Earlier this year, Congress passed the CARES Act to provide an economic stimulus to assist businesses, individuals, and health care providers impacted by the Coronavirus pandemic. The idea behind CARES was to offer businesses incentives with various tax provisions and loan opportunities, including the well publicized “Paycheck Protection Program” (PPP).
Another incentive, which has been available to businesses for nearly 40 years, is the “Credit for Increasing Research Activities” (“Research Credit” or R&D Credit). Many businesses do take advantage of this incentive, and while it has gone through several changes and enhancements over the years, there were no changes to the Research Credit as part of any stimulus legislation related to the pandemic.
There could be an opportunity for businesses that obtained a PPP loan and also expect to claim the Research Credit this year. This Sikich Tax Alert highlights the intersection of the PPP loan and the Research Credit and how to get the most benefit out of both.
Background
As PPP loans were designed to provide working capital and liquidity to employers impacted by the Coronavirus, companies needed to use the PPP loans to pay certain necessary expenses, primarily payroll. For the loan to be forgiven, the companies, as borrowers, will need to file an application for PPP loan forgiveness and document how their loan proceeds were spent.
The Small Business Administration (SBA) and the IRS have issued guidance on the PPP loan process and the tax provisions of CARES to assist borrowers, lenders, and advisors. In addition, Congress made changes to address various issues and concerns with the PPP loan program, including the following:
- The CARES Act initially set an 8-week period for a company to spend its loan proceeds on required expenses. Congress then increased this period to 24 weeks. This means a company has a much longer period to spend its loan proceeds and document it.
- Congress made revisions so a business must spend at least 60% on its payroll, and thus it can spend up to 40% of the loan on non-payroll costs such as interest, rent, and utilities (the SBA had initially set these ratios at 75% for payroll and 25% for non-payroll).
- Congress indicated that PPP loan forgiveness would not be taxable. The IRS then released guidance clarifying that the qualified expenses incurred (payroll, rent, interest, and utilities) using PPP loan proceeds would not be deductible.
- The PPP payroll costs apply to all employees of a business, with certain limitations for owners and higher income individuals. These payroll costs, however, could also include “qualified research expenses” (QRE) that the company incorporates into its Research Credit calculations. Since the PPP costs are not deductible, the company’s QRE costs would be reduced and it could lessen its R&D credit.
Threading the Needle
The idea is for a company to accomplish two goals: (1) have their PPP loan fully forgiven; and (2) at the same time, maximize the R&D credit for 2020. With the expanded 24-week period and the ability to have 40% of the qualifying costs as non-payroll, many companies may generate qualifying costs that greatly exceed the amount of their PPP loan. As it is likely to have excess qualifying costs for PPP loan forgiveness, a company should be able to have its entire loan forgiven—but the key will be for the company to allocate the costs in such a way as not to reduce the impact on its R&D credit. If possible, any payroll costs that would be includible as a QRE should not be reported on the Loan Forgiveness Application.
Therefore, companies should look at several strategies to achieve these goals.
- First – for the costs submitted for PPP loan forgiveness, allocate as much (up to 40%) of the qualifying expenses as possible to non-payroll qualifying costs of interest, rent, and utilities.
- Second – the remaining 60% (or more) must be supported by payroll costs. There is nothing in the current guidance on whether a company must allocate the PPP across all employees on the payroll evenly. Thus, there is the possibility to allocate the PPP loan to employee wages that are not QRE wages eligible for the R&D credit. This may vary from one company to another, so all amounts should be gathered, and a detailed analysis conducted. This assumes the company has enough non-QRE payroll costs to fully absorb the PPP loan forgiveness amount. The example below should help illustrate this point.
- When the PPP loan forgiveness application is filed, we encourage the borrower to specifically identify the employees for whom the PPP proceeds are being allocated, and if possible, exclude employees that would be treated as a QRE expense.
The following other points should be noted in this situation:
- There is some uncertainty regarding if a company were to file its tax returns before it files and receives its PPP loan forgiveness. For instance, a fiscal year borrower/taxpayer with say a June 30, July 31, August 31, or September 30 fiscal year. The IRS has not offered official guidance on this matter, but is expected these expenses will be treated as non-deductible as they are incurred if the taxpayer expects their PPP loan (that funded these costs) to eventually be forgiven. Thus, the borrower in this case might want to extend their fiscal year tax return to see if any IRS guidance is issued on this matter.
- This is not just an R&D tax credit issue; rather, the first step involves dealing with the PPP loan forgiveness. Any company that has received PPP loans will need to determine how to handle the proceeds and associated expenses. A company must first determine how the PPP loan proceeds are treated and the amount of any forgiveness.
