The Research and Development Tax Credit Program, or RTCP, was introduced into the Internal Revenue Code to encourage businesses to invest in significant research and development efforts with the high expectation that such an advantageous tax incentive program would help stimulate economic growth and investment throughout the United States and prevent further jobs from being outsourced to other countries.
In December 2015 the Protecting Americans from Tax Hikes Act of 2015, or PATH Act, made the RTCP a permanent tax incentive within the Code and considerably restructured the program to allow eligible “small businesses” (i.e., $50 million or less in gross receipts) to claim the RTC against the Alternative Minimum Tax for tax years beginning on January 1, 2016.
Businesses with average annual gross receipts of less than $50 million for the three taxable year period preceding the current taxable year are now eligible to offset both their regular income tax and their AMT with RTCs. Before the enactment of the PATH Act, businesses in AMT positions were unable to utilize their RTCs to offset their tax liability. Regardless, it is important to point out that RTCs can generally be either carried back 2 years or carried forward up to 20 years before the RTCs could expire unutilized
In addition, PATH allows eligible “start-up companies”, which is defined in this section of the Code as companies with less than $5 million in gross receipts in the current taxable year and that have no gross receipts for any taxable year prior to the five taxable year period ending with the current taxable year, to claim up to $250,000 of the RTC against the company’s federal payroll tax for tax years beginning on January 1, 2016.
Using the Research & Development Credit to Offset Payroll Taxes
New businesses or start-up companies may be eligible to apply the research and development (R&D)tax credit against their payroll tax for up to five years. The R&D credit was permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. It includes some enhancements starting in 2016, including offsets to alternative minimum tax and payroll tax for eligible businesses.
The credit is still based on credit-eligible R&D expenses, but offsets apply to only those costs incurred beginning in 2016. The new payroll tax offset allows companies to receive a benefit for their research activities regardless of whether they are profitable. The new payroll tax offset is available only to companies that have:
The maximum benefit an eligible company is allowed to claim against payroll taxes each year under the new law is $250,000.
Regardless of industry, if a company’s activities meet the following requirements, known as the four-part test, then they could potentially be eligible for this credit:
Additional thresholds may apply if a company develops software for internal use. Also, activities must be performed in the United States and can’t be funded by another party.
Eligible Research and Development Costs
Eligible R&D costs include these categories:
Social Security Tax
Companies are required to pay Social Security tax of 6.2 percent on up to $118,500 of each employee’s salary in 2016. A company that employs 50 employees with an average salary of $75,000 per person would pay approximately $232,500 in Social Security payroll taxes in 2016. The credit can only be applied to the employer’s Social Security portion of payroll taxes. As such, a company would need to have more than $4 million in annual payroll subject to social security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.
Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis and also file a quarterly payroll tax return (Form 941). The credit will be applied against the Social Security tax on the quarterly return, not when it’s deposited monthly or semiweekly. It’s important to note, however, that the IRS is still formulating a plan for how the process will be formally implemented.
The payroll tax offset may be available to new businesses and start-up companies for up to five years. Any unused R&D credits that aren’t elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.
IRS Risks to Claiming the R&D Credit
Once a company starts to use these credits, they see a much higher level of scrutiny from the IRS. In fact, R&D credits are often a high priority for the agency every year and it’s assembled project teams by industry with technical specialists that assist in reviewing R&D credit claims. Even at the small business level, it’s common for IRS technical specialists to be involved in R&D credit examinations. In general, larger credits may receive more scrutiny from the IRS and, therefore, require a higher degree of review and documentation.
Although many companies in the technology industry are likely engaged in activities that would otherwise be eligible for R&D credits, the rules surrounding the credit are complex and ever-changing. New legislation, regulations, court cases, and IRS guidelines have drastically shifted the landscape of R&D tax law over the past few years and will continue to do so in the future.
Considering these complexities and potential financial penalties, companies should have their activities analyzed by a CPA, attorney, or enrolled agent familiar with the intricacies of tax law and accounting rules that govern the R&D credits as well as the IRS examination and appeals process. To deter companies from claiming credits without the proper level of review and documentation, the IRS has the ability to impose penalties in excess of 20 percent of the credit amounts claimed. For example, if a taxpayer claims a $250,000 R&D credit and the credit is then audited by the IRS, it’s possible that the agency could deny the entire credit and fine the company with accuracy-related penalties in excess of $50,000.
IRS audits of businesses have dropped in 2016 to just 0.49% of all business tax returns, the lowest level since 2004. IRS audits of large corporations have also dropped. The IRS audited 6,458 large corporations, which are entities with assets exceeding $10 million. Four years ago, the IRS audited over 10,000.
Tax audits of individual by the IRS declined for the fifth straight year in 2016. The IRS audited just 0.7% of tax returns, which represents 1 in every 143 individual tax returns, down from 1 in 90 back in 2000. In 2016, the IRS audited 5.83% of high-income households, which is defined as returns with income over $1 million, down from 9.55% in 2015, which represents the lowest audit rate for that income group since 2008.
