Research Credits Offer Increased Opportunities for Tax Savings Post Tax Reform

The Tax Cuts and Jobs Act (TCJA) included significant changes to the taxation of individuals, businesses, and multinational entities.

In exchange for reduced rates, many deductions and credits were eliminated or are now subject to substantial limitations. In one notable exception, the TCJA preserved the federal credit for increasing research activities (research credit), including the ability for qualified small businesses to designate up to $250,000 of the research credit as an offset to payroll tax as well as the ability for eligible small businesses to use the research credit against alternative minimum tax (AMT) liability (which was repealed for corporate taxpayers). Discussed below is the impact the TCJA has on some popular tax deductions and insight on how research credits may be an even more valuable tool for taxpayers to manage their tax position post tax reform.

Impact of Tax Reform on Deductions

Despite reduced tax rates, the loss or limitation of certain deductions may have an overall negative effect on a taxpayer’s position. Under the TCJA, the Sec. 199 domestic production activity deduction was eliminated. There are also new limits on deductions for business related entertainment and meal and beverage expenses. In addition, the TCJA imposes a broad new limitation on business interest deductions and limits the use of net operating loss (NOL) carryforwards to offset taxable income in subsequent tax years.

The new law limits the amount of NOL carryforward that can be utilized to 80% of taxable income, effective for losses arising in tax years beginning after December 31, 2017. The ability to carryback NOLs to prior tax years was rescinded for losses arising in tax years ending after December 31, 2017 (i.e., no carrybacks permitted), but the 20-year expiration of NOLs was also eliminated, meaning NOLs arising in tax years ending after December 31, 2017 can be carried forward indefinitely. Without the ability to use all NOL carryforwards due to the new 80% limitation, companies may have to pay tax on a minimum of 20% of their taxable income. Research credits present an opportunity for these taxpayers to mitigate the new loss limitations and reduce taxes paid on the income that cannot be offset by NOL carryforwards.

Reduction in Corporate Tax Rate

The TCJA reduced the maximum corporate tax rate from 35% to a flat 21%. Taxpayers are generally required to reduce their research and experimentation (R&E) deduction by the amount of research credit claimed, unless they make a Sec. 280C reduced credit election which allows them to retain the full R&E deduction. The Sec. 280C reduction to the research credit is equal to this new 21% maximum corporate tax rate.

Pass-through business owners will see a greater benefit from making the Sec. 280C election post tax reform. The TCJA increased the spread between the corporate tax rate and the highest marginal individual tax rate (a 35% corporate rate compared to a 39.6% individual rate under pre-tax reform rates, versus a 21% corporate rate compared to a 37% individual rate under the TCJA). Therefore, the benefit of making the reduced credit election is enhanced for individual taxpayers. For every $100 of research credit, an individual taxpayer gives up $21 of credit to avoid paying an additional $37 of tax (a net federal benefit of $16). Prior to the TCJA, the same individual had to give up $35 of credit to avoid paying an additional $39.60 in tax (a net federal benefit of $4.60).

There are however some situations where forgoing the Sec. 280C reduced credit election is advisable, even under the new rate structure. Early-stage companies with losses should forgo the reduced credit election if the reduction to their credit reduces the amount available to offset payroll tax to an amount under $250,000. It is expected that the cash value of the payroll credit will be more valuable than preserving the full value of the R&E deduction, which will be embedded in an NOL carryforward as a deferred tax asset.

Alternative Minimum Tax

The TCJA repeals the corporate AMT for tax years beginning after December 31, 2017. The Protecting Americans from Tax Hikes (PATH) Act of 2016 designated the research credit as a specified credit for eligible small businesses to offset AMT. Eligible small businesses are businesses with less than $50 million in average gross receipts in the prior three tax years (defined in Sec. 38(c)(5)). With the repeal of the AMT, businesses now subject to regular tax can use research credits to offset a portion of their regular tax liability. Under Sec. 38(c), the research credit is limited to offsetting up to 25% of the amount of regular tax that exceeds $25,000. Individuals can still benefit from the pass-through of research credits from eligible small businesses to offset AMT liability arising from the same trade or business.

Section 174 Deduction for R&E Expenses

Under prior law taxpayers could elect a method of accounting for R&E expenses that allowed them to currently deduct the expenses in the year they were incurred, or to amortize them over a period of no less than 60 months. Under the TCJA changes, specified R&E expenses under Sec. 174, including software development expenditures that are paid or incurred in tax years beginning after December 31, 2021, must be capitalized and amortized over a five-year period for research conducted in the U.S. Specified R&E expenses that are attributable to research conducted outside the U.S. must be capitalized and amortized ratably over a 15-year period.

The pending elimination of the current deduction for R&E expenses provides strong incentives for companies to undertake capital development projects that require significant research and development before 2022 so that they can maximize the value of the related R&E deductions. The longer capitalization period for foreign research beginning in 2022 creates additional incentive to locate development efforts in the U.S.

Choice of Entity and M&A Planning

Some taxpayers are evaluating choice of entity options after the TCJA’s rate reductions and other new provisions. Taxpayers should be sure to consider research credit utilization in the context of any change in entity structure. Those taxpayers considering a switch to an S corporation from a C corporation should be aware that research credit carryforwards that passed through to shareholders may be suspended indefinitely at the shareholder level if the S corporation will never generate taxable income that can absorb the research credits at the shareholder level. Credits generated by the newly designated C corporation will be claimed on the corporate income tax return. Business entities that are considering a merger or acquisition should also address the impact of the TCJA changes to their research credits in the context of that planning.

International Tax

Another trade-off for reduced tax rates is apparent in the TCJA’s new base broadening provisions, including the Global Intangible Low-Taxed Income (GILTI) regime and the Base Erosion and Anti-Abuse Tax (BEAT). After foreign tax credits, general business credits (including the research credit) may be used to lower total U.S. tax liability for GILTI inclusions. For purposes of GILTI, some of the limitations that apply to other tax incentives do not apply to research credits. Likewise, there are limits on the application of some business credits to reduce BEAT liability, but for years beginning before January 1, 2026, the research credit can be utilized against BEAT.

The Takeaway

While always an important consideration, the research credit’s value to taxpayers has been enhanced by the recent tax reform legislation. Research credits now represent a significant opportunity for taxpayers to minimize their federal tax liabilities due to the elimination or limitation of many business deductions. In the context of the new tax landscape, it is critical that taxpayers and their providers understand how research credits can be utilized to reduce tax liabilities.