Accessing Working Capital Through Tax Credits

Katrina Faessel:
Many SMBs are not taking full advantage of the available tax credits. In our next session, we will break down the types of credits available, such as R&D, recent changes in legislation that have expanded the credit offerings and the best practices for qualifying for and claiming credits with TriNet's VP of Tax Credit Business Unit, Chris Winslow, and Monika Diehl, TriNet's Divisional Vice President, Tax.So with that, I want to thank you very much.

Chris Winslow:
Good afternoon. Thank you for joining us for this session. Monika and I are excited to be with you today as part of TriNet's National Small Business Week Summit. Today we want to talk to you about some significant tax credit opportunities available to small businesses. First one is the Research and Development or R&D Tax Credit.

This credit is an incentive written into the tax code in the early 1980s that was intended to encourage businesses to invest in developing and improving new products and technologies inside the United States. As originally written into the tax law, the credit was available to businesses as a credit that reduced the company's income tax liabilities.

The PATH Act passed in 2015 provided another avenue for smaller startup companies that do not yet have taxable income to be able to use the credit to offset employer payroll taxes. This is a lucrative credit rewarding businesses for their innovative work. Obtaining an R&D credit to be used to reduce income or payroll taxes to a business does require effort to identify the eligible work that was done and to document requirements to support the credit.

Work that can be included for the credit must be conducted inside the United States, rely on the principles of hard science and involve a process of experimentation undertaken to resolve uncertainty around how or if the technology can be developed at all. The costs included in the credit calculation must be incurred as a part of that process of experimentation and clear documentation of all the requirements is critical.

In the event of an IRS audit or inquiry into the credit claimed, this support would be needed to be on hand. It is imperative that a company claiming the credit work with a reputable provider to ensure that all qualifications and exceptions are considered and only costs associated with eligible work are included in determining the credit. TriNet acquired Clarus R&D in 2022 because of our expertise in this area and because of the software tools that we've developed to help determine if your business qualifies and to create defensible documentation for the credit.

The other credit that we're going to touch on today is the Employee Retention Tax Credit, or ERTC, as many of you may know. This credit was developed to assist businesses that continue to pay employees while enduring hard, economic hardship related to COVID. Eligibility for this credit is fairly broad, including companies experiencing a defined level of decline or interruption to their business or a new business that was just getting started at that time.

The credit amount available to a business can be substantial at up to 70% of wages paid to employees during eligible quarters. That whole program, however, is going through a lot of transition as the IRS and other parts of legislative bodies are evaluating the length of time that is still available to be claimed as well as the scope of the requirements for that.

Our plan today is to discuss what is happening with these various credits and the best practices for small businesses to deploy while looking to claim them. To do that, I'm going to rely upon our senior tax expert and vice president, Monika, to really walk us through various aspects of this. I'm gonna ask her a few questions now.

Monika, you just finished the April 15th tax deadline and there's been a lot happening in the last year as it relates to these tax benefits for small businesses. Can you tell us about some of the changes that have happened over the past year and give some advice for how small businesses can maneuver if they hope to take advantage of the R&D and even the ERTC tax credits going forward?

Monika Diehl:
Sure, Chris. Yeah, I can do that. If we're thinking about the last year, small businesses were dealing with filing income tax returns for the first time that were impacted by new legislation. The Inflation Reduction Act was passed in August of 2022 and it created some additional opportunity for qualifying startups eligible to use the R&D credit to reduce their employer payroll tax liabilities.

This is the new avenue for using the credit that you mentioned earlier was created with the PATH Act in 2015. The maximum R&D payroll credit that was available for tax years beginning prior to January 1st, 2023 was $250,000 and it could be used to reduce the employer's portion of Social Security tax.

The Inflation Reduction Act expanded this credit for tax years beginning after December 31st, 2022. They doubled the maximum payroll credit to $500,000 and permitted the payroll credits to be used to offset both the employer's portion of Social Security tax and the employer's portion of Medicare tax.

And that was beginning with payroll tax returns that were filed for quarters in 2023. And so, the Inflation Reduction Act actually created more opportunity through the research credit for early-stage companies. A larger payroll tax credit is now permitted and businesses are able to use the credits to offset more of their payroll tax expense.

This change provides additional non-dilutive capital for startups which helps them to keep cash in their businesses.

