The research and development (R&D) credit provides an incentive for companies to invest in innovation in the United States. The credit is available to companies in any industry that develop new products or processes or improve upon existing products or processes. Companies that qualify can claim certain wages, supplies, and contract research costs associated with R&D projects and activities.
Since the R&D tax credit is a nonrefundable credit, startup companies are frequently limited in their ability to claim it in the current tax year because they have net operating losses. For example, a startup company that is not yet generating taxable income will not have federal income tax liability needed to use the R&D credit originating in the credit-claiming year. Although the R&D credit may be carried forward for 20 years, the company will receive no immediate tax advantage from the credit in its early years when R&D activities may be substantial.
A payroll tax offset rule included in the Protecting Americans From Tax Hikes (PATH) Act of 2015, P.L. 114-113, helps to remedy this limitation by allowing certain small businesses to offset the R&D credit against payroll taxes instead of federal income taxes for tax years beginning after Dec. 31, 2015. This change in the law to offset payroll taxes may provide a significant cash flow opportunity for small businesses and startup companies that do not have federal income tax liability to otherwise offset the credit.
To qualify for the payroll tax offset under the new law, a business must be a qualified small business, which is defined as having gross receipts of less than $5 million for the tax year and no gross receipts for any tax year before the five-tax-year period ending with the tax year. To illustrate, if the credit-claiming tax year is 2016, a company must have had less than $5 million of gross receipts in 2016 and no gross receipts prior to 2012.
Despite this welcome news for small businesses, and particularly startup companies, recent interim guidance issued by the IRS on the definition of "gross receipts" for the payroll tax credit will limit the number of small businesses that qualify for the payroll tax offset allowed by the PATH Act. In Notice 2017-23, the IRS clarifies that gross receipts include total sales (net of returns and allowances), all amounts received for services, and any income from investments and other incidental sources. Accordingly, investment income from interest, dividends, rents, royalties, and annuities—regardless of whether those amounts are derived in the ordinary course of the taxpayer's trade or business—are included as gross receipts for purposes of determining eligibility.
This definition of gross receipts adopted by the IRS surprisingly is more inclusive than the definition of gross receipts used by businesses that calculate the R&D credit using the regular credit method. Including investment income, such as interest income, in the definition may be a limitation to a startup company that had a bank account open for even a brief time before receiving sales derived in the ordinary course of business, perhaps before five years prior to the current tax year. On the other hand, the investment income may cause total gross receipts to exceed the $5 million gross-receipts limitation in the current year even if sales derived in the ordinary course of business are less than $5 million. This inclusive definition of gross receipts seems counterintuitive to the advantageous addition of the payroll tax credit offset, which could be remedied by defining gross receipts more narrowly.
Additionally, also unlike the regular credit rules, Notice 2017-23 does not provide an exception for a de minimis amount of gross receipts. As mentioned above, with the inclusive definition of gross receipts including investment income from all sources, a startup company may have interest or dividend income long before it derives sales from the ordinary course of business. This is particularly problematic for many small businesses in existence before 2012, as they may have income from investments before 2012, no matter how small the amount, which means they are not eligible for the payroll tax offset.
To demonstrate the limitations caused by both the overly inclusive definition of gross receipts and the lack of a provision for a de minimis amount for gross receipts, consider the following scenario:
Example: A startup company founded in 2011 set up a bank account that year and earned $50 of interest income on the account for the year. The company did not receive sales derived in the ordinary course of business until 2012. It reports the $50 of interest income on its federal tax return. Under the guidance in Notice 2017-23, the $50 is determined to be gross receipts from before the five-tax-year period (in 2011), and the company is precluded from electing the payroll tax credit for tax year 2016.
If the definition of gross receipts excluded investment income, the business would still be eligible for the payroll tax offset. Alternatively, if the definition included a de minimis amount of gross receipts, with only $50 of interest income, presumably, the business would also still be eligible for the payroll tax offset.
In summary, unless the IRS narrows the definition of gross receipts included in the interim guidance or adds a de minimis rule, startup companies in situations similar to the example may face the same disadvantage that they did before the PATH Act in that they would be unable to monetize their investments in R&D activities. The IRS requested comments on the interim guidance described in Notice 2017-23. Proponents of the R&D credit are hopeful the IRS will reconsider the definition of gross receipts to enable worthy small businesses to realize the tax advantages associated with R&D expenditures.
Mark Heroux is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.