Companies of all sizes can access several tax credits for activities related to encouraging innovation and job growth. The purpose of these credits is to spur advancements in technology, new products, new processes, and inventions that keep the U.S. at the vanguard of innovation. They can enable businesses to make capital investments, hire new employees, grow existing operations, and invest in new service lines and products, all while substantially reducing their tax liability.
Many business owners assume they do not qualify for these tax credits; however, many normal business activities are applicable. In addition, evolving working environments such as working remotely can affect the applicability of these tax credits. We can help you determine if your business qualifies for the following tax credit opportunities:
Research and Development Tax Credit – Federal and State
The federal government and 36 states recognize the positive economic impact of research and development (R&D) activities conducted within the U.S. by offering tax credits that can stimulate capital investment and reduce tax liability.
Established 40 years ago, the federal R&D tax credit is a dollar-for-dollar credit available to businesses of all sizes. It can apply to a wide range of activities, including:
- Core R&D activities
- New product development/design
- New processes development/design
- New manufacturing processes development/design
- New product manufacturing trials
- Prototype development or pilot processes
- Performance of environmental testing
- Enhancements to existing products or processes
- Technology development for regulatory compliance
Most companies can calculate the federal R&D tax credit when preparing their annual tax compliance filings. To claim the credit, a taxpayer must concurrently document its research activities to establish the amount of qualified research expenses paid for each qualified research activity. Some expenses can be estimated, but there must be a factual basis for the assumptions used to create the estimates. Typical documentation may include project notes, project lists, payroll records, and general ledger expense details.
First-time applicants may have additional opportunities for tax savings. If a company has never applied for the federal R&D tax credit, it can amend its tax filings to capture the previous three years of activity. First-time applicants often generate a large refund, depending on their previously paid taxes, or a sizable tax credit that can be carried forward for 20 years.
Many states also offer significant R&D tax credit opportunities that generally follow federal guidelines for qualification activities, but they may apply their application methodologies and calculations.
Payroll Tax Credit – Federal R&D Tax Credit
Qualified small businesses (QSB) can take the R&D tax credit against their payroll taxes (the employer-paid FICA of 6.2%) for tax years beginning in 2016. A QSB is a company that was formed during or after 2017 and has less than $5 million in annual gross receipts. The Protecting Americans from Tax Hikes Act of 2015 (The PATH Act) extended this tax-saving opportunity which essentially is a refundable credit that caps at $250,000 for up to five years.
The election to offset payroll taxes must be made on a timely filed income tax or informational return, including extensions. For partnerships or S corporations that are QSBs, the election must be made at the entity level. For corporations and partnerships, the gross receipts and the credit limitation apply on a controlled group basis.
Work Opportunity Tax Credit
The Work Opportunity Tax Credit (WOTC) encourages workplace diversity by making a tax credit available to employers who hire individuals from certain target populations who have faced barriers to employment. These targeted groups include qualified veterans, qualified IV-A recipients, ex-felons, designated community residents, vocational rehabilitation referrals, summer youth employees, Supplemental Nutrition Assistance Program (SNAP) recipients, Supplemental Social Security Income (SSI) recipients, long-term family assistance recipients, and qualified long-term unemployment recipients.
Established in 1996, the WOTC was due to expire in 2020 but it was extended through the Taxpayer Certainty and Disaster Tax Relief Act of 2020, a part of the Consolidated Appropriations Act of 2021. The WOTC covers individuals who begin work for an employer on or before December 31, 2025.
The WOTC is based on qualified first-year wages for members of targeted groups. It generally is equal to 40% of the first $6,000 of wages, for a maximum credit of $2,400 per employee. For certain targeted groups, it can provide an even greater tax incentive than the general maximum credit. For several categories of qualified veterans, more than $6,000 of first-year wages are eligible for the credit and the increased wage amounts for qualified veterans range from $12,000 to $24,000 per employee. The WOTC for long-term family assistance recipients equals 40% of qualified first-year wages paid, up to a maximum of $10,000 per employee (maximum credit of $4,000) and 50% of qualified second-year wages paid, up to a maximum of $10,000 per employee (maximum credit of $5,000).
Each potential employee is subject to a pre-screening application process and specific requirements must be met before an employer is eligible for the WOTC. These include the certification and verification of a job applicant’s status as a qualifying member and the submission of IRS Form 8850 with ETA Form 9061 or ETA Form 9062 to the company’s state workforce agency. The company must submit the required forms and application within 28 calendar days of the employee’s start date. Once the state agency determines that the individual meets the requirements and certifies the application, then the employer may claim the WOTC.
Empowerment Zone Employment Credit
The Empowerment Zone Employment Credit allows companies to claim an income tax credit for paying wages to qualified zone employees. The empowerment zones are determined by various federal agencies—a list of federally designated empowerment zones is provided by the IRS in the Instructions to Form 8844, Empowerment Zone Employment Credit.
The credit is 20 percent of the eligible wages paid to qualified zone employees. However, only the first $15,000 of qualified zone wages for each employee each year is considered in computing the credit. The $15,000 limitation for any calendar year is reduced by the amount of wages paid or incurred during that year, which are considered in determining the work opportunity credit. Because of the $15,000 limitation, the maximum credit that an employer may claim each year for each qualified zone employee in an originally designated empowerment zone is $3,000 ($15,000 × 20%).
A qualified zone employee is any employee if the following three conditions are satisfied:
1. Substantially all — the services performed during that period by the employee for the employer are performed within an empowerment zone in a trade or business of the employer.
2. The employee must live within an empowerment zone while performing the services.
3. The employee must not be _ineligible. Ineligible employees are generally employees who are related individuals, a 5% owner, a short-term employee, a recreational employee, or a farm employee.
Author’s Note: Although your business may not be in an empowerment zone, if your employee lives in an empowerment zone and works remotely, you may still meet the 1st requirement if substantially all the services performed during that period by the employee were from home—assuming that the 2nd and 3rd requirements are met.
It is possible to claim all three credits in the same year. However, these credits comprise the Internal Revenue Code Section 38, General Business Credit (GBC). The total GBC allowed for any tax year is subject to certain limitations based on the taxpayer’s filing status. Any unused credits can be carried back one year and carried forward for a maximum of 20 years. In addition, the credits may result in disallowed expenses under Code §280C, which effectively reduces deductible expenses dollar for dollar for those expenditures claimed as a credit. However, there are certain elections and state adjustments that can help minimize the impact of the disallowed wages.
Ultimately, everyday business activities can potentially result in substantial income tax credits. These credits can be complex to determine, calculate and report. Talk to your MichaelSilver tax advisor to review these valuable tax credit opportunities. We can be reached at 847-982-0333.
Carlos Salgado, CPA, MSA – Supervisor, Tax, works with mid-size enterprises focusing on flow-through taxation within a variety of industries, including manufacturing and distribution, professional services, real estate, and retail. He has provided accounting and tax services for over six years, including compliance, tax planning, and management consulting. Carlos is a member of the AICPA and ICPAS.