Michael Krajcer writes about how the Virginia research & development tax credit encourages innovation.

1. 5 Favorable Areas of Change Impacting the 2016 R&D Tax Credit
Both the Virginia and federal research credits have been recently strengthened in an
effort to provide further incentive for expanding innovation.
By Michael Krajcer
Major changes to both the Virginia and federal research tax credits take effect this filing season.
New legislation will provide Virginia-based companies with one of the most lucrative research
and development (R&D) tax savings opportunities in the nation, and the now-permanent federal
credit has new provisions benefiting start-up companies and taxpayers paying Alternative
Minimum Tax (AMT).
The federal R&D tax credit offers a dollar-for-dollar offset to a company’s income tax liability. It’s
a broad incentive intended to cover millions of taxpayers, and businesses of any size and
industry sector can qualify if they meet the criteria governed under IRC section 41. Many states
also offer their own version of the credit, and typically the rules to claim it follow that of the
federal credit, with the exception that the costs can only be claimed for activity taking place
within the given state. In many instances, businesses qualifying for the credit will be able to
claim both the federal and state incentives.
Historically, Virginia has offered its taxpayers one of the best state credits available, often
considered to be more lucrative than the federal credit due to its refundability. Yet in 2016,
Virginia Gov. Terry McAuliffe surprised taxpayers when he signed new legislation that further
broadened the credit’s applicability and appeal and extended it until 2022. Businesses in any
industry, but specifically those investing significant dollars in R&D, will benefit from these
changes.
And thanks to monumental changes stemming from the Protecting Americans From Tax Hikes
(PATH) Act of 2015, 2016 was also the first year that business located in any state could begin
to utilize the now-permanent federal research credit and its new AMT and payroll tax offset
provisions — both of which were enacted to benefit small businesses. Virginia’s emerging wine
and brewery industries, as well as its expanding technology sector comprised of many startups,
will likely look to take advantage of these provisions.
Also in 2016, the U.S. Internal Revenue Service (IRS) issued final regulations related to
software development. The favorable guidance contained within these regulations is likely to be
embraced by Virginia’s government contractor industry, as well as the local and regional
financial institution industry that have long been investing in customer-facing software
development initiatives, but had been limited to claiming the credit due to stringent
requirements.
These new enhancements to the federal and state credit provide Virginia businesses with
significant new tax savings opportunities while serving as important tools in enhancing Virginia’s
competitiveness, as taxpayers will have more reason to consider it a preferred location for R&D
investment and activity.

2. VIRGINIA R&D CREDIT CHANGES
Enhancements to the Existing R&D Credit
"To invent, you need a good imagination and a pile of junk." — Thomas A. Edison
And as our country’s most prolific inventor, Thomas Edison would also have known that
inventing requires a great deal of time and financing. The intent behind R&D incentives is to
provide financing to the private sector, whose R&D activities will develop into cutting-edge
technologies, create new jobs and grow the domestic economy. And in the case of the Virginia
credit, legislators want to attract new businesses into the state.
Gov. McAuliffe signed State Bill 58 into law on March 7, 2016, extending the existing R&D credit
to Jan. 1, 2022, and greatly enhancing it as follows:
 The amount each taxpayer can generally claim annually increases from $35,100 up to
$45,000. The annual credit limit is now calculated as 15 percent of the first $300,000 in
Virginia-qualified R&D expenses to the extent the expenses exceed a base amount.
 If the research was conducted in conjunction with a Virginia public or private college or
university, the annual limit per taxpayer increases from $46,800 to $60,000, calculated
as 20 percent of the first $300,000 of Virginia-qualified research and development
expenses to the extent the expenses exceed a base amount.
 The total amount of credit allowed to all taxpayers annually increases from $6 million to
$7 million.
 In addition the primary credit calculation, a taxpayer may elect a new simplified method
of calculating the credit. Under this new alternative simplified computation method, the
credit is equal to 10 percent of the excess of the Virginia-qualified R&D expenses paid or
incurred during the tax year over 50 percent of the average amount paid or incurred over
the three immediately preceding tax years. If you have not incurred Virginia-qualified
R&D expenses during any of the three immediately preceding tax years, the credit is 5
percent of the amounts paid or incurred during the taxable year.
 Prior to Jan. 1, 2016, taxpayers making a Virginia state R&D credit claim had to file an
application with the Virginia Department of Taxation by April 1. SB 58 changes the
application date to July 1.
With the addition of the simplified calculation methodology, which incorporates a 50 percent
reduction to the average research spend of a business, even taxpayers that are not increasing
their R&D expenses may qualify for this incentive. Also note that if the $7 million cap is not
reached by filed claims, taxpayers may actually receive a credit in excess of what they applied
for.
The New Major R&D Credit
"Our greatest weakness lies in giving up. The most certain way to succeed is always to try just
one more time." — Thomas A. Edison