Chris:
That's great. As we talked about this, R&D tax credit now has been around for quite some time and the federal government is so enamored with it. They keep doubling down on the available credit for small and medium-size businesses as well as large businesses but in relation to the actual use of it against payroll taxes is really centered on the small and medium-size business, which is outstanding. That being said, there are some changes that are going on that are creating some headaches for taxpayers engaged in research and development work over the past year. Can you talk a little bit about what those are?

Monika:
Sure, I can do that. The Tax Cuts and Jobs Act that was passed back in 2018 had a provision limiting the deductibility of costs associated with conducting research and experimentation work, and that's the section 174 costs in the tax code. You'll hear it referred to as 174 costs a lot of times.

These costs had been fully deductible in the year paid and with this change, they were now required to be spread out over five years or amortized over a five-year period for costs that were incurred in the U.S. This resulted in businesses receiving a benefit of only around 10% of the actual spend during a particular year in their tax return for the year that those costs were actually paid.

While this was passed in 2018, this particular provision was not scheduled to first take effect until tax returns were filed for tax years beginning after December 31st, 2021. That means 2022 tax returns for the first year that a lot of businesses were actually dealing with this. This change didn't have any impact on the R&D tax credit directly, but the fact that the expenses that are eligible to be included for the Research and Development Tax Credit are a subset of Section 174 costs caused a lot of confusion around whether the credit should still be claimed, whether the credit could still be used and if the credit would have the same value for taxpayers in prior years.

We spent a lot of time last year reassuring clients that the limitation on deducting these costs didn't impact the R&D tax credit. They were able to claim the same credit using the same expenses as they had paid during the year for the research and development. They're eligible work. And in fact, these credits were more valuable than they had been in prior years to taxpayers.

Chris:
Yeah, that's really interesting. Yeah, obviously it's a very significant provision that was added in. I know that there's a lot of discussion going on about whether it should be suspended or not, but right now it is in place, which frankly, as you pointed out, actually makes the R&D tax credit even more valuable to a lot of companies as it helps them lower their overall tax obligations for that year or perhaps get it from their payroll taxes as some relief as well. So can you maybe elaborate a little bit more then on the challenge that it's now created and kind of how to manage around that?

Monika:
Sure, I can do that. So let's look at it very simply. Let's take a very simple basic tax return. We'll say that we've got income minus the deductions and that gets the business to their taxable income number, right? That's the portion of their income for the year that is subject to tax. That's what they have to pay tax on, that portion of their income. If the deductions that are allowed are smaller, the taxable income and the related tax liability are going to go up.

We have a smaller deduction for the research and experimentation costs, and the tax liability in a lot of cases is going to go up. So having credits to help reduce these higher taxes to be paid, assuming all else is equal, nothing else has changed in the business. This makes those credits more valuable.

Let's think about a business, like a specific example here, business developing software. If the business had earned $1 million during the year and also invested a million during the year in their ongoing development efforts, they've reinvested all of their earnings. Under the old rules, they have zero taxable income and no liability for the year because all of those costs could be deducted against their income. With the change and the required amortization of research and experimentation costs, now the same business has reinvested all of their earnings, but they're now getting a deduction of only $100,000 on the current year income tax return rather than the full $1 million and they're left paying tax on $900,000 of taxable income. That's really tough for a lot of small companies.

Let's think about how this works. Where does the rest of the R&D spend for the year go. It doesn't just go away. We still have to have the benefit of that spend, the expenses that were incurred by the business at some point. What happens is that while the business is not able to deduct the cost in full for the current tax year, the year they actually paid those expenses, the deductions are available to be used in subsequent years.

They're actually layered on the allowed amortization of this spend that is incurred in later years. The company's eventually going to catch up, but it's those earlier years that are really harder for small businesses finding that they have income tax to pay. This is where we can see the value in claiming the R&D tax credit. This is where we're sharing with businesses that the R&D tax credit is actually more valuable because of this change. The amount of the credit is generally going to be about 7 to 10% of the spend on qualifying research activities. If we think about that example and we think that million dollars of spend were all qualified R&D expenses, that would generate a credit of about $100,000 for that business.

That credit can be used to reduce the amount of income tax liability that the business would otherwise be required to pay with their income tax return. It really kind of helps them to offset, like we said. With all else being equal, this impact is causing additional taxable income to these businesses and additional liability, so claiming the R&D credit is something that they're going to be able to use right away to offset some of that additional expense.

Chris:
That's great. While we can't change any of those things, through our process, through our software, through our team, we can help clients navigate the allowable credit through our software, through our process to make sure that they get the maximum amount that is available to them.

That's great. I know there's a lot of other things that are in the works right now. Other changes. Can you talk about some other changes that are on the horizon as well?

Monika:
Sure. The 174 amortization has been kind of a big sticking point with a lot of businesses. There have been business owners, perfectly honest CPAs and tax advisors and of course, small businesses and legislators that have been frustrated by the impact that this 174 amortization has had on particularly small businesses and the impact on them actually having to pay these tax liabilities so much earlier than they otherwise would have had to and so another change, or it's a proposed change at this point actually would actually help this situation and would also have some impact on the employee retention tax credit.

That has to do with a currently proposed tax extenders legislation, which passed the U.S. House, but is waiting for consideration in the Senate. What tax extenders legislation, you might have heard that before, because it kind of can come up pretty much once a year. It's often proposed towards the start of a new year and it's written as certain provisions that were in place for a limited period of time when they were initially written into the law are set to expire. Congress can decide to let the provisions expire or propose new legislation extending them to a later date. We have that legislation that is proposed at this point, this is the Tax Relief for American Families and Workers Act. That's the extender's legislation that's currently being considered. Included in that legislation are provisions to restore the immediate full expensing of the Section 174 Research and Experimentation costs, but it also has a provision to end the employee retention tax credit early on January 31st, 2024, the date that it's already passed at this point. It would be in place there rather than the original deadline, which had the ERTC credit expiring April 15th of next year of 2025. So the IRS has expressed concerns around a significant amount of fraud found in ERTC claims that have been submitted.

Because of this, in September of 2023, the IRS announced a moratorium on processing of ERTC claims, at least through the end of 2023 and the IRS assured that there would be increased scrutiny on any ERTC credits processed going forward. This tells us that there will be longer delays in getting refunds for taxpayers who are claiming these credits.

The proposed tax extenders legislation has the ability to return that full deduction for the 174 expenses to small businesses allowing them to fully deduct those expenses in the year paid. It also includes a number of other taxpayer favorable provisions that benefit both businesses and individuals.

There's some, a number of good things in there, positive things for taxpayers. What they're thinking is that the early end of the ERTC program, also a part of that legislation, those credits that they would have otherwise paid out between January 31st of this year and April 15th of next year, they're going to kind of save those credit payments.

And those payments and that those costs that they would otherwise been paying for the ERTC program can fund all these other benefits that are in the bill. The legislation passed in January in the House. It's been stalled in the Senate since early February with other priorities. At this point in the year, it's probably unlikely that it's going to be passed and that means that April 15, 2025 deadline currently stands as far as ERTC claims are considered.

That's currently the deadline that is in place. The timing of processing by the IRS is a concern to taxpayers and the possibility of will there be a last-minute vote? And this will get passed during the year, even though all these tax returns have already been claimed, have already been filed and the credits claimed.

We'll have to see what happens there. But we've got a lot of taxpayers kind of asking, “Am I still allowed to claim this credit? And if I do claim the credit, when will I actually receive my refund back from the IRS?” These are the businesses that are legitimately may still have an honest claim for the ERTC credit with all these questions.

They're just not sure kind of what direction to go. TriNet and Clarus R&D, we're really looking to watch the progress of this bill. We're watching closely. We're ready to support clients with substantiated ERTC claims when it appears that there's a reasonable chance that the processing is going to be restarted and clients will actually be able to expect to be paid by the IRS for these benefits.

Chris:
Yeah, ERTC was a great program to really help stabilize the economy and stabilize small medium-size businesses during that period. Obviously, a big trade off in this legislation as it goes on seems less likely it'll pass. Our team is very much on it. I think there's opportunities either way that we can help navigate our clients through.

With that, we just finished one tax season, but we have another tax season coming up here in the fall and many of the clients that we have extended their filing until September or October timeframe partially related, perhaps, to the uncertainty that we just talked about, but also, for other reasons as well. What tips do you have to help businesses so that they can maximize their R&D credits for this upcoming tax season that do not create undue issues for them or for TriNet?

Monika:
Right. Yeah. First, I would say any business who's looking to claim the research credit should be sure to work with an experienced professional who knows the qualification criteria and can help you to go through your development work. Think about your development work and identify those expenses that may not be as obvious to you that could qualify. So an experienced professional is also going to assist to ensure that a detailed study report, including the documentation that would be requested in the event of an IRS audit, is created to support the credit that is claimed.

