If your company hasn’t ever claimed the Research and Development (R&D) Tax Credit, you may have overlooked a valuable tax benefit.
The R&D credit is available to businesses that incur expenses while attempting to develop new or improved products or processes—even those developed for internal use. It can offer a significant tax benefit for eligible taxpayers. The Coronavirus Aid, Relief and Economic Security (CARES) Act also created new opportunities to reduce your tax burden.
While the CARES Act itself didn’t alter the R&D Tax Credit, several provisions of this COVID-19 relief legislation interact with it. Here are two specific ways your company may be able to leverage the R&D Tax Credit in light of the CARES Act.
Net Operating Losses Carrybacks and the R&D Tax Credit
Many companies experienced losses in 2020 due to the COVID-19 pandemic, so now is a good time to look at how the CARES Act changed net operating loss (NOL) rules.
Before 2017, companies could fully deduct NOLs, carrying them back two years and forward 20 years. The Tax Cuts and Jobs Act (TCJA) changed that, limiting NOL deductions to 80% of taxable income and disallowing NOL carrybacks.
The CARES Act temporarily and retroactively changed NOL rules again, allowing companies to carry NOLs from tax years beginning in 2018, 2019 or 2020 back five years. The Act also repealed the 80% income limitation for NOL carryovers.
If your company paid federal income taxes in 2013 through 2017 but experienced a loss in 2018, 2019 or 2020, you may be able to claim a tax refund by carrying those losses back to a closed tax year.
This creates a significant opportunity compared to carrying the losses forward. Tax rates were higher prior to the TCJA, making deductions more valuable in those years.
For example, the TCJA reduced the corporate tax rate from a maximum of 35% to a flat rate of 21%. So, a $100,000 loss from 2020 carried back to 2016 would result in a refund of up to $35,000 ($100,000 x 35%). If the same loss were carried forward to 2021, the tax savings would be only $21,000 ($100,000 x 21%).
That alone is reason enough to consider taking advantage of the NOL carryback provision of the CARES Act, but an NOL carryback can also free up unclaimed federal tax credits from a closed tax year.
Say you claimed the R&D Tax Credit in 2016, but carrying back a 2020 NOL to that tax year results in the R&D Tax Credit no longer being used in 2016. That R&D credit isn’t lost. You can carry it forward to a subsequent tax year.
And what if your company was eligible for the R&D Tax Credit (or another tax credit) in a prior year and missed claiming it? The taxpayer may be able to determine the unclaimed credits in the closed tax year and carry them forward without having to amend the tax returns. There are additional requirements that must be met to qualify for this strategy, which is beyond the scope of this article.
The Employee Retention Tax Credit and the R&D Tax Credit
Another element of the CARES Act, the Employee Retention Tax Credit (ERTC), provides employers with a way to offset up to $5,000 of employer payroll taxes per eligible employee for 2020 and up to $7,000 per employee for 2021. Tracking of wages allocated to the R&D credit is crucial here.
For 2020, large employers (those employers with more than 100 full-time employees) can only claim the ERTC on wages paid to employees who were not performing services. If employees are not performing services, they cannot be engaged in “qualified research activities” under the R&D Tax Credit. So be sure to review employee hours to ensure that wages paid during a period when they were not performing services are backed out of your R&D credit calculation.
For 2021, the ERTC rules were revised to exclude any wages used to determine the ERTC from being treated as “qualified research activities” to calculate the R&D credit. Again, employers claiming both the ERTC and the R&D credit will need to ensure no overlap between wages used to calculate each credit.
Startups may want to consider using the R&D credit to offset payroll taxes instead of income taxes. Companies can use the R&D credit to offset up to $250,000 of payroll taxes each year for up to five years, if they have less than $5 million in gross receipts for the credit year and have no more than five years of gross receipts.
Since the ERTC is refundable and the R&D credit is not, companies may be able to use the R&D credit to eliminate payroll taxes then receive a federal income tax refund for the ERTC amount. Maximizing the benefit from both the R&D credit and the ERTC can provide startups with fast access to cash when it’s needed most.
Learn More about Tax Credits Like R&D Your Company Can Leverage
As always, claiming the R&D credit is highly dependent on the facts and circumstances of your business. If you have any questions about qualifying for or calculating the R&D credit, please contact a Warren Averett advisor.