Credits Against Tax
Small and mid-size companies are eligible for a research tax credit (RTC) of up to 20% of the amount by which their qualified research expenses (QREs) in a tax year exceed their statutorily determined base amount for that year (Sec. 41). According to recent data, however, most RTCs have been claimed by large corporations (U.S. Government Accountability Office, The Research Tax Credit’s Design and Administration Can Be Improved (GAO-10-136), p. 13 (Nov. 2009). Tax commentators have observed that small to mid-size companies (usually passthrough entities, such as partnerships and S corporations) may be overlooking the RTC because they are not aware that they are engaged in eligible RTC activities, do not think their activities are qualified, or do not believe they can meet the various administrative and documentation requirements for claiming the RTC. Despite these reservations, many kinds of product, process, and software development projects undertaken by passthrough entities across the country may be eligible for the credit, and this item outlines some key points that passthrough entities should keep in mind when considering whether to claim RTCs.
Although the RTC in its current form expired at the end of 2011, it continues to remain relevant for credits that could not have been used in any of a taxpayer’s last 15 tax years (including by reason of having net losses or being subject to the alternative minimum tax (AMT)), given that these credits can be carried forward and used against current regular tax liabilities under Sec. 39(a). (The carryforward period was changed from 15 to 20 years for credits generated in tax years beginning after 1997 by the Taxpayer Relief Act of 1997, P.L. 105-34. Therefore, RTCs generated after 1997 may be carried forward 20 years.) In addition, most commentators believe the RTC will be renewed retroactively because it has been renewed 14 times since it was first introduced in 1981, continues to enjoy widespread congressional support as a robust vehicle for creating jobs, and is a critical driver of U.S. technological progress and economic growth.
Key Points for Passthrough Entities Claiming the RTC
Individuals’ limitation under Sec. 41(g): In general, for individuals who are partners in a partnership, shareholders in an S corporation, or beneficiaries of a trust or estate, the allowable passed-through RTC cannot exceed the amount of tax attributable to that portion of the individual’s income that is allocable or apportionable to the individual’s interest in that partnership or S corporation (Secs. 41(g)(2) and (4); Regs. Secs. 1.41-7(a)(1) and (3)). Because the RTC is expenditure-based, it must be allocated among the partners in the same proportion that their Sec. 174 expenditures are allocated for that year, and the passthrough of credits must be applied in accordance with the principles set forth in Regs. Sec. 1.53-3. If an individual’s share of the passthrough entity’s RTC exceeds his or her regular tax liability, the apportioned credit may be carried forward 20 years, but the limitation on general business credits (GBCs) under Secs. 38 and 39, which apply to the RTC (one of several GBCs), will still apply (Secs. 38 and 39 and Regs. Sec. 1.41-7(a)(5)).
Example: In 2010, J received a Schedule K-1 with $300,000 of taxable income and $75,000 of RTCs from an S corporation in which he is a shareholder. J also has $5,000 of interest income related to his personal portfolio and $50,000 of W-2 wages from the S corporation. In calculating the amount of RTC he can use on his 2010 tax return, J must first calculate what portion of his total income is attributable to the activity that generated the credit. J achieves this by dividing the net income from the activity that produced the credit (numerator) by the total gross income from all activities (denominator). The ratio calculated based on the facts above is as follows: $350,000 ÷ $355,000 = 98.59%.
Next, assuming that all deductions are allocated to these two categories in the same proportions, J would multiply his total tax by 98.59% to determine how much of his 2010 tax liability can be offset by the credit. Assuming his total tax after deductions and exemptions is $70,000, J would be able to apply $69,013 ($70,000 × 98.59%) of the $75,000 in RTCs against the tax liability before any limitations imposed under Sec. 38(c) (see “Small Business Limitation Under Sec. 38(c)” below for more information on these limitations).
Note that an additional step would need to be taken if J has deductions on his K-1 that are not directly attributable to the activity or that are limited under another provision of the Code, such as charitable contributions. Under this scenario, the deduction must be prorated among the items taken into account in computing the deduction. See Regs. Sec. 1.53-3(d)(1) and the corresponding examples for more information.
Small business limitation under Sec. 38(c) : Sec. 38(c) imposes a limitation that applies primarily to individuals owning interests in passthrough entities. This limitation states that GBCs for any tax year may not exceed the excess (if any) of the taxpayer’s net income tax over the greater of (1) the taxpayer’s tentative minimum tax for the tax year, or (2) 25% of the amount by which the taxpayer’s net regular tax liability exceeds $25,000. Under the first part of this limitation, a passthrough entity’s RTC can reduce its tax only by the amount equal to the difference between the taxpayer’s regular tax liability and tentative minimum tax, not by the full amount of the taxpayer’s RTC. Any remaining RTC may be carried forward 20 years. This means that many individuals owning interests in passthrough entities cannot reap the benefits of their RTCs the same year their QREs were incurred.
Small Business Jobs Act of 2010, P.L. 111-240: For tax years that began in 2010, eligible small businesses may treat their tentative minimum tax as zero for purposes of determining their Sec. 38(c) limitation for the first tax year after Dec. 31, 2009. This means they can use 2010 RTCs to offset AMT and also carry back 2010 RTCs to offset AMT in prior years. An eligible small business is an entity whose average annual gross receipts for the three-tax-year period preceding a tax year beginning in 2010 does not exceed $50 million, and that is either a corporation (the stock of which is not publicly traded), a partnership, or a sole proprietorship.
The AMT Adjustment for Sec. 174 Expenses
Passthrough entities should also be aware that a taxpayer’s treatment of Sec. 174 expenses can affect the taxpayer’s AMT if the taxpayer does not materially participate in the activity. Sec. 174 generally provides that research and experimental (R&E) expenditures may be currently deducted even though the expenditures may create an asset with an extended long-term useful life. (Ordinarily, an expense incurred for an asset with a useful life that extends substantially beyond the current year must be capitalized and amortized over its useful life.)
In the alternative, if an individual owning an interest in a passthrough entity elects to capitalize R&E expenditures under Sec. 174(b), that person would be required to amortize those capitalized expenditures ratably over a minimum of 60 months beginning in the first month that the individual realizes a benefit from that expense. For individuals who own interests in a passthrough entity and do not make the Sec. 174(b) election (choosing instead to deduct their R&E expenditures currently), for purposes of determining AMT, their Sec. 174 R&E expenditures must be amortized ratably over 10 years.
Note that this requirement only applies to individuals who do not materially participate in the passthrough entity activity generating the R&E expenditure(s) in question. Individuals who do materially participate in the activity generating R&E expenditures are not required to capitalize and amortize their apportioned Sec. 174 expenses for AMT purposes. Finally, in the alternative, such individuals may also choose to make elections under Sec. 59(e) to ratably amortize all or a portion of R&E expenditures for regular tax purposes, thereby avoiding the AMT adjustment.
The RTC is a valuable incentive for small to mid-size companies and entrepreneurs, and the availability of an alternative simplified credit calculation method under the Code has made reporting the RTC even easier. Therefore, passthrough entities servicing the technology, bioscience, computer science, engineering, or manufacturing industries should consult their tax advisers about their product-, process-, and software-development and improvement activities to determine whether they are eligible for RTCs, keeping in mind the special rules and limitations imposed by Secs. 38(c) and 59(e).
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.