Effective financial decisions are crucial in ensuring that a business is a going concern, for this reason, the tax and accounting strategies adopted by a company can provide current and future financial benefits. One way to maximize your company’s net income, effectively manage taxes and increase business valuation is through the research and development tax credit, also known as the R&D tax credit, and the net operating loss (NOL) tax credit.
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The R&D tax credit program was introduced in 1981 through the Economic Recovery Tax Act (ERTA). This tax credit assists companies that incur qualified research expenditures (QREs). Qualified research expenditures are costs incurred for discovering technological information intended for developing a new or improved business component. Also, to be eligible for the R&D tax credit, research activities should be channeled towards improvement and innovation.
Non-allowable research activities under the tax credit may include research activities conducted after commercial production has started, duplicated processes or products, surveys, funded research or activities carried out in other countries.
If your company develops new or improved products, manufacturing processes, or software, you may be eligible for the R&D tax credit.
How to take advantage of R&D tax credits
In a tax expenditure report released by the Joint Committee on Taxation (JCT), the estimate of federal R&D tax expenditures for corporations engaged in qualifying research and development activities, under the U.S Code section 41, is $11.6 billion for 2021 and $12.6 billion for 2022. This provides an incentive for research and innovative solutions in the United States and companies need to strategize on tapping into this benefit through the R&D tax credit.
The R&D tax credit is accessible to businesses in any industry that meet the QRE requirements, however, some companies fail to take advantage of this tax break either because they are not aware that it is accessible to them, or they get discouraged by the complexities involved with claiming R&D tax credits.
In deciding whether to claim R&D tax credits, many companies weigh the benefits and costs associated with the process. While R&D tax credits can be applied in the current tax year, or accumulated and carried forward, they require a lot of manual documentation and processes that discourage the tax and accounting team of a business. It is however important to identify the total benefits of the R&D tax credit in both financial and non-financial terms.
The small business payroll tax credit
If your company qualifies as a small business with gross receipts below a $5 million mark for the tax year, and no gross receipts for 5 tax years up to the current tax year, you may be able to claim the Qualified Small Business Payroll Tax Credit for Increasing Research Activities using the Form 8974. By making the payroll tax credit election, a company may access research credit of up to $250,000 applied against the employer’s portion of the social security liability. The credit is limited to the current year research credit – below $250,000, and the general business credit carryforward for the tax year, whichever is the least.
Eligible small business tax credit
Additionally, as an eligible small business with average annual gross receipts of not more than $50 million for 3 tax years before the tax year of the credit, your company may be eligible for tax credits for reducing alternative minimum tax (AMT).
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Calculating the R&D tax credit
R&D tax credits may be claimed through either the regular research credit (RRC), the alternative simplified credit (ASC), the energy research credit, or the basic research credit. Generally, the tax credits do not cover the entire research and experimental costs incurred by a business. The federal government applies a base amount calculation based on the QRE that limits how much can be claimed.
The tax credit calculations may differ based on if your company is considered to be an established entity or a start-up. It may be beneficial to consider the available research credit calculation methods to identify the most beneficial for your company.
For example, let’s consider an established C-corporation applying R&D tax credit using the regular research credit (RRC) method through the federal government.
| Hypothetical R&D Tax credit Calculations | ||
| A | Qualifying research expenditures (QRE) in the current tax year | $11m |
| B | Calculated fixed-base percentage | 5% |
| C | Average annual gross receipts for the four previous years | $85m |
| D | Calculate the base amount (B x C) | $4.25m |
| E | Calculate 50% of QRE in the current tax year (A) | $5.5m |
| F | Determine the greater of D or E | $5.5m |
| G | Reduce the QRE in the current year by F i.e (A – F) | $5.5m |
| H | Apply the regular credit rate of 20% on the reduced QRE (20% x G) | $1.1m |
Based on these basic calculations (real-life calculations may be more complex), this company may be able to claim R&D tax credits of up to $1.1m provided they provide the required documentation and meet all the requirements by the federal government. If this credit is not used, it can be carried over to future years.
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Associated benefits of the R&D tax credit
Advantages of the research tax credit for businesses can be realized through:
- Unused tax liabilities that are carried forward and applied as a dollar-for-dollar tax liability reduction in future years.
- Accumulated credits carried forward for up to 20 years or backward for 1 year.
- Assets recognized on the balance sheet as a result of R&D tax credit carried forward
- Innovation and automation of business documentation processes.
Possible costs of the R&D tax credit
Costs that may accrue to companies in the process of claiming R&D tax benefits may include:
- Record keeping and documentation costs may be substantial. Information gathering and documentation of the entire research and development activities of a company may require time commitments from limited staff. Personnel expenses are also incurred in putting together the final documentation required by the Internal Revenue Service (IRS) for tax filing or audit purposes.
