Learn how the PATH and Inflation Reduction Acts help small businesses use the R&D tax credit to offset their expenses.
In 2022, the Inflation Reduction Act (IRA) was signed into law. It's a 10-year plan designed to improve a range of tax laws, upgrade technology and simplify the filing of tax returns.
Along with the Protecting Americans from Tax Hikes (PATH) Act of 2015, the IRA enhances the federal tax credit that eligible small businesses can use to offset their research and development (R&D) expenses.
In 2015, the PATH Act expanded (and permanently extended) the R&D tax credit to encourage small businesses to invest in research and development activities.
According to the Internal Revenue Code (IRC Section 41), the following expenses—when related to qualified R&D activities performed in the United States—are eligible for the R&D tax credit:
- Wages paid to employees performing the R&D activities
- Supplies (tangible, raw materials) used to conduct the activities
- Cloud computing expenses used to develop qualified software
- Amounts paid to contractors involved in the R&D activities
The IRA and PATH Act also offer a number of other incentives for small businesses to claim the R&D tax credit.
The IRA doubles the amount a qualified business can claim against its payroll tax. Starting in tax year 2023, qualified businesses can claim up to $2.5 million over five years—$250,000 against FICA and $250,000 against Medicaid per year. This allows them to appreciate the benefits of the R&D tax credit even if they have little or no tax liability—thus freeing up their cash flow.
To qualify for the payroll tax credit election, a business must be a corporation or partnership with average gross receipts under $5 million for the tax year, and no gross receipts older than five years. For example, the R&D tax credit is not available in 2023 for companies that had gross receipts in 2018. (Specifics regarding eligibility can be found on IRS form 6765.)
Offsetting the Alternative Minimum Tax (AMT)
Under the PATH Act, beginning in tax year 2016, small businesses can apply the R&D tax credit against their AMT.
The credit equals whichever of the following is the smallest:
- The current year's IRC Section 41 credit,
- An elected amount not exceeding $250,000, or
- The general business credit carryforward for the tax year before the application of the payroll tax credit. (This rule differs for S corporations and partnerships.)
To be eligible for this tax credit, a business cannot be a publicly traded corporation, a partnership or a sole proprietorship—and must have average annual gross receipts under $50 million for the three years preceding the current taxable year. (Specifics regarding eligibility can be found on IRS form 6765.)
Are you on the PATH?
Is your business undertaking R&D activities? If so, you may be eligible for the R&D tax credit. Consult with the R&D tax experts at ADP and get on the PATH to innovation.
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