3. SB 58 also includes a new form of R&D credit. The Major Research & Development Expenses
Tax Credit is available starting in 2016 for taxpayers incurring Virginia-qualified R&D
expenditures more than $5 million. The total amount of this credit available to all taxpayers
annually is $20 million.
The new credit is calculated in much the same fashion as the federal Alternative Simplified
Credit (ASC), and is identical to the simplified calculation method now allowed as an election for
the existing Virginia R&D credit. The credit equals:
 10 percent of the excess of:
o The R&D expenses paid or incurred activity taking place in Virginia during the
taxable year, over
o 50 percent of average Virginia-qualified R&D expenses paid or incurred by
taxpayers for three taxable years immediately preceding the taxable year for
which the credit is being determined.
 Or, if no R&D expenses were incurred in any one of three immediately preceding taxable
years, then the credit is equal to five percent Virginia-qualified R&D expenses paid or
incurred by the taxpayer during taxable year.
The amount of the credit claimed for the taxable year shall not exceed 75 percent of the total
amount of the taxpayer’s tax liability for the taxable year. And since this credit is nonrefundable,
that statute allows for a 10-year carryover.
As with the existing R&D credit, taxpayers who want to claim this credit must file an application
by July 1 of the calendar year following the close of the taxable year in which the expenses
were paid or incurred. It’s also important to note that taxpayers are prohibited from claiming both
this credit and the existing refundable credit for the same taxable year, and that no credit is
available for R&D expenses incurred in research using embryonic stem cells.
With no limit to how much can be claimed by an individual taxpayer, and a sizeable overall cap
of $20 million, businesses investing significant resources in R&D now have serious reason to
consider Virginia their home for this type of activity. For example, a business that has invested
$5 million each year in R&D in Virginia from 2013 through 2016 may now apply for $250,000 of
major R&D credits as opposed to the maximum of $45,000 under the existing general credit.
FEDERAL R&D CREDIT CHANGES
PATH Act Provisions to Offset AMT and Payroll Tax
Signed into law on Dec. 18, 2015, the PATH Act made the federal R&D credit permanent and
added two significant provisions. For tax years starting after Dec. 31, 2015, taxpayers may be
eligible to offset AMT and payroll taxes using the research credit.
AMT Offset
"Genius is one percent inspiration and ninety-nine percent perspiration." — Thomas A. Edison
Historically, AMT has served as a limitation barring many small and medium-size businesses
from benefiting from the research credit, since prior law prohibited the use of the credit to

4. decrease tax liability below AMT levels. For instance, even if a business was conducting credit-
eligible activity and calculating a credit on its tax return, the company would not be able to utilize
the credit against its full tax liability if it was subject to AMT. Hence, many businesses found it
difficult to justify the work involved in calculating the credit when only a portion, if any, of that
credit would be available for their immediate use.
Going forward, the research credit may now offset both regular tax liability and AMT liabilities for
taxable years beginning on or after Jan. 1, 2016. Key components of the provision are:
 Applicable to taxable years beginning after Dec. 31, 2015.
 The business (and if a flow-through entity, its partners or shareholders) must have
less than $50 million in average gross receipts for the three preceding years.
 Only credits earned after Dec. 31, 2015, apply to the provision (i.e., carryover credits
from earlier tax periods will not be allowed to offset AMT).
Thus for those taxpayers who meet the gross receipts test noted above, AMT liability may now
be reduced utilizing research credits. This will be an important reason for businesses to
consider or reconsider the research credit opportunity in the future. With the opportunity to
secure current cash-flow benefit of the credit, (i.e. as opposed to counting on future benefit
during the credit’s 20-year carryover period), taxpayers suffering from the effects of AMT finally
have something to cheer about.
Payroll Tax Offset
“I have not failed. I've just found 10,000 ways that won't work.” — Thomas A. Edison
Fortunately, a successful invention is not a requirement to claim the federal R&D credit.
However, until now, it was necessary to have a tax liability to utilize it. Simply, the federal credit
has never been refundable. And although still not refundable, starting in 2016 the research
credit may now be utilized to reduce a portion of a qualifying small businesses payroll taxes,
thus affording those without an income tax liability a means to benefit currently from the credit.
Without this provision, the only other option was to wait for the business to incur an income tax
liability during the 20-year carryover period of the credit. Key components of the provision are:
 Applicable to taxable years beginning after Dec. 31, 2015.
 A qualified small business is defined, with respect to any taxable year, as a corporation
(including an S corporation) or partnership (1) with gross receipts of less than $5 million
for the taxable year, and (2) that did not have gross receipts for any taxable year before
the five taxable year period ending with the taxable year.
 Offset limit is up to $250,000 in credit against employer OASDI liability (the employer
portion of tax equal to 6.2 percent of all wages).
 The payroll tax credit portion is the least of (1) an amount specified by the taxpayer that
does not exceed $250,000, (2) the research credit determined for the taxable year, or (3)
in the case of a qualified small business other than a partnership or S corporation, the
amount of the business credit carryforward under section 39 from the taxable year
(determined before the application of this provision to the taxable year).
 A taxpayer may make an annual election under this section, specifying the amount of its
research credit not to exceed $250,000 that may be used as a payroll tax credit, on or

