New Law Opens Door for Businesses to Take R&D Tax Credit and Other General Business Credits
The elimination of the alternative minimum tax bar to general business credits allows small and medium businesses to take advantage of these credits—often for the first time.
By: Dean Zerbe, Benjamin Yaker, and David Ji
The Small Business Jobs Act of 2010 (Jobs Act), signed into law in late September 2010, provides a little-reported change in the tax laws that can have a big impact on the ability of small and medium businesses to claim general business credits such as the research and development (R&D) tax credit.
The bad old days
The great barrier preventing small and medium businesses from taking general business credits has been the alternative minimum tax (AMT) bar provided in Section 38(c) has meant that the owners of a pass-through entity cannot use most general business credits (there are a few exceptions) to reduce taxes below their tentative minimum tax (TMT).
In plain language—if business owner Jill was paying AMT in tax year X, she could not take any general business credits for tax year X. If Jill was paying regular tax (and paying no AMT because her regular tax was above her TMT), she could reduce her tax liability—but only to her TMT level. So, in effect, a business owner would often get little to no benefit from filing for a general business credit.
Many tax advisors have found that it is a good idea not to have any breakable objects within arm's-reach of a client when explaining that yes—the client has engaged in activities that make them eligible for a general business credit, but no—the client cannot use the credit to reduce his or her taxes this year (or only a much reduced portion of the taxes) because of the limitations of Section 38(c).
Given that a strong majority of small and medium businesses are organized as pass-through entities (the owners of which are often subject to AMT), the reality of the AMT bar has been that tens of thousands of these businesses are effectively prevented from taking full advantage of their general business credits. In the authors' experience, four out of five businesses that would qualify for the biggest general business credit—the R&D tax credit—are effectively precluded from taking the credit because of the AMT bar in Section 38(c).
The cavalry arrives
In drafting a bill to provide tax relief to small business, the Senate Finance Committee not only considered old stand-bys (e.g., Section 179) but also looked at new provisions that would encourage job growth as well as support small and medium businesses. Included in the Senate's final package for the Jobs Act was section 2013 of the bill, which provided:
[T]hat the tentative minimum tax is treated as being zero for eligible small business credits. Thus, an eligible small business credit may be used to offset both regular and alternative minimum tax liability.
Needless to say, this caused much rejoicing. The package passed the Senate, was agreed to by the House, and the President signed the bill on 9/27/10. Finally, small and medium businesses could see real benefit from taking general business credits—just like Fortune 500 companies.
Details on the change in law
While section 2013 of the Jobs Act does “turn-off” the AMT bar for businesses taking general business credits, practitioners need to be aware of three nuances of the new law: (1) the effective date and carry back; (2) the definition of a small business that benefits from the AMT turn-off; and (3) the 25/25 test.
Effective date and carry back
This is a one-year provision good only for tax years beginning in 2010. (Most of the provisions in the Jobs Act are good for one year.) The outlook is that Congress may extend this provision—especially given the continued tough economic climate.
While the provision is good only for tax-year 2010, taxpayers can carry back the tax benefits up to five years. The Jobs Act also includes section 2012, which allows small and medium businesses to carry back general business credits for five years instead of just one year. Under section 2013(d), taxpayers can use these credits to offset AMT in the carryback years. Thus, taxpayers must first take the benefit of the elimination of the AMT bar in tax year 2010 and can then take unused tax credits back five years and offset AMT in the prior years. Taxpayers that carry back credits must go all the way back to the oldest year available and then work their way back through 2009 before carrying the credits forward to 2011.
It is worth noting for clarification that this provision applies only to credits generated in tax years beginning in 2010, not to credits generated in earlier years and then carried forward to 2010. However, because credits are used on a first in/first out basis, these carryforward credits can be used first in 2010 to reduce tax to the AMT threshold before the 2010 credits are applied to reduce tax even further.
Definition of small business
Removal of the AMT bar is limited to “eligible small businesses.” Section 2013 defines eligible small businesses as non-publicly traded corporations or partnerships that meet the gross receipts test of Section 448(c), but it substitutes $50 million for $5 million dollars (three-year average). The Joint Committee on Taxation write-up states that in the case of a sole proprietorship, the gross receipts test is applied as if it were a corporation. Credits determined with respect to a partnership or S corporation do not benefit from the AMT turn-off unless the partner or shareholder meets the gross receipts test for the tax year in which the credits are treated as current-year business credits. This means that both the entity and the shareholder/owner must meet the $50 million gross receipts test. It should be noted that the special rules and aggregation rules of Sections 448(c)(2) and (3) apply.
Happily, the Joint Committee on Taxation provides an example: A calendar year corporation meets the $50 million gross receipts test for the 2010 tax year if, as of 1/1/10, its average annual gross receipts for the three-tax-year period ending 12/31/09, do not exceed $50 million.
This $50 million dollar limitation was put into place because of cost. As is often the case in drafting tax laws, there is an eye to the cost of a provision. The $50 million limitation was designed to ensure that small and medium businesses benefited but that the costs of the provision were reasonable.
