The research credit is back and maybe better than ever. This business credit, which had expired and been reinstated numerous times since its inception in 1981, was permanently preserved by the Protecting Americans from Tax Hikes (PATH) Act of 2015. What’s more, the PATH Act version of the credit contains a couple of key enhancements, making it even more attractive to some manufacturing firms.
Now the IRS has issued interim guidance relating to the “new and improved” research credit. The guidance 
provides important information on an election for qualified small businesses. (Notice 2017-23, 3/31/17)
Background Information
The research credit is intended to encourage spending on research activities by established firms and startups. In its current form, the credit generally equals the sum of:
- 20% of the excess of qualified research expenses for the year over a base amount,
- The university basic research credit (i.e., 20% of the basic research payments), and
- 20% of the qualified energy research expenses undertaken by an energy research consortium (see box).
For this purpose, the base amount is a fixed-base percentage (not to exceed 16%) of average annual receipts from a U.S. trade or business, net of returns and allowances, for the four years prior to the year of claiming the credit. It can’t be less than 50% of the annual qualified research expense. In other words, the minimum credit is equal to 10% of qualified research expenses (50% rule times the 20% credit).
But be aware that the credit is available only for qualified expenses. This includes an expense if:
- It qualifies as a research and experimentation expenditure under Section 174 of the tax code,
- It relates to research undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in developing a new or improved business component, and
- Substantially all of the activities of the research constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality.
When the PATH Act permanently preserved the research credit, it improved it for qualified small businesses in two ways:
1. AMT liability. Effective for 2016 and thereafter, an eligible small business may claim the research credit against alternative minimum tax (AMT) liability. For this purpose, the business must have $50 million or less in gross receipts.
2. Payroll taxes. Also effective for 2016 and thereafter, a qualified small business may elect to claim the research credit against up to $250,000 in payroll taxes annually for up to five years. In this case, the company must have less than $5 million in gross receipts.
Regarding the payroll tax election, the credit amount is applied against the Old Age, Survivors and Disability Insurance (OASDI) tax liability paid for employees, the portion of FICA commonly called “Social Security tax.” For wages earned in 2017, the employer share of Social Security tax is equal to 6.2% of each employee’s wages up to a base of $127,200. The Social Security Administration (SSA) adjusts this wage base annually.
A manufacturing firm or other business entity must make the election to use the research credit against payroll tax liability on an original return. Thus, the election can’t be claimed on amended returns. Because the election takes effect for credits generated in 2016, it is available to offset payroll taxes during the second quarter of 2017.
New IRS Guidance
The new Notice includes interim guidance with respect to the payroll tax election.
First, it clarifies that the definition of “gross receipts” used to qualify a business is determined under Section 448(c)(3) of the tax code without regard to Section 448(c)(3)(A) and its accompanying regulations. In essence, this means that there’s no exclusion of amounts representing returns or allowances, receipts from the sale or exchange of capital assets under Section 1221, repayments of loans or similar instruments, returns from a sale or exchange not in the ordinary course of business and certain other amounts.
Second, to make a payroll tax credit election, the IRS requires a qualified small business to attach a completed Form 6765 (Credit for Increasing Research Activities) to a timely return, including any extensions, for the appropriate tax years.
Third, the new Notice provides interim relief for qualified small businesses that filed returns for tax years after 2015 in a timely fashion, but failed to make the payroll tax credit election. In this case, the entity may make the election on an amended return filed on or before December 31, 2017. To accomplish this, the business must either:
- Indicate on the top of its Form 6765 that the form is “FILED PURSUANT TO NOTICE 2017-23;” or
- Attach a statement to this effect to the Form 6765.
A qualified small business can claim the payroll tax credit for the first calendar quarter beginning after it makes the election by filing the Form 6765. Similarly, if the small business files annual employment tax returns, it may claim the credit for the return including the first quarter beginning after the date on which the business files the election. The business is instructed to attach a completed Form 8974, providing the Employer Identification Number (EIN) shown on Form 6765, to the employment tax return.
When your small business files quarterly employment tax returns, use Form 8974 to apply the Social Security tax limit to the amount of the payroll tax credit elected in Form 6765 to determine the credit amount allowed on its quarterly return. If the payroll tax credit elected exceeds the employer share of the Social Security tax for that quarter, the excess determined on Form 8974 is carried over to the next quarter, subject to the applicable Social Security tax limit.
The new guidance, which is technical in nature, is probably best left to the tax professionals. What manufacturing firm owners and managers can take away is the realization that the research credit, which is valuable in its own right, can now be used to offset payroll tax liability for qualified small businesses. Factor this into your business decisions.
Simple Does It
In lieu of claiming the regular 20% research credit, your firm can rely on the alternative simplified credit (ASC).
Currently, the ASC is equal to 14% of the amount by which qualified expenses exceed 50% of the average for the three preceding tax years. The ASC, which first became available in 2007, replaced the alternative incremental research credit (AIRC).
Some manufacturing firms prefer the ASC to the regular credit. For instance, the ASC may be used instead of the regular credit if the firm has a high base amount for the regular calculation, doesn’t have detailed records to support qualified expenses during the base period years, has experienced significant growth in receipts in recent years or has a complex history of organizational activity (e.g., mergers, acquisitions and dispositions).