The best approach at this point is for borrowers to allocate the PPP loan proceeds for non-payroll costs up to the lesser of: (1) their actual non-payroll costs; or (2) 40% of the total loan proceeds. Next, for the remaining 60%+ of the payroll costs, assign as much of this remainder to non-QRE costs. The final Research Credit calculations can then be performed when the company files its tax return (including an extension of time to file). As a result, we would suggest businesses refrain from filing early to see if any additional IRS guidance is issued.
Case Study
This example further illustrates the strategy of what payroll costs to treat as being forgiven.
Harvest Company (“Harvest”) makes high-tech pumpkin and fall decorations. The Company applied for and received a PPP Loan of $1,000,000. Using a 24-week covered period, Harvest incurred $1,800,000 of expenses eligible for loan forgiveness as follows:
- Non-payroll PPP Expenses (interest, rent, utilities)
- Payroll Costs (QRE eligible)
- Payroll Costs (non-QRE eligible)
- Total PPP Eligible Costs
- $600,000
- 400,000
- 800,000
- $1,800,000
Harvest applies for its PPP loan forgiveness using the following amounts:
- Non-payroll PPP Expenses (interest, rent, utilities)
- Payroll Costs (non-QRE eligible)
- Payroll Costs (QRE eligible. None submitted)
- Total PPP Eligible Costs
- $400,000
- 600,000
- – 0 –
- $1,000,000
Harvest submitted total qualifying costs of $1,000,000 and received full PPP loan forgiveness of 1,000,000. Thus, no taxable income is recognized to Harvest on the forgiveness of this $1,000,000 in PPP loan. Further, Harvest is not able to deduct the corresponding $1,000,000 of expenses, with $400,000 being assigned to the non-payroll expenses (interest, rent, and utilities), and $600,000 assigned to payroll costs that are non-QRE-related.
Harvest also takes advantage of the Research Credit every year. Over the prior three years, it incurred average annual QREs of $3,000,000. It also expects to incur $3,000,000 of QRE expenses in 2020, which includes the above $400,000 of expenses that were eligible costs for PPP loan forgiveness but not submitted as part of the loan forgiveness application.
In this situation, Harvest would be entitled to a Research Credit calculated as follows using the Alternative Simplified Method (“ASC”):
- Current year QRE for 2020
- Reduction of QREs for PPP Loan Item
- Total Net Current Year QRE
- Less: 50% of Average QRE of Prior 3 Years
- Excess over Base
- Gross Research Credit (14% of Excess)
- $3,000,000
- -0-
- $3,000,000
- <1,500,000>
- $1,500,000
- $210,000
If, instead, Harvest had included all $400,000 of its qualifying payroll costs that were QRE-related in its PPP loan forgiveness application, these costs would still have resulted in the full PPP loan forgiveness of $1,000,000. The 2020 QRE costs would, however, have been reduced from $3,000,000 to $2,600,000. Thus, Harvest’s 2020 Research Credit calculation would have been determined as follows:
- Current year QRE for 2020
- Reduction of QREs for PPP Loan Item
- Total Net Current Year QRE
- Less: 50% of Average QRE of Prior 3 Years
- Excess over Base
- Gross Research Credit (14% of Excess)
- $3,000,000
- <400,000>
- $2,600,000
- <1,500,000>
- $1,100,000
- $154,000
By assigning the full 40% of the non-payroll costs and the non-QRE payroll costs for its PPP loan forgiveness application, Harvest is able to: (1) receive full loan forgiveness on its PPP loan of $1,000,000; and (2) receive the maximum R&D Credit of $210,000. Had Harvest not allocated the QRE payroll costs in this manner, Harvest could still have received full loan forgiveness of $1,000,000 but would have seen its Research Credit cut by $56,000 from $210,000 to $154,000.
Takeaways
The PPP loan has provided much needed funding for many businesses in 2020 as they navigate the many challenges presented by the pandemic. However, the PPP loan also introduced many questions and uncertainties for borrowers and lenders. Despite these challenges, the loan forgiveness presents an incentive for borrowers, and if a borrower also claims a Research Credit, they might be able use both. Please contact your Sikich advisor with any questions or for help analyzing your tax situation.
About our authors
Jim Brandenburg
Jim Brandenburg, CPA, has extensive experience and knowledge in corporate and partnership tax law, mergers and acquisitions and tax legislation. His expertise includes working with owners of closely held businesses to identify tax planning opportunities and assist them in implementing these strategies.
Tom Bayer
Thomas E. Bayer, CPA, CExP, has more than 25 years of experience providing a broad range of accounting, tax, and business advisory services to commercial clients across various industries and Sikich offices. Tom has specialized expertise in the areas of business succession planning, tax planning and compliance, and business advisory. He puts his business succession planning abilities and knowledge to work firm-wide, serving clients in advisory services across the country.
