The Protecting Americans From Tax Hikes (PATH) Act of 2015, part of the Consolidated Appropriations Act, 2016, P.L. 114-113, was enacted Dec. 18, 2015. The PATH Act retroactively renewed the research and development (R&D) tax credit, which had expired at the end of 2014, and made it permanent. PATH also retroactively renewed the work opportunity tax credit (WOTC), extending it through 2019. These provisions and other developments, including regulations on internal-use software, are very favorable for taxpayers. This article examines them.
Payroll tax credit election
Effective for tax years beginning after Dec. 31, 2015, a qualified small business (QSB) is permitted to make an annual election to use R&D tax credits to offset up to $250,000 of the employer portion of old age, survivor, and disability insurance (OASDI) (otherwise known as the Social Security portion of the Federal Insurance Contributions Act taxes). The IRS issued interim guidance on making the payroll tax credit election in Notice 2017-23 on April 17, 2017. The notice clarifies that a QSB is a corporation (including an S corporation), partnership, or individual with:
- 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 of the claim (e.g., taxpayers claiming the credit on 2016 tax returns cannot have had any gross receipts before 2012).
A QSB does not include an organization that is tax exempt under Sec. 501. Gross receipts are determined under Sec. 448(c)(3), which addresses short tax years, treatment of predecessors, and calculating gross receipts (without regard to Sec. 448(c)(3)(A), which involves calculating gross receipts for entities that were not in existence for an entire three-year period), and Temp. Regs. Secs. 1.448-1T(f)(2)(iii) and (iv) (rules for short tax years and accounting methods for the $5 million gross receipts test). The credit is equal to the lesser of:
- The R&D tax credit calculated for the tax year; or
- In the case of a QSB other than a partnership or S corporation, the amount of the general business credit carryforward under Sec. 39 for the tax year (determined before the application of Sec. 41(h), which is the payroll tax provision permitting the R&D credit).
The payroll tax credit election is made by completing the appropriate section of Form 6765, Credit for Increasing Research Activities, and including the completed form with a timely filed (including extensions) return for the year of the election. The interim guidance permits QSBs that failed to make the election on 2016 returns to file amended returns by Dec. 31, 2017.
To qualify for this extension of time to make the election, the QSB must either:
- Indicate on the top of its Form 6765 reflecting the payroll tax credit election that the form is "FILED PURSUANT TO NOTICE 2017-23"; or
- Attach a statement to its Form 6765 reflecting the payroll tax credit election that the form is filed pursuant to Notice 2017-23.
A QSB that elects to claim the payroll tax credit and files quarterly employment tax returns will claim the payroll tax credits on its employment tax return the first quarter immediately following the filing of its income tax return. Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must also be completed and attached to the payroll tax return.
The interim guidance provides special rules for controlled groups. Regardless of whether each member in the controlled group makes the election, the $250,000 amount is allocated to each member of the controlled group in the same manner as the group's R&D tax credit (i.e., in proportion to the qualified research expenses under Temp. Regs. Sec. 1.41-6T(c)).
The Treasury Department and the IRS have requested comments on the interim guidance described in this notice and other issues affecting payroll tax credit elections that may require additional guidance by July 17, 2017.
Alternative minimum tax
Another component of PATH is a provision to allow businesses (and business owners) to claim the R&D tax credit against the alternative minimum tax (AMT) under Sec. 38(c)(4)(B)(ii). As a general business credit, the R&D tax credit generally cannot be used to reduce tax liability below the amount of the taxpayer's tentative minimum tax. This restriction has been a disincentive for any taxpayer with AMT liability. Congress amended Sec. 38 to allow an eligible small business (ESB) as defined under Sec. 38(c)(5)(C)) to ignore the tentative minimum tax limitation effective for credits generated beginning Jan. 1, 2016. An ESB, which is different from a QSB because it has a much higher gross receipts limit, includes:
- A corporation whose stock is not publicly traded;
- A partnership; or
- A sole proprietorship.
