With the first full year of tax reform behind us, practitioners and taxpayers are now evaluating the actual impact to their bottom line.
One of the areas impacted by the Tax Cuts and Jobs Act most significantly, albeit indirectly, was the Research and Development (R&D) credit. Technically speaking, the R&D credit was one area of the tax code that was left relatively untouched by congress this last go-round. However, the tax law changes have impacted the effectiveness of the credit, resulting in even more tax savings than initially anticipated.
The Reduction in Corporate Tax Rates
The most important change in the law, in terms of its impact on the R&D credit, was the reduction in corporate tax rates. To understand why this happened, it’s necessary to understand how the R&D credit impacts taxable income. In general, the R&D credit is required to be added back to taxable income, which undermines the effectiveness of the credit. It results in a higher base for state tax purposes and makes the calculation of taxable income more complicated. However, you can select an annual election to avoid the add-back and instead take a reduced credit pursuant to IRC 280C(c)(3).
Essentially, the 280C election reduces the credit by the corporate tax rate. Since the corporate tax rate was reduced from 35 percent to 21 percent, this means that the amount of credit is reduced by a smaller amount than it was before tax reform. Even better, congress made the corporate tax rate permanent so it won’t automatically expire in 2026, like many provisions of the new law. Most taxpayers make this election for the aforementioned reasons—and one easy takeaway is that doing so still makes sense post-tax reform for the vast majority of taxpayers.
The Impact of the R&D Credit on Your Business
This impact is beneficial to taxpayers regardless of their entity type, as well. In fact, even though it’s the corporate rate which changed the most, it’s ultimately individual owners of pass-through entities that will benefit the greatest from making this timely election. If not for the 280C election, those individuals would be taxed on the amount of the credit at their top marginal rate. And the top bracket only decreased the top rate from 39.6 percent to 37 percent, making that delta all the more meaningful. Add to this the fact that the 280C election needs to be checked on a timely filed return (so there’s no going back and amending to claim this benefit), and it adds up to one thing – make sure this is on the agenda in 2019!
Start Planning for 2020
With the 2020 election looming, now is the time to look at anticipated business expenses to see if there are opportunities to classify those as qualified expenses. On a related note, it’s an even better time to look at potentially accelerating projects that could result in significant expenses. That’s because many of those same currently deductible expenses are required to be amortized over five years for amounts paid or incurred in tax years beginning after December 31, 2021.
The R&D credit is an even more powerful tax planning tool than ever before, and it should be a priority point of discussion in year-end tax planning meetings for both small and large companies alike. Some taxpayers can utilize the benefits of this credit even when their company is in a loss position. Yes, there is work involved to gather the necessary records to substantiate the qualified expenses, but it is worth the time and effort.
We encourage you to contact us to discuss your individual situation and how your manufacturing company can potentially benefit from the R&D credit.