Research Credits – Not sure if you qualify?

As 2016 concludes, you’re most likely wrapped up in holiday festivities and gatherings that don’t leave much time for your business.  However, it’s probably wise to consider tax benefit strategies that can make a big difference in your bottom line for 2016 and generate increased margin going forward.

One of the biggest impacts to the tax benefit services industry occurred on December 18th, 2015 when Congress enacted the Protecting Americans from Tax Hikes (PATH) Act.  This act permanently extended the R&D tax credit and extended its reach:

  • Permanent extension of the R&D tax credit effective January 1, 2015.
  • As of 2016, Eligible Small Businesses are able to use the R&D tax credit to offset AMT (Alternative Minimum Tax).
  • Startups less than $5 million in gross receipts and having gross receipts for no more than five years are able to use the R&D tax credit to offset the FICA employer portion of payroll tax up to $250,000 for each eligible year.

The biggest question surrounding the R&D tax credit seems to be whether or not a business has enough Qualifying Research Expenditures (QRE’s) that would result in enough tax credit to make it worthwhile to go after the credit.  How can you figure that out?

  1. Review our R&D Credit Opportunities Checklist and Examples of Qualifying Activities that will help you determine activities you engage in that may qualify.
  2. Test the result via our R&D Credit Rules Overview.  This will help you disqualify those activities which don’t fit within the IRS Regulations.
  3. Get a rough idea of the Qualifying Research Expenditures (QRE’s) for your business.
  4. Decide whether you can provide documentation of the identified expenditures in a cost effective manner by reviewing Examples of Contemporaneous Documentation.

It’s not as hard as you think to benefit from the R&D tax credit.  If you qualify, you may also be eligible to look back three to four years depending on when your taxes were filed AND you may also be eligible for State R&D tax credits.

If you believe you have QRE’s in excess of $100,000 per year, please contact ThreeFive at 612.353.6372 to get the process started.

Our process is painless:

  • Initial Consultation: 30-minute phone conference to determine scope of project.
  • Phase I Study: Our experts work with you to determine the potential benefit by reviewing your prior three years of tax returns, current year income statement trial balance, legal entity structure, wages paid and full review with your subject matter expert.  There is no cost for this phase, only a commitment to move forward with ThreeFive® should we find the benefit is worth pursuing.
  • Phase II Study: Our experts obtain detailed wage information and specific GL data along with fleshing out expenditures that qualify and can be documented.  Ultimately, our final deliverable provides you and your tax professionals with all you need to file for and receive your credits.

Let’s take the first step together, we’re here to help!

Internal Use Software (IUS) Regulations

After much anticipation the United States Treasury issued final regulations for Internal Use Software (IUS) regulations. The good news is they are substantially similar to the proposed regulations issued on January 20, 2015. They are taxpayer friendly as they clarify and arguably expand the definition of non-IUS. Citing the intent behind the credit (to incentivize increasing research on a go forward basis) they determined the regulations will not be retroactive (the bad news if we can really call it “bad”). However, the IRS will not challenge returns consistent with the proposed regulations and filed on or after January 20, 2015.

Clarification of IUS
The biggest highlight in the finalized regulations is the clarification of the definition of IUS. First, the finalized regulations clarify that software developed for general and administrative functions that facilitate or support the conduct of the taxpayer’s business is IUS. The regulations define general and administrative functions in three categories:

  1. Financial management
  2. Human resources management
  3. Support services.

Each of these three functions are further defined in the regulations and are essentially “back office” functions that are neither marketed to, or interact with, potential clients. The clarification is applicable to related parties treated as single taxpayer pursuant to section 41(f).

The final regulations then clarify what is not included in IUS as software a taxpayer offers for sale, lease or license or is otherwise marketed to third parties OR developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. The italicized portions of this regulation have the potential for very broad application. Regardless, the entirety of the clarification is an expansion of what most taxpayers have considered qualified research expenses and will necessitate a rework of any process they currently use to calculate their research credit.

