The Internal Revenue Service issued a statement on May 10, 2021 that it will revise Form 6765 (“Credit for Increasing Research Activities”) to provide that wages for qualified research do not include 2021 wages claimed for the Employee Retention Credit (Section 2301 of the CARES Act), or the Employee Retention Credit for Employers Affected by Qualified Disasters (e.g., tornadoes, floods, wildfires or other qualified disasters). Previously, Form 6765 only listed the Work Opportunity Tax Credit (“WOTC”) as wages that could not be counted for both R&D and WOTC.
The revision was brought on by adjustments contained in the Taxpayer Certainty and Disaster Tax Relief Act of 2020 (“TCDTRA”), enacted Dec. 27, 2020.
The IRS statement provides that, in addition to WOTC, wages for qualified research services do not include:
- Wages paid to or incurred for any employee after Dec. 31, 2020, and before July 1, 2021, if a taxpayer uses the same wages to claim the Employee Retention Credit on an employment tax return such as Form 941, Employer’s QUARTERLY Federal Tax Return; and
- Wages paid to or incurred for any employee generally after Dec. 27, 2019, and before Apr. 17, 2021, if a taxpayer uses the same wages to claim the 2020 Qualified Disaster Employee Retention Credit on Form 5884-A, Employee Retention Credit for Employers Affected by Qualified Disasters.
Note that the IRS statement does not address the extension of the Employee Retention Credit by the American Rescue Plan (ARP). Under the ARP, signed into law by President Biden in March, the retention credit is available for qualifying wages paid or incurred after June 30, 2021 and before Jan. 1, 2022. Similar to TCDTRA, wages for qualified research services do not include wages used to claim the Employee Retention Credit.
Qualified wages for Employee Retention Credit purposes are determined under Internal Revenue Code section 3121(a) (FICA wages) or 3231(e) (railroad retirement compensation) while an employee’s qualified wages for R&D tax credit purposes are generally determined under section 3401(a) (federal income tax withholding wages).
In addition, qualified research can also be impacted by costs included in determining orphan drug credits (Form 8820). Though it is not called out on Form 6765, qualified clinical testing expenses which are claimed as orphan drug credits on Form 8820 cannot be taken into account for determining section 41 R&D credits (Sec. 45C(c) - Coordination with credit for increasing research expenditures).
Example of Interaction of R&D Tax Credits with Employee Retention Credits
For 2020 Wages -- As the limitation regarding qualified research and Employee Retention Credits is effective for wages paid or incurred after Dec. 31, 2020, wages paid or incurred during 2020 could potentially qualify for both R&D and Employee Retention Credits.
For 2021 Wages -- An employer that is eligible for both Employee Retention Credits and R&D credits may use wages paid or incurred during 2021 in excess of the maximum allowed per employee ($10,000 per employee per quarter) for Employee Retention Credits as potentially qualified wages for R&D purposes.
To illustrate -- If an eligible employer pays an R&D engineer $80,000/year in 2021 and is eligible to claim Employee Retention Credits for that employee, up to $40,000 may qualify as wages for Employee Retention Credits and $40,000 (assuming Box 1 wages) may qualify as wages for R&D tax credits. The limitation is that the employer cannot use the same wages for R&D and also for Employee Retention Credits, WOTC, or Orphan Drug Credits.
The interaction of wages for the R&D credit and wages for the employee retention credit are just one item surrounding R&D that companies will have to track during the 2021 compliance season. Per TCJA, changes to section 174, starting in tax years beginning after Dec. 31, 2021, companies will need to track and capitalize their research and software development expenditures and recover them over a period of 5- or 15-years, for domestic and foreign expenditures, respectively. Companies would benefit from reviewing the changes to research cost expensing as they are determining the wages allocable to the R&D credit or the employee retention credit.