Welcome to the new year and another tax season. The year 2017 brought major developments to the tax code with the Tax Cuts and Jobs Act signed into law on Dec. 22, 2017. The changes were talked about throughout the year, and the nuances will be discussed throughout 2018. Everyone is busy this time of year with tax planning, so the point of this article is to quickly touch upon a few major points of the tax reform legislation as it relates to the Research and Development Tax Credit.
Two changes that will drastically affect the bottom-line of C-Corps and will have a major impact across C-Corp returns are 1) the removal of the corporate Alternative Minimum Tax (AMT), and (2) a reduction of the C-Corp tax rate from 35% to 21%.
How these two major points are going to affect C-Corps who receive the benefits of the Research and Development Tax Credit
The Research and Development Tax Credit, or R&D Credit, remains a major factor in economic growth in the United States. Congress preserved the R&D Credit in the final tax bill, including the two taxpayer-friendly provisions added by the Protecting Americans from Tax Hikes (PATH) Act of 2015: the eligibility of small businesses ($50 million or less in average gross receipts for the three preceding years) to claim the R&D Credit against their AMT, and certain qualified start-up businesses to apply the R&D Credit against their payroll tax. However, the new law further enhances the benefits of the R&D Credit with the repeal of the corporate AMT. Prior to the passage of the 2017 tax reforms, C-Corps that had revenue exceeding the listed restriction could not use the R&D Credit to offset AMT, but instead had to designate the funds as a loss carryforward. With the corporate AMT no longer an issue, C-Corps can potentially offset their income tax liability to zero. While the individual AMT is still intact for S-Corps and other pass-through entities, those that qualify as small businesses can still take advantage of the PATH Act provision to utilize the R&D Credit against their AMT on shareholder returns.
The change in the corporate tax rate has also had a major impact on how the credit is adjusted from its gross figure to the net benefit. Under IRC 280C, the common formula used for calculating the net credit rate utilizes the current corporate tax rate as the rate of adjustment to achieve the net benefit. The decrease in the C-Corp tax rate subsequently results in an increase in the value of R&D credits. Previously, 35% was subtracted from the gross credit amount, but now 21% will be used for 2018 going forward. Thus, 79% of the gross credit can be utilized rather than the 2017 adjustment amount of 65% of the gross credit. This change impacts all entities who benefit from the R&D Credit, and not just C-Corps.
The carryforward of R&D credits may also affect the value of a company differently between C-Corps and other pass-through entities. When an entity is an S-Corp, or other flow-through entity, the credit will sit on the shareholders’ returns as a loss carryforward. Since the loss carryforward is sitting on the individual returns, it is not an asset of the company. When incorporated as a C-Corp, any R&D Credit that is not utilized will also become a loss carryforward. However, since a C-Corp is not a flow-through entity, the loss carryforward will sit as an asset of the company, potentially increasing the value of the company if there is ever a sale negotiation. Many startups and early stage small businesses utilize this technique as part of their exit strategies.
The passage of the Tax Cuts and Jobs Act reinforces the significance of the R&D Credit. All of the benefits added in 2015 remain unchanged, and the repeal of the corporate AMT and lower tax rate make the R&D Credit a more lucrative and stronger incentive for businesses to innovate and invest in the US. Taxpayers should consider how these changes affect their taxes and ability to claim the R&D Credit. With the tax deadline coming up, it is important to act sooner rather than later to take advantage of the R&D Credit and maximize its benefits.