While the Jobs Act removes the AMT bar on small and medium businesses taking advantage of general business credits, practitioners need to be aware that the Jobs Act did not remove the “25/25” test contained in Section 38(c). Most practitioners may understandably not even be aware of this additional limitation contained in Section 38(c) given that the AMT bar was so high that it usually stopped any further consideration of taking the general business credit.
The 25/25 test prevents a credit from reducing tax below 25% of the amount by which regular tax liability (RTL) exceeds $25,000. For most taxpayers, the 25/25 test will have little or no impact, at most a slight shave on the benefit of taking the general business credits. What the 25/25 test is effectively saying is that general business credits cannot be used to reduce one's tax liability to zero.
Xenon, a C corporation that meets the qualifications of an eligible small business, generates $150,000 in small business credits in 2010. Xenon has taxable income of $500,000, RTL of $170,000 and TMT of $100,000. Under the previous law, Xenon could use only $70,000 of in credits ($170,000 - $70,000 = TMT level of $100,000). This left $80,000 of unused credits to carry over to other tax years. Now under the new law, Xenon is no longer limited by the TMT level.
Can Xenon reduce its tax liability from $170,000 to $20,000 ($170,000 - $150,000) under the new law? It cannot do that because the 25/25 rule kicks in; RTL cannot be reduced below 25% of the amount by which RTL exceeds $25,000. However, Xenon can reduce its tax liability to $36,250 and carry the remaining $16,250 to other years. (Xenon's RTL of $170,000 - $25,000 = $145,000. 25% of $145,000 = $36,250.) Therefore, thanks to the new law, X is able to use $63,750 in additional general business credits and slash its tax bill by nearly two thirds.
The general business credits
Section 38(b) lists 36 different business credits. A few of these credits already have in place a partial or complete exemption from Section 38(c)‘s AMT bar. These include the small employer insurance credit contained in the health bill, the empowerment zone employment credits (reduce AMT by 25%) and the Section 48 energy property credit. However, the vast majority of general business credits have been subject to the full effect of Section 38(c), the major ones being:
• R&D tax credit— Section 41
• Work opportunity tax credit— Section 51
• Low-income housing tax credit— Section 42
• Disabled access tax credit— Section 44
• New markets tax credit— Section 45D
• Employer-provided child care tax credit— Section 45F
The R&D tax credit
This article will give special attention to the R&D tax credit because it is the most generous of the general business credits—and is also significantly underutilized by small and medium businesses. A recent Government Accountability Office report found that the vast majority of dollars of the R&D tax credit go to the largest corporations.
Certainly, a significant hurdle to the use by small and medium businesses of the R&D tax credit has been Section 38(c). That hurdle has been removed for tax year 2010. Still remaining, however, is the other major barrier to using the R&D tax credit—self-censoring by business owners or tax practitioners. Too often, business owners or tax practitioners take a narrow—and often incorrect view—of what activities are eligible for the R&D tax credit.
The following are four myths surrounding the R&D tax credit:
(1) No discovery test. The R&D work does not have to be new to the world, require a patent, or place the company on the shortlist for the Nobel Prize. The R&D work only has to be new to the company. Often a company receives the R&D tax credit for applying known scientific/engineering principals to a specific problem that is new to the company.
(2) No eureka moment. Similar to the discovery test, there is no shout of eureka required for the R&D tax credit. The work does not have to be a breathtaking discovery or leap forward. Commonly, the R&D tax credit is received for incremental and modification changes and improvements (read small steps) of known and existing products or manufacturing processes.
(3) No lab coat required. Probably the biggest pitfall is the erroneous view that one must have a research lab and people wearing lab coats in order to apply for the R&D tax credit This is wholly incorrect; R&D takes place in a myriad of settings and places, including at an engineer's drafting table, on a software designer's computer, or on the factory floor.
(4) Not just for the space shuttle. The R&D tax credit is not limited to suppliers of NASA. Congress intended the R&D tax credit to encompass a broad array of businesses, including: manufacturing (all types), software, food processing, agricultural, architectural, and engineering.
The bottom line is that if a business is making a widget, unless it has been making the exact same widget the exact same way for the past 20 years, it is probably engaged in research and development.
The Jobs Act has provided a tremendous opportunity to tax practitioners to assist their small and medium business clients to take advantage—often for the first time—of the general business credits. Tax practitioners need to make sure that they are reviewing each of their clients' expenditures to determine whether they are eligible now to use the general business credits. CPAs should go back through any of their clients who are subject to AMT, or close to it, and reassess opportunities for them to claim and use all of the general business credits. In particular, CPAs should focus on flow-through entities since they were often the ones most affected by the Section 38(c) limitation.
The Jobs Act and the elimination of the AMT bar to general business credits has provided tax practitioners the chance to be heroes this filing season by providing their clients much-needed extra dollars to keep doors open and create new jobs.