For years, many businesses were prevented from getting the full benefits from their R&D tax credits, even though they engaged in qualified activities. The reason for this problem was the alternative minimum tax (AMT). However, due to the PATH Act, many eligible small businesses (ESBs) no longer face that burden.
The PATH Act includes provisions allowing certain taxpayers to offset AMT liabilities with their R&D tax credits for every taxable year on or after 2016.
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Like most tax laws, the AMT is full of hard-to-discern nuances that require taxpayers to consider carefully. First, however, let’s look at a simplified definition: it’s a federal income tax that’s levied on qualifying individuals and corporations. It’s a required alternative to income tax and triggered when a taxpayer generates income above a designated threshold.
AMT calculations start with taxable income and systematically eliminate certain deductions, like medical expenses, state income tax, some forms of depreciation, etc. After removing those deductions, the AMT gets recalculated using a flat percentage, which allows entities to compare the calculated tentative minimum tax (TMT) to their calculated regular tax. Then, once both taxes are computed, the taxpayer pays the higher amount.
Considerations of R&D Credits & AMT
Once taxpayers in the R&D space recognize the basic AMT guidelines, it’s not uncommon for them to wonder how the AMT will affect their R&D tax credits.
So, can R&D credits offset AMT? If you want a short answer: yes. However, this is a fairly new development. Previous generations of business owners didn’t have the ability to offset their TMT—only their regular income tax. Previously, taxpayers that had to pay TMT could not receive a reduction or refund when filing their R&D tax credits.
In the 2010 tax year, struggling taxpayers were offered an exception by Congress. That tax year, they could utilize some Section 38 tax credits (like R&D) against their AMT. However, it was short-lived, and the exception was eliminated the following tax year. That is, until 2015, when Congress passes the PATH Act.
They implemented the PATH Act to help eliminate many of the barriers that business owners faced when trying to claim their R&D credits. The legislation also helped streamline the access to the credit for ESBs, allowing them to leverage up to $250,000 of their R&D credits against their liability for payroll tax each year. Finally, the act allowed ESBs with qualifying R&D activities to offset their AMT with their research and development credits. The PATH Act was a major win for many taxpayers looking to reduce their tax obligation and create new cash flow opportunities.
Limitations of AMT
Before the PATH Act, the AMT restrictions prevented otherwise qualified companies from using 100% of their R&D tax credit. Their leftover credits often got carried forward. However, due to the PATH act, ESBs can now offset their AMT using their R&D tax credits for years beginning in 2016.
But some limitations, including the 25/25 rule, still remain. This regulation still restricts taxpayers that have over $25,000 in regular liability from offsetting any more than 75% of their entire tax liability using R&D credits. Carryforwards before 2016 remain limited by the AMT.
Which Small Businesses Can Offset Their AMT With R&D Tax Credits?
Small businesses can be eligible to offset their AMT by using R&D tax credits if they:
- Are not publicly traded and have an average of $50,000,000 or less in gross receipts over the past three years
- Have conducted qualified research as defined by IRC Sec. 41
Types of Eligible Businesses
Any partnership, sole proprietorship, or corporation in any industry that meets the above criteria may qualify for the credit. Most commonly, the following industries engage in R&D activities qualified for the tax credit:
- Life sciences
- Technology and software
Qualified Expenses and Research Activities
The IRS defines qualified R&D activities based on a four-part test:
- Were the R&D activities intended to either develop or improve the quality, reliability, functionality, or performance of a product, software, process, formula, technique, or invention?
- Was the development technological in nature?
- Was there uncertainty about the method, capability, or design at the outset of the research and development process?
- Was a process or experiment (e.g. simulation, modeling, systematic trial and error, or an evaluation of alternatives) used to overcome that technical uncertainty?
The most common qualified expenses for the R&D credit are employee wages, supplies, contract labor, and cloud computing costs. Employees and any contracted labor must work in the US (or one of its territories) to maintain eligibility. Administrative and general expenses don’t qualify, even if they were in support of other qualified R&D activities.
There are some R&D activities that will not qualify for the credit. These include:
- Any development performed outside of the US or its territories.
- Production and routine maintenance.
- Cosmetic developments
- Routine quality control testing
Challenges of Claiming R&D Credits & Offsetting AMT
There are some hurdles that companies might face when it comes to R&D credits and AMT:
Highly-compensated employees have an impact on the credit, particularly those in executive roles. When those employees contribute significantly to a company’s qualified R&D activities, the IRS will look closely at their activities and the reasonableness of their wages allocated to the credit.
Project ID & Documentation
Businesses must take a project-based approach by identifying each project for which they claim credit and quantifying the number of qualified expenses associated with it.
It’s crucial that the credit calculator complies with the IRS’s requirements, or they may deny the claim with the belief that the business isn’t entitled to the R&D credit.
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