Consistency Rule
Another highlight from the finalized regulations includes the requirement that a taxpayer must continue to apply the Consistency Rule. Therefore, taxpayers who have claimed the research credit on prior returns will be required to recalculate and adjust their base calculation accordingly if they intend to claim research expenses under these new favorable regulations on current and future years’ returns. Note the Consistency Rule will require a base calculation adjustment. However, the nature of the prospective application of the new regulations requires a taxpayer to continue to choose between the application of TD 8930 and regulation 1.41-4(c)(6) to calculate their prior year credit. Therefore, two calculations will be required. One using the new regulations for tax years after January 20, 2015 and one for any returns amended for prior years utilizing the taxpayer’s choice between TD 8930 and regulation 1.41-4(c)(6).

“Dual Function” Software
What about IUS that also interacts with third parties or “dual function” software? There is a Safe Harbor rule that allows the taxpayer to claim 25 percent of the expenses if the third party’s interaction is reasonably anticipated to constitute at least 10 percent of the dual function software.

What if you start out with the intent to develop IUS and then change your mind and decide to license it or otherwise convert it into non-IUS or vice versa? The determination is based on the taxpayer’s intent at the outset of the development considering all the facts and circumstances. However, that determination can be converted if the taxpayer changes their intent. The qualification determination is determined on a prospective basis at time of the change in taxpayer intent.

Three Prong Test for IUS
For IUS the qualification remains a three prong test. The first prong or innovation test remains consistent with the proposed regulations in that it provides a test for what the Service says is “measurable and objective, and should reduce the potential for controversy.” But don’t relax too much because the second prong or significant economic risk test tends to muddy the waters. Instead of sticking with the proposed version and requiring the uncertainty to relate to capability or methodology the Treasury settled on a reasonability test. As we all know, reasonable minds can differ so this test will require documenting the facts and circumstances. The third prong or commercially available test remains the same as the proposed regulations. Recall the commercially available test which simply asks whether similar software may be purchased, leased or licensed and used for the intended purpose without modification that would satisfy the first two tests.

The bottom line is if you are going to take a research credit on your tax returns for software development or in the past you thought or have been told you do not qualify, you need to speak to an experienced, capable professional. Between adjusting the base calculation, weeding through the reasonableness test, along with all the facts and circumstances tests, you need an expert who has experience. ThreeFive Inc. has the experienced, knowledgeable professionals you can trust to help you navigate the new R&D and Internal Use Software landscape.

Submitted By: Joyce Exmundo

Recent R&D Updates

Brief History:

  • The R&D credit was enacted in 1981 as a temporary credit and has been extended 16 times.
  • The credit last expired on December 31, 2014
  • On December 18, 2015 under the Protecting Americans from Tax Hikes (PATH) Act of 2015, the R&D tax credit has been permanently extended by Congress
  • The permanent extension of the R&D tax credit is effective as of January 1, 2015

Legislation made two key expansions to the R&D credit which benefit certain small businesses.  This is effective as of January 1, 2016:

  • "Eligible Small Businesses" will be able to use the R&D tax credit to offset alternative minimum tax (AMT). An Eligible Small Business is defined as a business with less than $50 million in average gross receipts for the three preceding years. Under prior law, the R&D tax credit could only be used to offset regular tax, which limited several small to mid-sized businesses to use the credit if they were subject to AMT.
  •  The bill includes a provision that opens the credit up for start-ups, allowing businesses with less than $5 million in annual gross receipts and having gross receipts for no more than five years, will now be able to use the R&D tax credit to offset the FICA employer portion of payroll tax. The amount of credit that can be used to offset payroll tax is capped at $250,000 for each eligible year.  This is the first time start-up companies can benefit from the R&D Credit.

 These changes will be a great help to companies across the nation and will put valuable tax dollars back into the pockets of U.S. businesses for job creation and economic growth.

