CPA Partnerships

The IRS utilizes a “Four-Part Test” to define qualified research activities.

Part I: Permitted Purpose

The activity must relate to new or improved business components in one or more of the following areas:

• Function
• Performance
• Reliability
• Quality

The term “business component” means any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.

SPECIAL RULE FOR PRODUCTION PROCESSES. –Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).

Part II: Technological in Nature

The activity performed must fundamentally rely on the principles of:

• Physical science
• Biological science
• Computer science
• Engineering

Part III: Sense of Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design.

Part IV: Process of Experimentation

Substantially all the activities must be elements of a process of experimentation involving:

• Evaluation of alternatives
• Confirmation of hypothesis through trial and error
• Testing and/or modeling
• Refining or discarding of hypotheses

The R&D tax credit (known previously as Research and Experimentation or R&E) was instituted in 1981 as part of the Economic Recovery Tax Act. The credit was created as an incentive for US companies to maintain their technological competitiveness. However, due to extremely strict requirements and the high threshold of innovation only large corporations were able to utilize the credit (Guenther 2005).

In 2001, President Bush and his administration reviewed the utilization of the credit and discovered that small and mid-size companies were not taking advantage of the credit. This prompted a change in the regulations that removed the high threshold of innovation and allowed the threshold of innovation to be relative to the individual company and not the industry (Rivera 2011).

In 2008, Congress passed The Emergency Economic Stabilization Act of 2008, which retroactively extended the credit and increased the Alternative Simplified Credit rate to 14 percent. In 2010, President Obama signed into law the Small Business Jobs Act of 2010, which eliminated the 2010 AMT restrictions on sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years (Titan Armor 2010)

On December 18th of 2015, President Obama signed into law a sweeping $1.14 trillion-dollar funding bill that kept the federal government operating through September 30th of 2016. In connection to the tax aspects of this comprehensive and pivotal legislation, the Protecting Americans from Tax Hikes Act of 2015 (hereinafter the “PATH Act”) accomplished considerably more than the typical tax-extenders legislation passed in previous years and truly signifies a dynamic paradigm shift as the PATH Act makes permanent over twenty leading tax incentives while extending other tax incentives over either a five-year period of a two-year period.

In particular, the PATH Act meaningfully enhanced the R&D Tax Credit Program (hereinafter “RTC program”) on a myriad of levels. As an overview, the RTC program was initially added to the U.S. Internal Revenue Code (hereinafter the “Code”) in 1981 through the Economic Recovery Act of 1981 as a temporary provision of the Code. The RTC program had most recently expired on December 31, 2014. A tremendous paradigm shift to the RTC program was made possible through the PATH Act, which not only renewed the RTC retroactively for all calendar year 2015 but most importantly made the RTC program permanent. In addition, the enhanced RTC program has been considerably restructured to:

Allow eligible small businesses (i.e., $50 million or less in gross receipts) to claim the credit against the Alternative Minimum Tax (hereinafter “AMT”) for tax years beginning after December 31, 2015;

Allow eligible startup companies (i.e., those with less than $5 million in gross receipts and earning revenue for less than 5 years) to claim up to $250,000 of the credit against the company’s federal payroll tax for years beginning after December 31, 2015; and

Allow Alternative Simplified Credit (hereinafter “ASC”) filers an increase from 14% to 20% in benefit.

On December 22, 2017 the Tax Cuts and Jobs Act was signed into law by President Trump. The Research & Development tax credit survived this major reform and was identified as a priority tax credit by the administration. Taxpayers now are able to take a long-term view when evaluating annual R&D Credit benefits.