Nov 11, 2020 Downsides to the COVID-19 Tax Relief Legislation That Could Impact the R&D Tax Credit
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, was signed into law providing taxpayer favorable treatment of Net Operating Losses (“NOLs”) as well as the Paycheck Protection Program (“PPP”). PPP loan applications were first made available April 3, 2020, in which companies could apply for coverage up to 2.5 times their average monthly payroll expenses. With COVID-19 still impacting the country, companies are now able to apply for forgiveness on PPP loans.
Per the CARES Act, PPP loans were intended to allow a borrower to apply for loan forgiveness if 75% of the funds were used towards payroll expenses, but was later relaxed to 60%. The remaining funds can be used towards expenditures such as rent, utilities and mortgage interest.
The CARES Act also provided that loan forgiveness does not trigger taxable income and should be excluded from gross income. The IRS issued guidance in Notice 2020-32, interpreting this to mean that a company cannot deduct expenditures paid with PPP loan forgiveness funds. Specifically, this notice clarifies that no deduction is allowed for expenditures attributed to PPP loan funds.
Additionally, the CARES Act delays the 80% NOL limitation until tax years beginning after December 31, 2020 and allows NOLs generated during years 2018 through 2020 to be carried back five taxable years and carried forward indefinitely.
How Does This Negatively Impact the R&D Tax Credit?
Since taxpayers cannot claim expenditures paid by PPP loan funds as deductions, these expenditures cannot be included for purposes of calculating the R&D tax credit. This could translate into a significant decrease in qualified R&D expenditures and thereby decrease R&D tax credits for the 2020 tax year.
Example: Assume Company has taken a $150,000 PPP loan which all expenses were allocated to eligible QRE wages.
|Estimated ASC Credit||Estimated Traditional Credit|
|Description||2020 QRE||2020 QRE with PPP||2020 QRE||2020 QRE with PPP|
|PPP Loan Funds||$150,000||$150,000|
|Revised QRE for 2020||$400,000||$400,000|
|50% QRE Limitation|
|Prior YR 3 QRE||$350,000|
|Prior YR 2 QRE||$425,000|
|Prior YR 1 QRE||$505,000||$213,333||$213,333|
|Excess QRE over 50% Base||$336,667||$186,667||$275,000||$200,000|
|Estimated 2020 R&D Tax Credit||$47,133||$26,133||$55,000||$40,000|
While the R&D tax credit will be less impacted by the PPP loan funds using the Traditional method rather than the ASC method, both have a significant impact on the R&D tax credit. With taxable income being higher due to nondeductible PPP loan expenditures, losing R&D tax credits will have a greater financial burden. Further, with the ability to carryback NOL’s five years, there may not be NOLs available that were expected to help reduce taxable income in 2020.
How Can We Lessen the Impact?
Under the current guidelines, borrowers can potentially apply up to 40% of their PPP loan to expenditures other than eligible R&D wage expenditures. In doing so, a taxpayer will need to carefully document what expenditures were paid by PPP loan funds. The best approach for a company to accomplish this is to (1) Allocate 40% to actual non-payroll costs; and (2) Allocate 60% of the payroll costs to employees that do not participate in R&D activities. A company should document which expenditures the loan was applied before year end.
Additionally, if a company has been using the ASC method, they may want to consider reviewing their R&D tax credit method to assess if a larger credit would be generated under the Traditional method.
If no further guidance is issued, Notice 2020-32 will have a negative impact by reducing the qualified wage expenditures to generate R&D tax credits. It is advised that a company work in conjunction with their R&D tax credit provider and tax advisors to protect their R&D tax credits for 2020.
About the Author: Lacey Robb is the R&D Tax Credit Practice Leader for ICS Tax, LLC. She is an attorney and has an LLM in Taxation and has helped numerous taxpayers in a variety of industries take the R&D tax credit. She can be reached by phone at 310-968-0970 or by email at email@example.com.
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ICS Tax, LLC (ICS) is a consulting firm providing innovative tax planning strategies. ICS collaborates with taxpayers and their tax professionals to identify credits and incentives that reduce tax liabilities and increase profitability. ICS provides nationwide service through its offices located throughout the country.