Submitted By: Joyce Exmundo

Permanent Extension of Research & Development (R&D) Tax Credit

The Research & Development (“R&D”) Tax Credit was enacted in 1981 as a temporary
business credit. Since its enactment, the federal R&D tax credit has expired 16 times, only to
be reenacted and extended for a short period. The federal R&D credit last expired on
December 31, 2014. However, on December 18, 2015 under the Protecting Americans from
Tax Hikes (“PATH”) Act of 2015, the federal R&D tax credit was made retroactive to January
1, 2015 and has been permanently extended.

In addition to the permanent extension of the federal R&D tax credit, the legislation made two
key expansions to the R&D credit which benefit certain small businesses. The following
changes went into effect on January 1, 2016:

  • “Eligible Small Businesses” are able to use the federal R&D tax credit to offset federal alternative minimum tax (“AMT”). An Eligible Small Business is defined as a business with less than $50 million in average gross receipts for the three preceding years. Under prior law, the R&D tax credit could only be used to offset regular tax, which limited the ability of small to mid-sized businesses to use the R&D credit if they were subject to AMT.
  • “Qualified Small Businesses” are allowed to elect to claim the R&D tax credit as an offset to the employer portion of FICA payroll tax up to $250,000 for each eligible year. A Qualified Small Business is defined as a business with less than $5 million in annual gross receipts having gross receipts for no more than five years. This is the first time in history start-up companies in a net operating loss (“NOL”) position are able to benefit from the R&D Credit.

There has been no change to the carryback and carryforward period for federal R&D credits,
which is 1 and 20 years, respectively.

There are currently 39 states, including California that offer R&D tax credits. However, the
rules for each state offering R&D credits differ from the federal rules (i.e. qualifying R&D
activities, carryback and carryforward periods, characterization of credits as refundable or
nonrefundable, and the utilization against AMT) and should be reviewed independently of the
federal R&D credit requirements.

In light of the recent changes, taxpayers who were unable to utilize federal R&D credits
previously due to AMT or NOL limitations, should reevaluate their eligibility to take advantage
of these incentives.

Submitted By: Joyce Exmundo

Question Regarding the PATH Act

We had a question today about the new tax provisions:

“Does this mean you can revisit past clients’ situations that were nipped by AMT?”

The answer to that question is – NO.  These are not retroactive provisions, they are for the future (tax years ending after 12/31/2015). These new provisions will apply to each state that adopts them (a separate action).  A number of states follow the Federal, but they have to take their own steps to do so.  Some states follow the Federal, but not everything in the Federal provisions, like the Alternative Simplified Credit does not apply in MN.

The Research Credit is finally permanent after 30+ years!

On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act of 2015. This extends many business and individual tax provisions and finally makes permanent the research and development tax credit.

 

What does this mean?

The R&D credit is no longer a "preference" item and is now a permanent credit against Alternative Minimum Tax (AMT) or OACDI payroll taxes. The Act directs the Secretary to write regulations to "reduce the record keeping requirements," which is a big deal when it comes to sustaining these.

 

In the past, if a taxpayer fell into AMT, they had to exclude an R&D credit from the tax liability calculation. This exclusion was the largest obstacle that kept companies from taking advantage of the R&D Credit. In 2016 and going forward, the limitation will no longer be there and the R&D credit can be used to reduce both the Regular and AMT liability calculations for eligible small businesses, meaning companies with less than $50 million in gross receipts. Start-up companies can also apply the credit to offset up to $250,000 in payroll taxes after December 31, 2015. Start-ups are defined as businesses with less than $5 million in gross receipts in the current year and less than five years of historical gross receipts. 

 

A lot of these changes will be supplemented by regulations in the months to come, but so far this should provide stability and certainty to companies and likely will generate more interest in the research credit from "small businesses".

What is Cost Segregation?

Cost Segregation is a strategic tax savings tool that allows companies and individuals, who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes. In general, it is easy to identify furniture, fixtures, and equipment (FF&E) that are depreciated over 5 or 7 years for tax purposes. However, a Cost Segregation Study goes far beyond that by dissecting construction costs that are usually depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation Study is to identify all construction-related costs that can be depreciated over 5, 7 and 15 years. For example, 20% to 50% of the total electrical costs in most buildings can qualify as personal property (depreciated over 5 or 7 years). Reducing tax lives results in accelerated depreciation deductions, a reduced tax liability, and increased cash flow.