The above drop in audit rates are a result of budgets cuts at the IRS, which has lost 30% of its enforcement staffing since 2010. Expect Republicans to continue cutting the agency’s budget as part of broader spending cuts and the continued lowering of IRS audit rates.
The rules for the collection of New York State sales tax as it relates to computer software are quite complex. In this article we look to explain how sales tax applies to sales of computer software and related services.
Prewritten computer software is taxable as tangible personal property, whether it is sold as part of a package or as a separate component, regardless of how the software is conveyed to the purchaser. Therefore, prewritten computer software is taxable whether sold:
Prewritten computer software includes any computer software that is not designed and developed to the specifications of a particular purchaser. This includes software created by combining two or more prewritten programs or portions of prewritten programs.
Custom software is not subject to tax provided it is designed and developed to the specifications of a particular purchaser. If the custom software is sold or otherwise transferred to someone other than the person for whom it was originally designed and developed, it becomes subject to tax.
Prewritten software that is modified or enhanced to the specifications of a particular purchaser is subject to tax. However, if the charge for the custom modification or enhancement is reasonable and separately stated on the invoice, then the charge for the modification or enhancement is not subject to tax.
Computer software services
Many services related to computer software are exempt. Examples of these services include:
However, when these otherwise exempt services are provided in conjunction with the sale of prewritten software, the charge for the service is exempt from tax only when the charge for the service is reasonable and separately stated on the invoice or billing statement given to the customer.
Sales of software upgrades
Generally, the sale of a revision or upgrade of prewritten software is subject to tax as the sale of prewritten software. If, however, the software upgrade is designed and developed to the specifications of a particular purchaser, its sale to that specific purchaser is exempt as a sale of custom software.
Remotely accessed software
A sale of computer software includes any transfer of title or possession or both, including a license to use.
When a purchaser remotely accesses software over the Internet, the seller has transferred possession of the software because the purchaser gains constructive possession of the software and the right to use or control the software.
Accordingly, the sale to a purchaser in New York of a license to remotely access software is subject to state and local sales tax. The situs of the sale for purposes of determining the proper local tax rate and jurisdiction is the location from which the purchaser uses or directs the use of the software, not the location of the code embodying the software. Therefore, if a purchaser has employees who use the software located both in and outside of New York State, the seller of the software should collect tax based on the portion of the receipt attributable to the users located in New York.
Software maintenance agreements
Separately stated and reasonable charges for maintaining, servicing, or repairing software are exempt from sales tax. However, if a software maintenance agreement provides for the sale of both taxable elements (such as upgrades to prewritten software) and nontaxable elements, the charge for the entire maintenance agreement is subject to tax unless the charges for the nontaxable elements are:
Exempt sales for production or research and development
Prewritten computer software used or consumed directly and predominantly in the production of tangible personal property for sale, or directly and predominantly in research and development, is exempt from tax. The purchaser must provide the seller with a properly completed Form ST-121, New York State and Local Sales and Use Tax Exempt Use Certificate. See Tax Bulletins Exempt Use Certificate (TB-ST-235) and Research and Development (TB-ST-773).
Exempt sales to corporations and partnerships
Custom software is exempt from tax when resold or transferred directly or indirectly by the purchaser of the software to either:
However, the exemption does not apply if the sale or transfer of the custom software is part of a plan having as its principal purpose the avoidance or evasion of tax, or if the sale is prewritten software that is available to be sold to customers in the ordinary course of business.
As more companies in the manufacturing industry are becoming involved in foreign transactions, particularly exporting, they need to be aware that they can reduce their U. S. tax liability using an Interest-Charge Domestic International Sales Corporation, more commonly known as an IC-DISC. The IC-DISC is a federal tax export incentive entity structuring available for U. S. companies that export goods and services to foreign countries. An IC-DISC creates the opportunity to tax a portion of export related to profits at lower tax rates, and to potentially defer export related income to future years.
The IC-DISC allows certain U. S. exporters to reduce their overall tax liability through a commission mechanism. The exporter manufacturing company pays a tax deductible commission, based on qualified export sales, to a newly created corporation that makes an IRS election to be an IC-DISC. By design, IC-DISCs are exempt from federal tax, and therefore do not pay tax on the commission received. The IC-DISC then distributes the commission income to the shareholder as a qualified dividend subject to tax at reduced capital gains tax rates.
The IC-DISC entity can be created by the shareholders of the exporter manufacturing company as a brother-sister configuration, typically used when the exporter manufacturing company is a regular corporation for tax purposes. Or, the IC-DISC can be established by the exporter manufacturing company as a parent-subsidiary configuration when the parent exporter manufacturing company is a pass-through type tax entity.
In either case, the benefit received from utilizing an IC-DISC structuring is dependent on the tax structuring and the effective tax rates of the taxpayers involved in the commission transactions. The IC-DISC is not required to distribute its accumulated earnings, allowing for the dividend income to be deferred into future years.
Export sales must meet the following requirements in order to qualify for the IC-DISC benefit:
In addition to export sales of manufactured property, the following transactions may also qualify for IC-DISC treatment: