Articles & Alerts
The Tax Cuts and Jobs Act Doesn’t Cut the R&D Tax Credit
On December 22nd, President Trump signed the Tax Cuts and Jobs Act of 2017 (“TCJA”) into law, creating the most sweeping update to the U.S. tax code since the 1986 tax reform enacted under President Reagan. The centerpiece of the TCJA, is a permanent reduction in the corporate tax rate from approximately 35% to 21%.
As expected, the final law has preserved the research and development (“R&D”) tax credit, which was made permanent in December 2015 through enactment of the Protecting Americans against Tax Hikes (“PATH”) Act. While there are no direct changes to the R&D tax credit, there are four major ways that this tax reform will directly or indirectly affect the taxpayers claiming the R&D tax credit. To summarize, the TCJA of 2017: 1) repeals the corporate alternative minimum tax (“AMT”) while retaining and adjusting the individual AMT, 2) makes significant changes to the orphan drug (“OD”) credit, 3) repeals the Section 199 Domestic Production Activities Deduction, and 4) for tax years beginning after December 31, 2021, will require companies to amortize research and experimental expenditures under IRC Section 174 over a five-year period instead of immediately expensing those costs.
AMT – Corporate Repealed and Individual Retained and Adjusted
Thankfully, the final law reduces the corporate tax rate to 21% and repeals the corporate AMT. How does this change impact companies claiming the R&D tax credit? It removes the limitation for corporations to utilize the R&D tax credit by allowing an offset to regular tax liability. For small and mid-sized companies, the new law does not impact their ability to utilize the R&D tax credit to offset AMT if certain criteria are met.
The final bill retains the individual AMT with temporary increases in both the exemption amount and the phase out threshold. Exemption amounts are increased from $84,500 for joint filers and $54,300 for other filers to $109,400 and $70,300, respectively. This will decrease the number of households subject to the AMT.
Orphan Drug Credit
Congress passed The Orphan Drug Act in 1983 to provide a more lucrative incentive for companies that are willing to embark on the development of orphan drugs. An orphan drug is a drug developed to specifically target diseases that affect only a small percentage of the U.S. population (less than 200,000 people), also known as an orphan disease. Instead of calculating the benefit for orphan drug development using the rules under IRC section 41 for the R&D tax credit, the Orphan Drug Act provided for a tax credit of 50% of clinical testing expenses (“CTEs”) under IRC Section 45C. Under this new tax law, the OD tax credit will be dramatically reduced to 25% of a company’s costs related to clinical trials for developing rare disease treatments.
Repeal of Section 199 – Domestic Production Activities Deduction
Section 199 allows a taxpayer to claim a deduction equal to 9% (6% for certain oil and gas activities) of the lesser of the taxpayer’s taxable or qualified production activities income subject to a limitation of 50% of W-2 wages paid by the taxpayer during the calendar year that are allocable to the taxpayer’s domestic production gross receipts. Qualified production activities income is derived from certain production activities and services performed in the United States. The TCJA of 2017 has repealed Section 199 effective for tax years beginning after December 31, 2017.
Section 199 may still be claimed for any open tax years beginning before January 1, 2018. Accordingly, taxpayers with production or service activities that are within the scope of Section 199 should consider claiming the Section 199 deduction for current years or possibly reviewing claims made in prior tax years and filing amended returns where applicable.
Research Cost Amortization
With the newly enacted legislation, for tax years beginning after December 31, 2021 taxpayers will be required to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years in the case of foreign research) and Section 174 will be modified to require that all software development costs be treated as research or experimental expenditures.
The law’s five-year amortization requirement could have a dramatic effect on taxpayers currently deducting their research or experimental expenditures under Section 174. Taxpayers with significant foreign research will feel an even greater impact, as the provision provides a much longer recovery period for foreign research, presumably to incentivize domestic research.
For more information, please contact Yair Holtzman, Partner and Practice Leader of Anchin’s Research and Development