That documentation is important. Like many things in the tax code, there are eligibility guidelines, but there are also exceptions to consider. Certain types of expenses are included in the credit calculation where they can be tied back to that qualifying work. A clear description of the product or improvement that is the focus of your development work needs to be prepared as well.

The provider working on your R&D credit should be familiar with all of the needed support. For credits claimed with amended tax returns, the detailed information is actually required to be sent to the IRS with your tax return filing, so that's a little bit different. In this case, we have a taxpayer that's not waiting for some separate communication from the IRS requesting that documentation.

Those details actually need to be prepared and sent with the tax return, so that documentation obviously needs to be done as the credit's being prepared. A trusted partner working on your R&D study and helping your business to claim this credit can ensure that the documentation is thorough in case it is needed to defend your credit, and they can help you to maximize the credit claims that your business is not leaving any money on the table.

Chris:
Yeah, as you point out, the right provider is really important in this case. Many people assume that a qualified tax professional completing their business income tax return will have that experience. With the research credit, that's not always the case, right? What issues or missed details have you found when talking with clients about credits that they have claimed?

Monika:
Yeah, we've seen studies where expenses that were not eligible have been included in the credit calculation and eligible expenses that were left out. We have seen credit work where the requirements are not clearly laid out in the support or important components like Nexus, and that involves demonstrating the connection between the costs that are included in the credit and the eligible development activity, and that's not documented in the reports.

There's other issues that we've seen specifically related to the payroll credit that's available to startups. These are generally related to errors in making the credit election or in actually using the credit. After completing your study, the provider should give you instructions for next steps, and following those steps will be key to actually receiving your benefit.

While the R&D credit is actually claimed as a part of your business income tax return filing. If your business is a qualifying small business eligible to use that credit against payroll taxes, completing the form properly, paying attention to the deadlines for filing in coordination with your PEO or payroll provider are critical to ensure that the benefit is not missed.

And what we're talking about there is, you know, first of all, the election to use the credit against payroll taxes. That needs to be made in Section D of the IRS Form 6765, that form filed with your tax return to claim the credit. It's important that section is completed in the election, checking that box is properly done in order to receive that payroll credit.

The income tax return form, including the form 6765, and the properly made election needs to be filed by the original or extended due date of the taxpayer's return. The payroll election is not permitted to be made on an amended return or a late-filed return. Basically, you have a shot it at filing on time with your return or you're going to miss out on that payroll credit, so that's important.

Finally, after the income tax return is filed, you need to contact your PEO or payroll provider to communicate the credit amount, the income tax return filing date and potentially some other information that they request. Your PEO or payroll provider is going to include that credit on your 941 payroll tax filings and that's where your credit is actually used to offset those taxes paid and you can get a refund back from the IRS of those deposits that you made with each payroll run throughout the quarter.

We've unfortunately seen that missed a number of times. A business has gone through all the effort, the hard part of creating the documentation and pulling the information to complete that R&D study and calculate their credit. The last step is actually kind of providing that information to their PEO or their payroll tax providers that the credit can be utilized. TriNet Clarus R&D works with you to make sure that the credits are properly submitted for processing through TriNet PEO, TriNet HR platform, or if you're working with another provider and we're completing your study, we work with them as well to make sure these credits are actually received.

Chris:
Yeah, it sounds like it can be kind of complicated. As you just pointed out, I mean, can you talk a little bit about how TriNet Clarus R&D is helping small businesses navigate this complex world and make sure that they file accurately?

Monika:
Yeah, so the first suggestion I have is to consider whether this credit applies to your business. If your business is creating or improving products or technology, you may be eligible for the credit. Don't assume it doesn't apply to your business because you don't wear a lab coat to work every day.

Many industries from software and medical devices and product engineering are eligible for the credit, but so are other businesses that work in clothing manufacturing, consumer products. Even craft breweries would be eligible for an R&D credit as they create those new recipes. If your business is a TriNet HR platform client, you can work with TriNet Clarus R&D to complete your credit study and documentation.

Those clients also have real time access to these credits, getting the money back to them faster than the IRS would process them. If your business is a TriNet PEO client, TriNet Clarus R&D can again work with you on your study and documentation. We'll provide support to you and your partners through a credit review process where we have not been involved in the R&D study.

That review is intended to ensure that key eligibility details are met and documented, reducing risk to clients, to partners and to TriNet. We just want to make sure that everything claimed is accurate. When it comes to the employee retention tax credit, unfortunately, I think things are going to remain complex for a while.

