Tax Reform Enhances Value of Research Tax Credits for Government Contractors
The Research Tax Credit (“credit”) isn’t a new development, but some government contractors have yet to take full advantage of its benefits. For those who are, the credit provides a clear financial advantage in a highly competitive industry. The credit was enacted to encourage innovation. It achieves this by providing an offset of up to 15 percent of qualified spending against the regular income tax liability of businesses that attempt to develop or improve the functionality or performance of one or more of their products, software, or manufacturing processes. In general, businesses qualify to the extent their activities use engineering or the physical, biological, or computer sciences to try to eliminate uncertainty regarding the capability or method of developing or improving the product, process, or software, or uncertainty as to its appropriate design.
The credit was permanently extended with the passing of the Protecting Americans from Tax Hikes Act of 2015, a welcome reprieve from the credit’s history, where it often expired only to later be temporarily extended, sometimes retroactively. Now that the credit is permanent and has been expanded to benefit certain small businesses and startups, government contractors can incorporate the credit into their tax planning discussions.
Federal tax changes boost R&D
Recently, the value of the credit was enhanced by the Tax Cuts and Jobs Act of 2017 (TCJA), as reflected in BDO’s Tax Outlook Survey.
By reducing the maximum corporate tax rate from 35 to 21 percent, the TCJA effectively increased the credit’s value by 22 percent, from 65 percent when the maximum corporate rate was 35 percent, to 79 percent today.
In addition, by eliminating the corporate Alternative Minimum Tax (AMT), the TCJA affords AMT taxpayers, who generally couldn’t use the credit against their AMT, the opportunity to use their credits down to 25 percent of the amount their net regular tax liability exceeds $25,000. Changes to the AMT regime for individual taxpayers could also increase the amount of benefit allowed to owners of pass-through entities.
Not all contracts limit eligibility
A common misconception in the government contracting industry is that activities don’t qualify for the credit if the government or a third-party finances a contractor’s R&D activities. This isn’t always true: if the contract with the government or other third-party provides that the contractor bears the economic risk if the work fails and that the contractor retains substantial rights in the work’s results, the contractor’s activities can still qualify even if reimbursed by the government or another unrelated third-party.
Don't overlook software
More good news for government contractors arrived with the Treasury’s final regulations in late 2016. These regulations narrowed the definition of “internal use software” (IUS) activities, which generally must meet a higher standard to qualify. Now, the development of more software, including software to provide services, can qualify more easily, without meeting the higher IUS standards.
If government contractors pay employees or contractors who are software developers, process engineers, energy consultants, mechanical designers, or other technical personnel, they’re likely to be eligible for the credit. The same is true for government contractors who are trying to develop or improve cybersecurity solutions, aerospace equipment, defense components, cloud computing solutions, and the like.
With the recent taxpayer-friendly developments around the credit and U.S. taxes in general, government contractors should consider how they are impacted and whether they’re missing out on a significant tax-savings opportunity.
This article originally appeared in BDO USA, LLP’s “Government Contracting” newsletter (Summer 2018). Copyright © 2018 BDO USA, LLP. All rights reserved. www.bdo.com