- There is the possibility of IRS tax claim denials. This can be caused by incomplete documentation or heavy reliance on manual R&D processes.
- The greater cost to companies, however, is the R&D tax credits that are missed due to not exploring more effective and automated processes.
What is a Net Operating Loss (NOL)?
Net operating losses (NOLs) occur when the expenses of a company exceed the income resulting in a negative net income. When a business has an NOL, this can result in a tax refund.
While business losses are not exciting, the great part about NOLs is that they can be beneficial for your business when used effectively. Here’s how.
Ways to maximize Net Operating Losses (NOLs)
The two major ways to benefit from a business NOL are through the NOL carryforward and NOL carryback.
- NOL carryforward: Generally, if your business experienced a net operating loss from 2017 onward, you may carry forward the NOL to future years indefinitely. However, there are certain exceptions for some businesses in the agricultural and insurance industries. NOLs carried forward become a deferred tax asset on your financial books and reduce your tax liabilities in the year(s) applied.
- NOL carryback: On the flip side, any NOL in a current tax year can be carried back and applied to prior years that had taxable income. This makes your business eligible for a tax refund, that is, a cashback. For tax years ending from 2020, you may apply an NOL carry back up to the 5 years preceding the NOL year.
If your company expects to have an NOL and apply a carryback in a current year, you are allowed to automatically postpone paying all or part of your income tax for the immediate past year through the Form 1138, Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback.
NOL carryforward vs NOL carryback –– which is better?
The decision to use an NOL carryforward or NOL carryback will depend largely on factors such as the financial position of your business, the business goals and objectives, and overall strategy. From a net present value perspective, any cash you receive today is worth more than cash received in future years.
For this reason, some businesses may choose to use an NOL to claim a tax refund from previous years rather than wait to apply the NOL in future years’ tax returns. However, if you expect that your business taxes may increase significantly in future years, then you can use an NOL carryforward to reduce your future tax liability.
It is important to note that businesses can elect to forgo carrying back an NOL and instead choose to apply the NOL forward to future tax years. This decision cannot be reversed.
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How to calculate an NOL carryover
Your NOL carryback or carryforward should not exceed 80 percent of your business’s taxable income for the applicable year. If the NOL is greater than 80 percent of the taxable income for that year or 100 percent for tax years earlier than 2018, your business must apply a modified taxable income to calculate your NOL tax benefit.
The applicable NOL carryback or carryforward will be the available NOL less the modified taxable income for the carryback or carryforward year.
Net Operating Loss Carryback or Carryforward = NOL – Modified taxable income
The cash advantage of R&D tax credits and NOL carryovers
NOLs and tax credits can be utilized to minimize tax liability and increase cash flow. Tax credits and NOLs carryovers may be recognized as deferred tax assets on a company’s balance sheet. This ultimately adds more value to the company due to the fact that tax liabilities will be reduced and more cash flow is available for business operations.
It is however important to consider the time value of money when carrying forward tax credits, for this reason, a more accurate measure of the cash benefit of R&D tax credits or NOLs needs to be discounted to attain its present value.
For example, using the C corporation example above, if the company accumulates average tax credits of $1,100,000 million per year for up to 3 years, to a sum of $3,300,000, using a discount rate of 5%, this tax credit would be worth about $3,145,351 in today’s dollar value. If the associated total costs incurred in record-keeping and documenting the research and development process amount to $300,000 over the 3 years, this will amount to a present value of $285,941.
In essence, the cost of $285,941 incurred for documenting, filing, and claiming eligible tax credits will yield a return on investment (ROI) of 1000%, an annualized return of 122.4%.
| Calculating the ROI on R & D tax credits | ||||
| Year | 0 | 1 | 2 | Total |
| R&D tax credit | 1,100,000 | 1,100,000 | 1,100,000 | 3,300,000 |
| Cost of claiming R&D credit | 100,000 | 100,000 | 100,000 | 300,000 |
| Discount rate | 5% | 5% | 5% | |
| Discounted R&D tax credit | $1,100,000 | $1,047,619 | $997,732 | $3,145,351 |
| Discounted Cost of claiming R&D credit | $100,000 | $95,238 | $90,703 | $285,941 |
| Return on Investment (ROI) | 1000% | |||
| Annualized ROI | 122.40 |
While this is only a hypothetical case, it emphasizes the importance of taking advantage of tax credits through R&D tax credits and NOLs and the possible cash flow impact it could have on your company.
Learn how you can take advantage of R&D tax credits even when in NOL – BOOK YOUR FREE CONSULTATION
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