With start ups being all the buzz these days, we get a lot of questions as to when a start up company should start looking at generating R&D tax credit. The big question up until December was, “Will I ever be able to utilize these credits?” Now, that question has become, “When is the ideal time to file?” This is due mostly to the changes that were pushed through that allow companies with less than 5 years of history to generate a credit and utilize it to offset payroll taxes. However, this benefit is only allowed for the first 5 years of activity which hopefully, won’t be the last years of activity generated by the company in question. As such, in this post we will discuss opportunities for start up credit utilization outside of the umbrella of the payroll tax benefit.
So, we know we have great activity, but we aren’t yet generating revenue so there isn’t any tax liability. Or, we are generating revenue, but are still recording losses because of the cost to produce products or provide services. Don’t panic! This doesn’t mean that an analysis of your expenses won’t yield a meaningful benefit! One of the biggest considerations that most people ignore when evaluating the opportunity internally is that they are looking at the current tax year and the implications on a single year’s return. However, as you may or may not know, credits can be carried forward to offset future liability. On the federal side, that magic number is 20 years. Carry forward limitations also vary from state to state, but in the case of California, credits can be applied to future years indefinitely until credits are exhausted.
This means that while you may not be able to generate a true benefit immediately, if your company is growing at a fast pace and see tax liability on the horizon (within 3 years), it may be a good time to start evaluating the opportunity. This is for two reasons. First, generating credits in a current year on a timely filed return is the easiest way to reduce audit risk. Timely filed returns mean that your company isn’t going to be requesting any refunds of taxes already paid. In turn, you would be able to minimize the scrutiny by any regulatory taxing agencies like the FTB or the IRS. Secondly, audit risk is also reduced when amending years that carry net operating losses, or NOLs. In these cases, since amending returns to add back credits are not triggering any refunds since no taxes were paid in those years of loss.
Ultimately, as a business owner, tax professional or consultant, you will need to weigh the pros and cons of all decisions regarding the generation and filing of back year R&D credits. However, if you do see the value of carrying credits forward because you see tax liability on the horizon, it is best to amend or file timely returns with the R&D credit before statutes of limitations kick in and you are prevented from analyzing the years because they are considered “closed”. On the federal side, this period is three (3) years from the date of the actual filing of the return. In the case of California, it is four (4) years. So, in a situation where activity is strong and significant labor, contract research or research supplies were utilized, it would be prudent to file the credits before the past years become closed.