Four Things to Know About Federal and Virginia Research Tax Credits
Posted on 10.31.16
By: Ryan Beethoven-Wilson, CPA, Tax Manager | State and Local Tax Team
There have been several recent changes in the world of research and development tax credits which can result in substantial tax savings opportunities if properly utilized by taxpayers and their advisors. Here are four things to know about Federal and Virginia R&D credits, and some recent developments:
What is the R&D credit, and what’s new?
The research credit (aka research & development credit, research & experimentation credit, R&D credit) is a component of the general business credit that can be claimed against your tax liability for any year in which qualified research expenses are incurred. The computation of the credit is heavily dependent on facts and circumstances, but is generally calculated by taking a portion of a taxpayer’s qualified research expenditures (think research related wages, contractors, and supplies) in any given year. It is a powerful incentive to U.S. taxpayers who are engaging in research and experimentation, the definition of which is broader than most people think. There was danger that the credit incentives would expire at the end of 2014, however the 2015 PATH Act has made the R&D credit permanent. Additionally, the credit can now be used to offset payroll and alternative minimum tax (AMT) liabilities for certain taxpayers, which will be explained below.
How do I qualify for the credit?
When most think of research, development, and experimentation, images of lab coats and chemistry class probably come to mind. Fortunately, the definition of research for tax purposes is a bit broader. Testing of new products, new processes, plant layouts, and other efficiency increases all have potential to be considered qualified research activities for purposes of the R&D credit. The four main requirements that must be met to be considered a qualifying research expense are technical uncertainty, process of experimentation, reliance on hard science, and bona-fide purpose to increase performance. The key consideration is documentation of these activities so that you may be able to substantiate any credits claimed. In order to claim the credit, an analysis is performed on qualified research expenses and calculations are made to determine the credit amount. It is highly recommended that professional assistance is obtained to calculate and substantiate the R&D credit to offer protection against IRS scrutiny. Federal R&D credits are usable against your current year tax liability, and any unused credits are carried forward 20 years to offset future taxes.
I have a small business, how does this apply to me?
With the complexity and cost of calculating and substantiating R&D credits, they have typically been viewed as mainly beneficial to large taxpayers. However, there are some recent developments that may be very impactful to small businesses.
Beginning with 2016, businesses with less than $50 million in gross receipts will be able to use the R&D credit to offset alternative minimum tax (AMT) as well as regular tax. Prior to 2016, the credit was only eligible to offset regular tax. There a limitation on this however. Any credits carried forward into 2016 are NOT eligible to offset AMT. Only newly-generated credits for 2016 and beyond are eligible.
Perhaps even more importantly, small businesses who are less than 5 years old, with no gross receipts prior to 2012, and generate less than $5 million in receipts annually, can use the R&D credit to offset up to $250,000 of the company’s payroll tax obligations annually, for up to 5 years. The payroll credit will be available starting with expenses incurred in 2016, which can be used to claim the R&D credit on the 2016 income tax return. As soon as the 2016 income tax return is filed, the portion that will be used to offset payroll taxes can be identified and used against payroll tax obligations which will most likely be in mid-2017. Again, sufficient documentation will be key to substantiate any credits claimed.
What’s this I’m hearing about additional Virginia state credits?
While unused Federal R&D credits are carried forward to offset future taxes (unless it’s a small business), Virginia has a separate state-only credit that is refundable to the extent the credit is not used to offset state income taxes. The requirements to claim the traditional Virginia credit are similar to the Federal requirements, except the qualified research must be performed in Virginia and the qualified expenses must be under $5 million annually. As mentioned earlier, the state credit is refundable which makes the credit even more attractive. However, Virginia does cap the amount of credits that can be claimed each year. Also unlike the Federal R&D credit, there are specific application requirements that must be followed by Virginia taxpayers prior to filing a Virginia tax return. Documentation needs to be provided with the application, which is due by July 1 of the following year, and then the Department will notify taxpayers of credit approval prior to the taxpayer claiming the credit on their state return.
For large taxpayers, the traditional Virginia R&D credit is not available if qualified Virginia R&D expenses exceed $5 million annually. However, a new piece of legislation has created the Major R&D credit, which will benefit taxpayers who exceed $5M R&D expense threshold. The Major R&D credit is calculated at 10% of the difference between:
- The taxpayer’s current-year qualified Virginia R&D expenses, and
- 50% of the taxpayer’s average qualified Virginia R&D expenses for the three preceding tax years.
If the taxpayer has no qualified Virginia R&D expenses for three preceding tax years, then the credit is calculated at 5% of the current year qualified Virginia R&D expenses.
The calculated credit can then be used to offset up to 75% of the taxpayer’s current year Virginia tax liability. Any unused credits will be available for the next 10 tax years. So while the new Major R&D credit is not refundable, it will provide current and future significant benefits to businesses investing in R&D activities in Virginia.
The Virginia Department of Taxation has recently issued draft guidelines for the state R&D credits which are available on the department’s website. These guidelines are now available on the Department’s Research and Development Expenses Tax Credit Guidelines website, and Major Research and Development Expenses Tax Credit Guidelines website. We will be monitoring the progress of these guidelines to determine how they may impact businesses based in Virginia, and those from other states who are making investments into Virginia.
Interested in learning more about research and development tax credits, and how these may impact your bottom line? Contact your Keiter representative, Email us, or call 804.747.0000.
Other Tax Planning and Opportunity Resources:
Ryan works with both large and mid-market clients in the professional services, real estate, construction, manufacturing, and retail industries. He assists his clients with tax planning and saving opportunities to help their businesses grow. He is a member of Keiter’s Professional Services and Manufacturing, Distribution & Retail teams. Ryan also serves on the Firm’s State and Local Tax Committee and International Tax Committee. Ryan participates in the Greater Richmond Chamber of Commerce’s Helping Young Professionals Engage (HYPE) program and in the Richmond Venture Forum. Read more of Ryan’s insights on our blog.