Financial Reporting Treatment Under ASC 740 and ASC 450 of Tax Provisions in the PATH Act

Summary of R&D Tax Credit Accounting Treatment

BDO issued our first analysis on the financial reporting treatment under ASC 740 of certain income tax provisions in the Path Act in March 2016. This update is meant to provide additional guidance on accounting for the use of R&D credits against payroll taxes, as well as considerations that are necessary when assessing uncertain tax positions related to the R&D credits.
 
By way of background, on December 18, 2015, President Obama signed into law the Protecting and from Tax Hikes (PATH) Act of 2015 and the Fiscal Year 2016 Budget (the omnibus). The PATH Act contained provisions that retroactively restored and extended a large number of expired tax provisions, commonly known as “tax extenders.” These extenders, which had expired prior to 2015, were retroactively restored effective January 1, 2015. While some provisions have been extended permanently, others have been extended only temporarily. The omnibus also contained several important income and excise tax provisions (e.g., certain excise taxes required under the Affordable Care Act were delayed or temporarily suspended).

Details

The PATH Act restored and permanently extended the research credit under Internal Revenue Code (IRC) Section 41 for qualified research and development (R&D credit).
 
The PATH Act also created two new types of R&D credits: one for eligible small businesses and one for qualified small businesses. Eligible small businesses were allowed to utilize the research credit even if they were subject to the Alternative Minimum Tax¹ and qualified small businesses were allowed to utilize, for up to five years, the research credit against the employer portion of payroll tax (i.e., FICA tax) not exceeding $250,000 per year. These new research credits are available for credits generated in tax years beginning after 2015.    

This alert will highlight some of the PATH Act’s more significant income tax accounting implications accounted for under ASC 740 Income Taxes.
 

The Election to Treat R&D Credit as Payroll Tax Credit Available to Offset Payroll Tax

The PATH Act allows qualified small businesses to elect, pursuant to IRC Sections 41(h)(1) and 3111(f)(1), to apply a portion of their research credit, capped at $250,000 per year, as a payroll tax credit against their payroll tax liability (i.e., FICA tax), rather than income tax liability.² The payroll tax offset is an amount specified by the entity that cannot exceed the smallest of (1) $250,000, (2) the R&D credit determined for the current year, and (3) the business credit carryforward under IRC Section 39 to the following year.³ That is, the payroll tax offset is limited to the general business credit carryforward to the following year that would be available if the payroll tax offset were not available. Therefore, a payroll tax offset would be limited to the R&D credit after any offset of regular tax (said another way, a payroll tax offset would be available only when the R&D credit exceeds the pre-credit tax liability).

To qualify, an entity’s gross receipts for the taxable year must be less than $5 million, and the entity must not have had gross receipts for any taxable year before the five taxable year period ending with the taxable year. A qualified small business can be a corporation, including an S corporation, or a partnership that meets the gross receipts requirements in any year.⁴  This election can only be made during a five-year period, and the election must be made on or before the due date (including extension) of originally filed returns. The payroll tax offset is made on Form 941.

The PATH Act authorizes the Department of Treasury to issue regulations requiring recapture of R&D credits utilized as offset to payroll tax, including the filing of amended returns when an adjustment to the payroll tax portion of the research credit is necessary.

This change is beneficial to startups and small businesses with no current income tax liability (due to losses) that also generate R&D credits that would otherwise be carried forward into future periods and would require an  income tax liability to utilize. Assuming the requirements and limitations are met, a company can use its R&D credits to offset payroll tax expense recognized in operating income.

Qualified small business reporting entities would need to determine whether the R&D credit is an income tax benefit accounted for under ASC 740 or as an item of pretax income, such as reduction of payroll tax expense, accounted for under a different accounting standard in the Codification.⁵

The Master Glossary definition of “income tax” in ASC 740 states the following: “Domestic and foreign federal (national), state, and local (including franchise) taxes based on income.” In fact, ASC 740 does not apply to franchise tax based on capital or to certain withholding taxes for the benefit of the owners.⁶ The standard also explains that when the reporting entity incurs an excise tax that is independent of taxable income – i.e., the tax is due on a specific transaction regardless of whether there is any taxable income for the period in which the transaction occurs – the tax is not an income tax and it should be recognized as an expense in pretax income.⁷ The employer’s portion of FICA taxes (i.e., payroll tax) is based on the employees’ income and not the reporting entity’s income, making it clear that payroll tax is not an income tax.

However, ASC 740 does not specifically address the accounting for income tax credits that are also available, by election, to offset payroll tax (i.e., dual purpose tax credits). Generally, refundable tax credits (i.e., credits that can be refunded for cash) are not accounted for under ASC 740, even when the reporting entity is currently paying income tax and can utilize the credit to offset income tax liability. Rather, when entities determine the proper classification of credits used to offset payroll tax, the guidance under IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, may be applied in these situations. Specifically, IAS 20 notes that grants related to income are presented as part of profit or loss, either separately or under a general heading such as “other income”; alternatively, they are deducted in reporting the related expense.⁸

This new qualified small business R&D credit is not refundable. However, a qualified small business with currently minimal or no regular income tax liability has an option to either use the credit to offset income tax liability during a 20-year R&D credit carryforward period or use the credit to offset payroll tax (up to $250,000 per year for five years).

