Many of the ways the coronavirus has affected the economy are obvious, such as learning how to engage employees in a work-from-home environment or dealing with losses in revenue. Other issues are harder to see. For example, research tax credits under Section 41 of the Tax Code could look very different for some companies in 2020 compared to other years. These differences are partially due to statutory issues. Other differences are due to the changing work environment. However, businesses will need to be aware of these changes to maximize this important tax savings.
The research tax credit was first established in 1981 as a way to reward companies for their investment in research and development activities and expenditures. It is an incremental credit based on a company’s increase in spending on R&D, with qualified expenditures known as Qualified Research Expenses (QRE). For most companies claiming an R&D tax credit, the largest QREs relate to wages paid to employees for time spent conducting qualifying R&D activities. A number of qualifying criteria determine what a qualifying expense is, but for purposes of this discussion it is most important to understand that the credit is typically wage-driven.
When pursuing the R&D tax credit, most taxpayers hire a consulting firm to analyze their projects, activities and expenditures. As part of the study, the consulting firm will review R&D projects and employee activities to determine how much of their time is related to research activities. With the coronavirus changing the work environment of many employees, that time might have significantly changed in 2020.
Take an employee who in a normal year spends 70 percent of their time conducting qualified R&D activities by developing or improving processes. However, due to the coronavirus shutdowns, the employee’s activities may have changed in 2020. If the employee is working from home on mostly administrative functions for eight weeks, or 15 percent of the year, the percentage of time dedicated to qualified R&D efforts might be vastly different. On the flipside, a company that is revamping manufacturing processes during the pandemic may see R&D-related expenditures increase during this time frame.
It is not just the activities performed that may influence the amount of an R&D credit. Companies that received grants under the Paycheck Protection Program may see a reduction in their ability to claim the credit. The simplified explanation of the PPP is that companies can receive a loan equal to 2.5 months of their payroll. If a company maintains staffing and payroll, it will receive forgiveness on the loan equal to its payroll, rent and utilities over an eight-week period. Under the CARES Act, the PPP forgiveness was to be “excluded from gross income.” However, in Notice 2020-32, the IRS determined that otherwise allowable expenses, paid for with PPP forgiveness proceeds, will not be deductible.
What does this have to do with the R&D tax credit? If the IRS’s position under Notice 2020-32 holds up, a taxpayer will not be able to take deductions for expenditures paid for with PPP funds. This also likely means that the taxpayer cannot claim an R&D tax credit against these expenditures since they would not have been incurred by the taxpayer. This could mean a significant reduction in R&D expenditures in the 2020 tax year.
It is important to note that lawmakers are pushing back on the IRS’s interpretation of this provision. On May 5, lawmakers sent a letter to Treasury Secretary Steven Mnuchin stating their disagreement with his interpretation of the law. Since the IRS position does not follow congressional intent, it is highly likely that it will change. However, taxpayers need to be aware of this current rule if that interpretation stands.
Many businesses have relied on old research tax credit studies or standard time allocations for years. With all of the changes related to coronavirus lockdowns, taxpayers would be wise to connect with qualified consulting firms to analyze their 2020 expenditures and ensure their R&D tax credits are maximized. Understanding all of the laws surrounding the deductibility and allocation of expenses will be critical to making sure 2020 credits are maximized and defendable under IRS examination.