R&D Tax Credit May Be Reduced With PPP Loan Forgiveness

If you received a Paycheck Protection Program (PPP) loan AND want to take advantage of the R&D tax credit, make sure you understand the potential impact of PPP loan forgiveness.

Background

The Paycheck Protection Program was established by the Coronavirus Aid, Relief, and Economic Security Act  or CARES Act, to provide financial resources to small and mid-size businesses to enable them to maintain payroll and cover certain expenses during the coronavirus pandemic. PPP loans may be forgiven upon application. Although loan forgiveness typically creates a taxable event, under the CARES Act, PPP loan proceeds are specifically excluded from taxable income. However, if you received a PPP loan, be aware that forgiveness of the loan, in whole or in part, may cause 2020 qualified research expenses or QREs to become ineligible for the research and development or R&D tax credit.

Under Internal Revenue Code Section 41(d)(1)(A), you cannot claim an R&D tax credit on expenditures that are not deductible. Employee wages tend to be a large component of the qualified research expenses that are not deductible. Based on guidance issued by the IRS in March 2020  in Notice 2020-32, expenses paid using forgiven PPP loan funds will be nondeductible for tax purposes even if they would otherwise be deductible. So any wages paid to employees using forgiven PPP loan proceeds are not eligible as QREs, thus decreasing federal and state R&D credits.

Understanding PPP Loan Forgiveness

It is important to understand how forgivable PPP loan funds must be allocated among your costs so that eligible R&D expenses might still qualify for the R&D tax credit. Current guidance provides that PPP forgivable loan funds must be applied to the following expenses:

 

  • At least 60% of the funds must be used for eligible payroll costs, including cash compensation, employee benefits and owner compensation.
  • Up to 40% of the funds may be applied to the following nonpayroll costs:
    • Rent
    • Utilities
    • Interest on mortgage obligations
    • Interest payments on any other debt obligations that were incurred before February 15, 2020

PPP loan forgiveness application forms include a requirement that the borrower maintain all records relating to the PPP loan. This includes documentation necessary to support the loan forgiveness application, such as the names of individual employees and wages). However, there is no requirement on how the PPP loan funds have to be allocated to individual employees, which allows the borrower to determine which employees the PPP forgivable loan funds should be applied to.

Mitigating the Effect of PPP Loan Forgiveness on the R&D Costs

By applying the PPP forgivable loan funds to nonpayroll costs (up to 40% of the loan) and to employees that do not perform qualified research activities, you can preserve the wages paid to employees involved in qualified research activities as deductible, thus mitigating the impact of the forgiven PPP loan funds on your R&D tax credit.

Companies claiming R&D tax credits should consider analyzing the eligible costs and allocating the forgivable funds in the following order (up to the certain limitations):

  1. Interest on mortgage obligations
  2. Rent
  3. Utilities
  4. Interest on any other existing debt obligations
  5. Certain employee benefits relating to healthcare
  6. Payroll costs that are non-taxable
  7. Payroll costs for employees who are not performing R&D-qualified services, e.g., accounting, finance, human resources
  8. Payroll costs for employees who are performing R&D-qualified services. For each individual employee, the total amount of cash compensation eligible for PPP loan forgiveness cannot exceed an annual salary of $100,000 – as prorated for the covered period.
Example

The following example shows how PPP forgiven loan funds used for QREs can reduce the amount of R&D tax credit available to borrowers.
 

Alternative Simplified Credit

2020 Credit

Reduction for PPP Loan Forgiveness

Adjusted 2020 Credit

Qualified Wages

$3,500,000

($1,050,000)

$2,450,000

Qualified Supplies

$500,000

 

$500,000

Rental or Lease Cost of Computers

 

 

 

Qualified Contract Research

$225,000

 

$225,000

Total QREs

$4,225,000

($1,050,000)

$3,175,000

Base Amount (Sum of Prior 3 Years QREs Divided by 6)

$1,870,333

 

$1,870,333

Incremental Qualified Expenses

$2,354,167

($1,050,000)

$1,304,167

Total Gross Research Credit

$329,583

($147,000)

$182,583

 

Insights

If you received a PPP loan, review your PPP eligible costs to determine whether you can reduce the impact on the R&D tax credit by allocating some or all forgivable loan funds to expenses other than research-related costs. Key items to review include whether and to what extent you:

  • plan to file for or have received full or partial forgiveness of PPP loan funds
  • Allocate the potentially forgivable PPP loan funds to QREs
  • File for forgiveness, subject to limitations, on nonpayroll costs and non-QREs to reduce the impact on the R&D tax credit

Future IRS guidance may create additional requirements relating to the allocation of the PPP forgivable loan funds to costs. If you received a PPP loan and want to qualify for the R&D tax credit, be sure to monitor developments carefully. 

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