What are the benefits of a Cost Segregation Study?

  • Generates immediate increase in cash flow through accelerated depreciation deductions.
  • Reduces income taxes and can also reduce real estate property taxes.
  • Provides an easy opportunity to claim ‘catch up’ depreciation on previously misclassified assets.
  • Provides an independent third-party analysis that will withstand IRS review.

When should a Cost Segregation Study be conducted?

The ideal time for a Cost Segregation Study can vary depending on a client’s tax situation. At ThreeFive, our team of tax experts work together with clients and their accountants to recommend the best tax planning solution to fit their needs. A preliminary analysis can help determine the right timing and strategy for any investor.

  • Preconstruction: For investors who are in the planning phases of costruction or remodeling, this is the optimum time to consider a Cost Segregation Study as it is beforethe infrastructure of the building is set. ThreeFive’s Pre-Construction Consulting allows the project’s construction contractor to consider design alternatives to maximize tax benefits and the accountant and construction contractor to accurately track items that quality for accelerated depreciation, saving time and money.
  • Year Placed in Service: The best time for a Cost Segregation Study for new owners, is during the year a building is constructed, purchased, or remodeled. This allows an owner to immediately optimize tax savings and accurately classify assets before the building even begins to depreciate.
  • Post-purchase, Remodel, or Construction: “Look-back” Cost Segregation Study: A Cost Segregation Study can be completed anytime after the purchase, remodel, or construction of a property. In fact, current Internal Revenue Service procedures make it easy to go back and claim missed depreciation on assets acquired as far back as 1987 without amending prior tax returns.

What kind of real estate qualifies?

Any structure used for business or as rental property, is eligible for the benefits of Cost Segregation. The percentages of project-related construction costs that could be reclassified from 39-year real property to 5, 7, or 15-year property range from 10 to 60%.

How Does Peco Ruling Impact Cost Segregation?

ThreeFive Consultant, Mike Carlson Responds:

In answer to the question, “Have you guys found the Peco ruling to have an impact on your Cost Segregation business?”   I would say, “No”.  Here’s why – The situation in the Peco case is one where the FMV of the assets question was a product of an arms-length agreement, which is one of the more powerful concepts in the law.  Judges will very seldom stand between two parties who have reached an arms-length agreement.

The purpose of a Cost Segregation study is to fill a void created by the lack of such an agreement.  Keep in mind, such agreements as to the FMV of assets transferred between parties are fairly rare.  Usually, they have their hands full just agreeing to an overall price. 

The reason a Cost Segregation study didn’t hold up in court was because it was trying to challenge better evidence – an arms-length agreement.  Cost segregation studies of assets (normally, buildings or improved property, to be more precise) that have been in service for some time usually require a bunch of estimates.  For example – an asset placed into service 10 years ago – we may or may not even know how much it originally cost, so that has to be researched and often estimated.   Then you have to figure out how much it is worth today – another estimate.  Rinse and repeat for each asset.  

So, if you have an approach that comes up with FMV without requiring estimates – that’s going to be better evidence.   It may still require estimates, but if the estimates have to be agreed to by two adversarial interests (two parties to an arms-length agreement), then these estimates are better evidence than estimates performed by parties where there is no adversarial position involved (like when we sign up a client to do one of these studies and there is all this incentive to put most of the value in the shorter-lived assets, and no one to watch over the process to make sure we’re not biasing the results).

Bottom Line – If we are faced with a situation similar to that in the Peco case, there is no need for our services; we would not do a cost segregation study because it’s already been done.  On second thought, I guess the right answer is, “Yes, the Peco case DOES impact our Cost Segregation business.  We would not have done a Cost Segregation study under those circumstances.”