To be an ESB, the average annual gross receipts of the business for the three-year period preceding the tax year of the credit claim cannot exceed $50 million. Gross receipts must meet the definition under Secs. 448(c)(2) and (3) as well as Temp. Regs. Sec. 1.448-1T(f)(2)(iv). For purposes of the gross receipts test, all members of a controlled group of corporations (as defined in Sec. 52(a)) and all members of a group of businesses under common control (as defined in Sec. 52(b)) are treated as a single taxpayer.
Furthermore, the gross-receipts test must be met both by the entity and the partner or S shareholder level for the tax year.
The R&D tax credit rules generally prohibit time and expense incurred in the development of internal-use software with certain exceptions. The final regulations (T.D. 9786) issued on Oct. 3, 2016, address various items regarding internal-use software for purposes of claiming the R&D tax credit and slightly modify the proposed regulations (REG-153656-03) published in January 2015. Before it issued the proposed regulations, the IRS had waited more than a decade to offer guidance on internal-use software. The final regulations:
- Define internal-use software and adjust the definition of non-internal-use software;
- Provide that certain internal-use software is eligible for the R&D tax credit if the software satisfies the high-threshold-of-innovation test;
- Expand the concept of uncertainty in the "significant economic risk" prong of the high-threshold-of-innovation test;
- Provide that certain software enabling communication with third parties is not subject to the definition of internal-use software and must meet only the general four-part test;
- Provide rules for computer software that is developed for both internal use and non-internal use (dual-function computer software);
- Include examples to illustrate application of the regulations for internal-use software; and
- Limit the definition of "general and administrative functions."
The final regulations generally are effective for tax years beginning on or after Oct. 4, 2016, but taxpayers can generally rely on either the proposed or final regulations for any tax year that both ends on or after Jan. 20, 2015, and begins before Oct. 4, 2016.
PATH extended the work opportunity tax credit (WOTC) through Dec. 31, 2019. The WOTC rewards employers hiring individuals from targeted groups who have traditionally faced barriers to employment. The WOTC is available to both for-profit businesses and tax-exempt organizations.
PATH expanded the targeted groups to include long-term unemployment recipients hired on or after Jan. 1, 2016. Long-term unemployment employees must have been unemployed at least 27 consecutive weeks and received federal or state unemployment compensation during that period. The U.S. Department of Labor (DOL) later released Training and Employment Guidance Letter (TEGL) No. 25-15 on June 17, 2016. TEGL No. 25-15 provides guidance on claiming WOTC for long-term unemployment new hires. The DOL later issued the following revised forms, adding the long-term unemployment category:
- ETA Form 9175, Long-Term Unemployment Recipient Self-Attestation Form; and
- ETA Form 9061, Individual Characteristics Form.
The WOTC provides credits for hiring ranging from $1,200 to $9,600 depending on the category for the following groups:
- Unemployed veterans (including disabled veterans);
- Temporary Assistance for Needy Families recipients;
- Supplemental Nutrition Assistance Program (SNAP) (commonly called food stamps) recipients;
- Designated Community residents;
- Vocational rehabilitation referred individuals;
- Supplemental Security Income recipients;
- Qualified summer youth employees; and
- Long-term unemployed.
The U.S. Department of Agriculture issued a report on June 9, 2017, indicating that 42 million Americans are receiving SNAP benefits, so the WOTC program is potentially far-reaching. In addition, Congress is currently considering legislation to expand the WOTC program by adding at-risk and foster youth groups.
Both the R&D tax credit and the WOTC offer tremendous savings opportunities to taxpayers across industries. Practitioners are advised to consider these credits for their clients. Documentation and recordkeeping are imperative with both. After all, it's not what you claim, it's what you keep.
John Langreck, CPA, is the founding member of Fox Consulting Group LLC (foxconsultinggroupllc.com) in Sacramento, Calif., and can be reached at firstname.lastname@example.org or 916-996-1428.