Therefore, the accounting question is how to consider the ability to utilize current year R&D credits, after reducing net income tax, if any, to reduce payroll taxes. Two approaches are considered in this alert.

One approach is to account for the benefit consistent with the chosen annual election and management’s expectation concerning the manner in which a credit carryforward is expected to be monetized.⁹ For example, assume that a qualified small business generates a current year R&D credit of $200,000. Under this first approach, three scenarios exist:

1. The qualified small business expects that the credit would be used against income tax only. In this scenario, an entity would record an income tax benefit of $200,000 and either record a corresponding reduction in income taxes payable if the credit is being used to reduce current year taxes, or record a deferred tax asset, subject to valuation allowance assessment, if the credit is being carried forward.
2. The qualified small business has a pre-credit tax liability limitation of $130,000 and the entity elects to treat $70,000 as payroll tax credit available to offset payroll tax liability on Form 941, assuming the entity has no general business credit carryforward. Under this approach, the entity would recognize $130,000 as income tax benefit (the offset to current-year income tax) and $70,000 as pretax income benefit (the offset to payroll tax).
3. If the entity does not owe income tax in the current year, it can elect to utilize up to $200,000 of the current-year R&D credit as an offset to payroll tax. If payroll tax is less than $200,000, the entity would consider the manner in which it is expecting to monetize the R&D credit carryforward. If the R&D credit carryforward is expected to offset future income tax, it would be accounted for as income tax benefit and any deferred tax asset credit carryforward would be evaluated for a valuation allowance.

Note, that if the recognition requirements in ASC 740 are met, a deferred tax asset for an R&D credit carryforward must be recognized under ASC 740 regardless of the income statement presentation of the benefit (i.e., pretax income or income tax benefit).¹⁰

Another approach is to treat the R&D credit generated during the five year period up to $1,250,000 as a non-income tax benefit (i.e., an item of pretax income).

There are unique considerations that might favor the first approach.

The election is only available during a five-year period and the law, as currently written, limits the optionality to the R&D credits that are not otherwise used to reduce net income tax expense.

Recognition of the maximum credit amount (i.e., $1,250,000) in pretax income would potentially result in having to reclassify unused credits to income tax after the five-year period (a qualified small business would need to report approximately $20.2 million in payroll expense to owe $1,250,000 of FICA payroll tax during the five-year period). Further, an R&D credit utilized on the income tax return to offset income tax liability would necessitate complex accounting to gross up income tax expense and reclassify the benefit into pretax income.    

It should be noted that an election to offset payroll taxes does not affect the payroll expense amount allowable as a deduction (i.e., a taxpayer that elects to offset its payroll tax liability is not required to include such offset into income for tax purposes). Therefore, recognition of the R&D credit offset in pretax income (i.e., offset to payroll tax expense) would result in a book-to-tax adjustment (i.e., an “M-3” adjustment in Form 1120) to reflect a deduction for payroll tax expense without an offset (i.e., the R&D credit benefit is not taxable income and is thus removed from pretax income when it is recognized as a payroll tax expense offset). Finally, if a payroll tax offset is elected, the entity is required to follow the rules in IRC Section 280C and reduce deductible qualified R&D expenditures to the extent of the R&D credit (or elect a reduced credit rate).

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¹The Alternative Minimum Tax was repealed as part of the Tax Cuts and Jobs Act in 2017, effective for taxable years beginning after December 31, 2017.
² Payroll tax includes two components: (1) social security tax of 6.2 percent and (2) Medicare or hospital insurance (HI) tax of 1.45 percent. Under this change, R&D credits would be allowed, by election, to be treated as payroll tax credits to offset the social security payroll tax component, but not the Medicare or HI or the employee portion of payroll tax that the employer is required to withhold.   
³ There are many general business credits listed in IRC section 38, and the order of absorption is prescribed in IRC Section 38(d), which follows the order in which the credits appear in IRC Section 38(b) (the R&D credit coming fourth).
⁴ Individuals carrying active trade or business may also qualify if they meet the gross receipts test and requirement.
⁵ The Codification encompasses all of the U.S. Generally Accepted Accounting Principles (GAAP) standards, including the ASC 740 Income Taxes.
⁶ ASC 740-10-15-4.
⁷ ASC 740-10-55-75.
⁸ IAS 20, paragraph 29.
⁹ By analogy to ASC 740-10-55-23, which explains that the measurement of deferred income taxes is based on tax elections expected to be made in future years.
¹⁰ ASC 740-10-55-35.
¹¹ ASC 450-20-25-2.