS is focusing heavily on the calculation methodologies being utilized by taxpayers, the levels of documentation for their different R&D projects that they are claiming as qualified and just their technical methodologies that some may or may not be utilizable for that particular taxpayer or situation.
A focus there by the IRS on particular items. But the good thing is that there is this focus. It's not what we've seen somewhat in the past where the IRS would come in and more of a kind of a shotgun approach if you will, looking at just everything without really a plan. Now they're looking at certain areas that taxpayers can focus on improving upon if they have some weakness in what they've done in the past. And then B, better to substantiate those in an audit.
We're seeing a decreased in audit rate of the R and D credit area, at least in our experience. Really driven by a couple of reasons. First, the IRS has terminated what was called the tiering program where they're identifying certain audit issues and programs that they felt had more potential for adjustment than others. Unfortunately, the R and D credit was part of that program and had a higher audit rate because of that. But again, that has been eliminated so we're seeing less audits in the area and again, more focused audits so we can better prepare for those.
In addition, we've had very favorable IRS regulations come out clarifying many areas of high controversy in the past. Now we have a better landscape to deal with from a taxpayer standpoint, we have more clarification of what will qualify or how to document things better based on those regulations. Especially and most recently in the area of internal use software where we've seen an area that had great need for regulation for decades, finally get those regulations. And for the most part it was what taxpayers were really looking for: better rules, more clarification to, again, take advantage of this credit where it's appropriate. Finally, many favorable court decisions have been recently issued, holding for the taxpayer's position that have also given us not just that particular taxpayer relief and, again, acceptance of their credit, but they've had widespread applicability across industries and companies that have now had like issues clarified or like opportunities being presented to them to take advantage of.
Well, it's good to hear that the audit risk or number of audits has gone down, I guess.
[Krajcer] It is very good. Again, some of that is because of the change in the way the IRS is selecting taxpayers and issues for audit. But also I think we all know that there's less resources to go around by the IRS and so they're applying those into areas that, again, are felt to be more likely to be audit adjustment attached to them than the R&D credit. A very much improved landscape for taxpayers, considering this issue for the first time or wanting to continue to claim the credit going forward.