 

DEDUCTIONS

 

 

We set ourselves apart by performing 100% accounts payable reviews performed by teams that specialize in the subject matter under review.  This led to our ownership of the Sales Tax Refund market and our expansion into services that optimize deductions thereby increasing our client's refunds:

Cost SegregationCost segregation is a thorough asset analysis to identify building components, the costs of which can be recovered over 5 to 15 years instead of the standard 39 years. The net result is typically a large one-year tax deduction that will increase our clients’ cash flow.

Meals & EntertainmentWith tightened cash flows during these new and challenging economic times, taking a closer look at a company’s meals and entertainment expenses subjected to the 50% “haircut” can save tax dollars and lower a company’s effective tax rate.

Domestic Production Activities Deduction (DPAD)If you are engaged in domestic production activities, you may be entitled to an additional federal tax deduction amounting to 9% of your net income. These determinations can be simple or complex, ThreeFive works directly with you to determine the “qualified production activities” and to see if you are eligible. ThreeFive will help you decide if an IRS-recommended statistical sample is necessary.

Source: http://www.threefive.com

Tagged: ThreeFiveThreeFive DeductionsCorporate Tax DeductionsCost SegregationMeals & EntertainmentMeals & Entertainment StudyDomestic Production Activities Deduction,DPAD

 

R&D + DPAD = $$

ThreeFive Saves Company Over $100,000

We recently engaged with a Minnesota based plastic extrusion manufacturer that qualified for a Domestic Production Deduction.  After our analysis, we determined they could take an annual deduction of more than $30,000 that was applied to the open years of 2011, 2012, 2013 and 2014.  The $120,000 of additional deductions saved the company almost $40,000 in taxes.

On top of this, they qualified for both State and Federal R&D Tax Credits that otherwise didn’t qualify due to a lack of permanent records dating back to before the current ownership acquired the company.  Our expertise allowed us to extrapolate the missing information, thereby allowing the company to apply for the State and Federal credits.  The result provided over $150,000 in tax credits, some of which were refundable immediately.

The total savings for the company was over six-figures after fees and expenses.

“We referred one of our clients who was having difficulty with their current R&D Credit service provider. ThreeFive stepped in and did a great job by providing the right advice for both R&D and DPAD with a quick turn-around. The end result of us working together led to over six-figures in savings for our client.”
 - Managing Principal of Referring CPA Firm

REFUNDS

We set ourselves apart by performing 100% accounts payable reviews performed by teams that specialize in the subject matter under review.  This led to our ownership of the Sales Tax Refund market and our expansion into other refund-related services:

Sales Tax - MN65% of all state and local sales tax refunds due are not paid. This translates into an estimated $85 million in tax left unclaimed each year!  There are eleven areas of Minnesota sales tax that have potential for refunds. Two of the most widely defined areas are capital equipment and repair parts. Minnesota is one of only two states that taxes an item in advance, leaving it incumbent on the company to then apply for a refund which is often overlooked or miscalculated. This is only but two of the eleven areas where Minnesota manufacturers are due refunds.

Sales Tax - NationwideWhile Minnesota ranks number one nationally for recoverable sales tax paid in error, many other states are also well known for client over payments or accrual errors. ThreeFive has reviewed and submitted claims utilizing its methodical sales tax recovery service for clients in over 30 States. 

State Audit DefenseSales and use audit activity is on the increase as states are looking for greater revenues. Often corporate accounting staff is too understaffed and unprepared to handle an audit, including the audit sample selection and the audit defense. ThreeFive has over 80 people years of State DOR – sales and use and reverse audits and has successfully performed numerous audit defenses.

Energy Consumption AuditsAs corporate facilities change, so does the need to prevent over taxation of utilities consumption: electricity, natural gas, and water and sewer. ThreeFive can recover both current and past monies paid against utilities for the time frame allowed by state statute. We contract with a specialized engineering and sales tax audit team to analyze rate options, special zone pricing, load factor credits, peak versus off peak consumption, and uncover errors or overcharges on past billings.