The recent permanent renewal of the Research Tax Credit (RTC) has expanded opportunities for new and small companies to generate cash. The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), enacted in December 2015, allows start-up businesses to use RTCs to reduce the employer portion of their payroll or FICA taxes, and “eligible small businesses” to use the RTC against the Alternative Minimum Tax (AMT) starting in taxable years beginning after 2015. The permanent extension of the credit provides a particular advantage to life sciences companies, which often face significant uncertainty due to the unpredictable outcome of drug development. RTCs help mitigate the financial risks involved in new drug discovery and development, providing a reliable tax benefit that makes financial forecasting simpler and more predictable.
Start-ups and smaller life sciences companies will also benefit from the certainty that RTCs will be available once their organizations become taxable. The PATH Act provides two additional benefits for such companies:
Start-Up Business That Are “Qualified Small Businesses”
Before the PATH Act, start-ups in a taxable loss position did not receive an immediate benefit from the RTC because they could only use the RTC against regular income taxes. And even though the RTC can be carried back one year and carried forward twenty, that didn’t help companies who often weren’t sure if their business would survive to the next year.
Now, Qualified Small Businesses may elect to take up to $250,000 in RTCs against the employer portion of their payroll or FICA taxes. This election, which can be made for up to five taxable years, provides start-ups a significant and immediate benefit, enabling them to recoup some of their investment to develop new or improved technologies, even if they are not currently paying regular income taxes.
“Qualified Small Businesses” are corporations, partnerships or persons (1) not exempt from income tax under IRC section 501; (2) with gross receipts in the taxable year of less than $5 million; and (3) with no gross receipts prior to the five taxable years ending in the taxable year.
Eligible Small Businesses
Before the PATH Act, AMT taxpayers were only able to benefit from RTCs on a carryforward basis. Now, though, AMT taxpayers who qualify as Eligible Small Businesses can take advantage of RTCs in the present.
“Eligible Small Businesses” include closely held corporations, partnerships and sole proprietorships whose annual gross receipts for the three preceding tax years average no more than $50 million.
RTC Eligibility Criteria
Generally, the RTC is available to companies that:
- Attempt to develop or improve the functionality, performance, reliability or quality of a product, process, software, invention, technique or formula (business component);
- Encounter uncertainty regarding either their capability or methodology to develop or improve the business component or the component’s appropriate design;
- Engage in a process of evaluating alternatives to eliminate the uncertainty; and in doing so,
- Fundamentally rely on technological principles, i.e., those of engineering or the computer, physical or biological sciences.
Don’t Miss Out!
According to BDO's 2016 Tax Outlook Survey, 52 percent of tax directors who did not claim RTCs said they didn’t do so because they assumed they didn’t qualify. Other reasons cited for not claiming RTCs include the AMT bar (22 percent), the planning challenges of the annual renewal process (13 percent) and the assumption that an organization is too small to benefit (13 percent).
Now that the RTC has been enhanced and made permanent, most of these reasons no longer apply. The typical activities that take place during attempts to investigate new drugs, techniques or other components are prime targets for RTCs, but they’re hardly the only activities that qualify. Life sciences companies attempting to develop or even just to improve existing products or production processes are probably also eligible. The cost of supplies used to develop new or improved processes can qualify as well, including lab supplies, prototypes and experimental production lots. And costs related to many types of testing—such as those for product safety and by clinical research organizations—can qualify, too.
All companies, therefore, whether large or small, new or mature, should consider claiming the RTC to lower their tax liability and effective tax rate and increase their cash flow and earnings.
 Companies that attempt to develop orphan drugs should consider the Orphan Drug Credit (ODC). Equal to 50 percent of qualified clinical testing expenses paid or incurred during the tax year, the ODC is based on the RTC but can be more beneficial in some cases.
About the Authors:
Chris Bard is the Practice Leader for BDO’s Specialized Tax Services Research and Development (R&D) practice and Chairman of BDO International’s Global R&D Center of Excellence.
Sue Schwer is a R&D Tax Services Senior Manager at BDO USA, LLP.
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