How the PATH Act Helps Small Businesses
In a landscape where innovation and growth are the cornerstones of success, the Protecting Americans from Tax Hikes (PATH) Act of 2015 emerges as a beacon of support for small businesses. Signed into law by President Barack Obama, this pivotal legislation represents a significant stride in tax policy, particularly through its transformative impact on Research and Development (R&D) tax credits. By opening doors for a wider array of businesses to claim these benefits, the PATH Act not only fuels the inventive spirit of small enterprises but also provides them with a critical financial lifeline. This PATH Act represents a commitment to nurturing economic growth and technological advancement and laying a solid foundation for businesses to thrive in today’s competitive global market.
What is the PATH Act?
In December 2015, President Barack Obama signed into law the PATH Act of 2015, marking a significant bipartisan achievement. This legislation aimed to provide lasting tax relief to a broad spectrum of recipients, notably encompassing small and innovative businesses. At its core, the PATH Act sought to rejuvenate and permanently solidify essential tax incentives, thereby supporting the endeavors of both individuals and businesses in fostering job creation and economic growth. A key aspect of achieving this goal was through substantial revisions to the R&D credit, significantly expanding its scope and applicability.
What is the R&D Tax Credit?
The R&D Tax Credit (26 U.S. Code §41) is a federal benefit that provides companies dollar-for-dollar cash savings for performing activities related to the development, design, or improvement of products, processes, formulas, or software. This credit offers much-needed cash to hire additional employees, increase R&D, expand facilities, and more. The credit was enacted in 1981 to stimulate innovation and encourage investment in development in the U.S.
R&D Credits generation is dependent upon the performance of qualified research activities. Qualified research activities are defined by the “Four-Part” test outlined below:
- Technological in Nature: Activities must fundamentally rely on the principles of physical or biological science, engineering, or computer science.
- Permitted Purpose: Activities must be performed to improve the functionality, performance, reliability, or quality of a new or existing business component.
- Eliminate Uncertainty: Activities intended to discover information that could eliminate technical uncertainty concerning the development or improvement of a product.
- Process of Experimentation: All activities must include experimentation, including testing, modeling, simulating, and systematic trial and error.
If a Company’s activities successfully meet the criteria of the “four-part” test outlined above, it becomes eligible to claim a range of expenses directly related to these activities. This includes wages paid to employees engaged in the R&D processes, costs of supplies used in research, and payments made to third parties to perform research on behalf of the Company. Once the Company establishes that its activities are technological in nature, serve a permitted purpose, aim to eliminate uncertainty, and involve a process of experimentation, these related expenses are aggregated. This aggregation forms the basis for calculating the Company’s R&D tax credit, which typically amounts to a benefit of 7-10% of the Company’s current year expenditure on R&D activities.
The PATH Act and R&D Tax Credit
The PATH Act made three significant changes to Section 41 of the R&D tax credit statute. First, the R&D credit was made permanent. This allows companies to plan for the lucrative incentive annually. Secondly, Qualified Small Businesses (QSB) may utilize the R&D credit to offset a portion of the payroll taxes. A QSB is a corporation, partnership, or individual with less than $5 million of gross receipts during the tax year, AND the taxpayer did not have gross receipts for any tax year before the fifth tax year ending with the year of the claim. For example, taxpayers claiming the credit on their 2023 tax returns must have less than $5 million in gross receipts during 2023 and could not have had any gross receipts prior to 2019. Lastly, Eligible Small Businesses (ESB) may utilize the R&D to offset Alternative Minimum Tax (AMT). An ESB is defined as a Company with an average of $50 million or less of Gross Receipts for the prior three years.
These PATH Act changes have significantly broadened the scope for taxpayers to claim the Research and Development tax credit, resulting in substantial cash savings opportunities for small businesses. The increased access to the R&D credit benefit translates into reduced federal and state tax liabilities, not only for the current fiscal year but in perpetuity. Furthermore, these savings contribute to an uptick in a company’s market value, as the enhanced cash flow and reduced tax burden signal greater financial robustness and potential for growth to investors and stakeholders. The PATH Act’s provisions have created a more fertile ground for companies to flourish, leveraging tax incentives to foster innovation while simultaneously strengthening their financial footing.
In summary, the Protecting Americans from Tax Hikes (PATH) Act of 2015 has emerged as a game-changing piece of legislation for small businesses, particularly in its strategic enhancement of the Research and Development (R&D) tax credit. This Act not only offers substantial tax relief but also serves as a vital tool for small enterprises looking to maximize their financial strategies. By making the R&D tax credit more accessible, the PATH Act empowers these businesses to invest more in innovation while simultaneously benefiting from significant tax savings. This savvy tax strategy not only bolsters their immediate financial health but also sets the stage for long-term growth and competitiveness. Small businesses, often the backbone of the economy, now have an amplified ability to contribute to job creation and technological advancement, thanks to the PATH Act’s provisions. This Act exemplifies how targeted tax policies can be leveraged by small businesses to foster a thriving, innovative business environment.
Case Study: Qualified Small Business
Founded in 2021, this company performing R&D activities has been making losses since its inception. The Company does not generate an annual income tax liability due to the losses incurred. As such, the Company has not claimed the research credit. In 2023, the Company estimates gross receipts of $3 million with an estimated payroll tax liability of $120,000 in 2023. KBKG’s R&D Tax Credit experts calculated $320,000 of federal research credit. The Company may elect to offset $120,000 of 2023 payroll tax liabilities and carry forward $200,000 of unused R&D credits to offset future payroll tax obligations.