2023 brought several changes to the R&D tax credit and its related provisions. As many of you already know, the R&D tax credit can be used to offset both INCOME taxes and/or PAYROLL taxes depending on your company’s eligibility status. Let’s start with the change that would be relevant to your entity’s income taxes. Some are very business friendly while others are not. Here is a list of what you need to know for your business entity taxes and for your personal taxes starting in 2023.
1. Section 174 – Amortization of R&D Expenses
Back in 2017, when Congress enacted several rule changes on business taxes, this sleeper rule was put in place to be effective for tax years starting in 2022. For the tax year starting in 2022, all of the R&D expenses (not credits) need to be capitalized and deducted through a 5-year or 15-year amortization schedule depending on if they are domestic or foreign R&D. This requirement is hurting businesses with cash flow constraints that are otherwise able to deduct the R&D expenses outright before 2022.
For example, your business had 100 dollars of revenue, and you spent 100 dollars on doing qualified research work including paying your employees. Before 2022, you would end up with ZERO taxable income (100 -100 = 0). With this new rule, however, your taxable income is going to be $90 dollars (100 – 10 =90), and with a tax rate of 21%, you will now need to pay $18.9 tax to the IRS. So what happened with the math here? Well, only the $10 from the $100 R&D expenses is allowed as a deduction this year, and the rest are deductible in future years. Although you will get an extra deduction next year, this is creating an artificial income with real tax liabilities for businesses. Even if you claim R&D Credits on the $90 dollars, you are still left with a tax bill at the end.
At the time of this writing, there are no signs of this tax provision getting repealed by Congress although there have been several attempts made by both sides of the House representatives to eliminate it. So how businesses are dealing with it currently? In short, the word has been “waiting”. But others have taken different approaches:
- Not Claiming R&D Expenses or R&D Credits – The concept behind this thinking is that by claiming the company did no R&D, all the expenses are considered ordinary expenses and fully deductible in the year. And wait until this Law is appealed to claim R&D credits through an amended return.
- Waiting for Congress to Repeal before 10/15/2023 – This is to wish that with the extension filed, Congress will repeal it before businesses have to file tax returns and everything will be as good as pre-2022.
- Claiming R&D Expenses and R&D Credits – Most of the large accounting firms such as EY, PwC, and Anderson are advising their clients to just follow the rules. It might be paying a little more taxes currently, but with the hope that things will even out in the future if the rule continues to be in effect, or it will get repealed together.
It is important to know that for companies that are pre-revenue, have prior NOL, or still be in the loss even with the amortization, Section 174 doesn’t make any cash flow impact, and businesses are claiming R&D expenses and credits as usual.
2. Increase in Payroll Credits Offset Starting Q1 2023
Starting in 2023, The Inflation Reduction Act of 2022 (IRA) allowed credits claimed in the past to offset both the employer portion of the Social Security Tax (6.2% of wage) and Medicare Tax (1.45% of wage). This allows companies to offset more expenses (Medicare Taxes) although the 1.45% more refund on wages in 2023 won’t make it a huge saving for any businesses.
This added benefit will likely speed up the existing credit utilization, which would suggest that Companies should file 2022 returns sooner to have fresh R&D credits ready to go. Again, the payroll credit utilization rule is that the Company can only start the credit offset in the quarter after the return was filed.
3. Increase the R&D Credits Election Amount to $500,000
The same IRA states that for tax years starting after 12/31/2022, up to $500,000 of credits can be elected on a timely filed return (including extension). The payroll tax credit is first used to reduce the employer’s share of social security tax up to $250,000 per quarter and any remaining credit reduces the employer’s share of Medicare tax for the quarter. Any remaining credit, after reducing the employer share of social security tax and the employer share of Medicare tax, is then carried forward to the next quarter.
- Generally, for new payroll tax credit elections for tax years beginning after December 31, 2022, made on Forms 6765 attached to timely filed (including extensions) income tax returns, a Qualified Small Business claims the payroll tax credit against employer social security and employer Medicare tax liabilities beginning with the first calendar quarter beginning after the date the income tax return reflecting the election is filed.
- A short tax year filer may be able to make an election on Form 6765 attached to an income tax return filed in 2023. After filing its income tax return reflecting the election on Form 6765, the short-year filer would then claim the payroll tax credit with the first calendar quarter that begins after the date the income tax return is timely filed (including extensions). This may result in the payroll tax credit applying to a 2023 employment tax return.
- For older elections that are carried over into 2023, the carryover amount can now be applied against the employer’s share of social security tax (up to $250,000) and then to the employer’s share of Medicare tax for employment tax returns.
- For both new elections and carryover elections, a payroll tax credit in excess of the employer’s share of social security tax and the employer’s share of Medicare tax shown on an employment tax return may be carried over to the next period’s employment tax return.
This is definitely good news for most businesses that perform qualified research and development activities.
If you have any questions regarding how to claim, how to use, or need help with your R&D credits. Please submit an inquiry or book a free consultation with Zhen.