We'll need to continue to pay attention to updates on IRS processing of credits claimed and whether Congress will actually put in place an early end to that credit. The legislation ending on this credit is only proposed at this point, but there are a lot of questions and our team will continue to look for answers to help our clients.

Chris:
That's great. That's great, Monika. Thanks for that. We're coming near the end of our session. We do have a couple of questions that are out there. Let me ask you one of those, Monika, and hopefully you can quickly respond to that. What are the potential risks or pitfalls to be aware of when claiming R&D tax credits?

Monika:
Yeah, I just think some of the potential risks are, you know, making sure that first and foremost you're working with the right provider, you're including activity that is actually eligible for the credit. The tax code lays out very specifically a four-part test. This is what you need to hit these four points in order to have eligible work for the credit.

A lot of that is around conducting a process of experimentation, going through an iterative process of development before you kind of land on exactly what your product is like that you're going to sell to the customer. There are exceptions, like I said, there are certain expenses that can be included.

I think the biggest thing is working with the provider that is familiar with this credit and not every CPA is just because they work in the tax code. The tax code is vast. There's a lot of parts to it. They may not work in this specific part, so working with somebody who's familiar is probably your best bet.

Chris:
Yeah, that makes a lot of sense. I got another one for you. So this company's been in business for a number of years, but they've never filed for the R&D tax credit. Can they go back and file for past years?

Monika:
Yeah, we get that question a lot. Businesses will come to us and they'll be like, well, I have been doing R&D for a couple of years now and I had a lot of spend a couple of years ago.

Can I go back and claim that credit? Basically, you can go back and amend your business income tax returns to claim an income tax credit. As we mentioned earlier, the payroll tax credit has to be on that original return, so that might be missed, but if you go back, as long as the statute of limitations, which is generally about three years from when that first return is filed, if the statute of limitations is not up, if you're not past that three-year period, you can go back and amend your return and claim an income tax credit for the business.

Chris:
Yeah, that makes a lot of sense. Kind of a related question. This SMB doesn't currently generate a profit. Would the R&D tax credit actually be worthwhile for them to file?

Monika:
Yeah, so if the company isn't profitable, first thing we're going to look at, of course, is are they eligible for the payroll credit? Payroll credit will be beneficial if they have employees and they're paying those quarterly payroll taxes. That's the first thing. And that's primarily going to be related to startup companies within about their first five years of operations. Now, the income tax credit could be beneficial.

You've got an accumulated net operating loss that you're going to use to offset income. You want to start thinking about forecasting when your company how much profit your company expects to make in the next couple of years and when you expect to use up that net operating loss. That is going to be applied before any tax credits are going to be applied.

And if it looks like that NOL is going to go away in the next couple of years and within, we usually use as a ballpark figure, the next five years, you might be paying income tax, it would make sense to start accumulating those R&D credits. The R&D credit is a general business credit. It has a 20-year carryover period, and so that means we can accumulate those credits and you've got 20 years from when that credit was first claimed to use it before there's any risk of it expiring.

Chris:
That's great. Last one before we run. What type of activities and expenditures qualify for the R&D tax credit?

Monika:
Yeah, like I said, it's pretty broad. I mean, everybody's going to think pharmaceuticals and somebody's working in chemistry or they're working in aerospace or things like that. Those are definitely types of work that if you're building a plane or improving an engine or things like that, of course, there's going to be R&D there, but there's also R&D in manufacturing processes. Are you improving your process? Are you reducing waste? Are you gaining efficiency? Are you producing things faster? That's qualifying activity for an R&D credit. And it's also important to think it's not just the first time you create a product, you know, in the R&D that goes into developing that product.

If you're making improvements to your products. You are, maybe you're a software developer and you've developed the initial software platform. In later years, you're adding new functionality or features or capabilities to it. Those enhancements, those improvements and that activity related to developing those is also qualifying work for the credit, so it can be pretty broad. You want to think along the lines, "Am I building something new or am I making improvements that are technological?”

Chris:
Then the expenditures can be labor. They can be your direct material expenses, but they can even be things like your Amazon Cloud account, your AWS account. Part of our software helps to organize those and make sure you're claiming all of them. Well, I think that's all of our time for this session.

I want to thank everybody that came on board and participated. I hope we didn't make it sound too complicated, but a big part of our job is to try and simplify this. There is an area that you can go to next, where there will be some people that will give you an opportunity to ask live questions, also give you an opportunity to perhaps schedule an appointment with one of our tax professionals to evaluate your particular situation.