5. before the due date (including extensions) of its originally filed return. A taxpayer may
not make an election for a taxable year if it has made such an election for five or more
preceding taxable years.
 The payroll tax portion of the research credit is allowed as a credit against the qualified
small business's OASDI tax liability for the first calendar quarter beginning after the date
on which the qualified small business files its income tax or information return for the
taxable year. The credit may not exceed the OASDI tax liability for a calendar quarter on
the wages paid with respect to all employees of the qualified small business.
 If the payroll tax portion of the credit exceeds the qualified small business's OASDItax
liability for a calendar quarter, the excess is allowed as a credit against the OASDI
liability for the following calendar quarter.
Providing startups with the opportunity to offset payroll taxes with the research credit will allow
these businesses to conserve cash in the years that are most critical to their success. That’s
good news for them and for our economy, since every dollar that remains in the hands of these
growing startups helps drive further innovation and job creation.
Here’s an example of application of the provision: A software company started in 2012 has
conducted qualifying R&D activity in all the years of its existence. Related Qualifying Research
Expenses (QRE) are made up of wages paid to its employees. A summary of pertinent financial
data is in Table 1.
TABLE 1
Assuming $600,000 in total wages paid, annual OASDI tax liability owed by the software
company would be $37,200. With $300,000 in QREs, the software company would be eligible
for an R&D tax credit in the amount of $18,958.
Assuming the company files its 2016 federal income tax return on March 15, 2017, (the first
quarter of 2017), the eligible payroll offset election would be as follows in Table 2.
TABLE 2
Please note that the eligible payroll tax amount to offset is calculated using ALL employee
wages, not just the QRE wage amount.
TAX PERIOD 2012 2013 2014 2015 2016
GROSS RECEIPTS 50,000 150,000 500,000 750,000 1,000,000
WAGES 100,000 200,000 400,000 500,000 600,000
WAGE QRE 50,000 100,000 200,000 250,000 300,000
R&D CREDIT 18,958
PAYROLL TAX ON ALL WAGES
2017 TAX YEAR Q1 Q2 Q3 Q4 TOTAL
WAGES 150,000 150,000 150,000 150,000 600,000
EMPLOYER PORTION OF OASDI (6.2%) 9,300 9,300 9,300 9,300 37,200
ELIGIBLE OFFSET TO ELECT 9,300 9,300 358 18,958

6. In 2017, this taxpayer would not be allowed to elect to offset payroll tax with IRC Section 41
research credits, since it has gross receipts in five prior tax years. This is a specific exclusion in
the new provision, intended to limit the benefit to start-up companies only.
Final IRS Regulations for IUS
"There's a way to do it better — find it." — Thomas A. Edison
While the R&D tax credit is intended to be a broadly applicable incentive, Congress had
historically taken the position that software developed for internal use (called “internal use
software” or IUS) should be subject to a higher standard of credit eligibility. Hence, under IRC
section 41 and applicable U.S. Treasury regulations, businesses developing IUS have been
required to meet three additional stringent tests to qualify for the credit.
Many taxpayers investing in IUS could not meet these three tests as interpreted by the IRS, and
hence have not been able to claim this credit for their software development efforts. Taxpayers
have long approached the Treasury with concerns that the applicability of these three additional
requirements is too broad in scope and the IRS’s interpretation of each requirement has been
overly aggressive. After nearly 20 years of intense controversy and substantial debate, on Oct.
4, 2016, the Treasury published final regulations related to IUS development under Internal
Revenue Code Section 41 regarding to the research credit. Key components of the provision
are:
 Definition of IUS: The regulations provide a list of general and administrative functions,
intended to target the back-office functions that most taxpayers would have regardless of
the taxpayer’s industry, and that the characterization of a function as back office will vary
depending on the facts and circumstances of the taxpayer.
 Definition of Non-IUS: Added to the existing definition, software that is developed to
enable a taxpayer to interact with third parties or to allow third parties to initiate functions
or review data on the taxpayer’s system.
 Treatment of dual-function software: Provided rules on how to treat software that has
both IUS and non-IUS characteristics, including a safe harbor rule.
What is IUS?
The proposed regulations define software developed for internal use to be computer software
developed by (or for the benefit of) the taxpayer, primarily for the taxpayer’s use in general and
for administrative functions that facilitate or support the conduct of the taxpayer’s trade or
business. General and administrative functions, as defined in the proposed regulations, are
limited to (1) financial management functions, (2) human resource management functions and
(3) support services functions. Final regulations did not alter this list of functions or the more
detailed list of services that the proposed regulations listed as examples of each.
However, the final regulations again noted (as was the case in the proposed regulations as well)
that the list of general and administrative functions is intended to target the back-office functions
that most taxpayers would have regardless of the taxpayer’s industry, and that the
characterization of a function as back office will vary depending on the facts and circumstances
of the taxpayer. In addition, the final regulations clarified that the determination of whether

7. software is developed primarily for internal use depends on the intent of the taxpayer and the
facts and circumstances at the beginning of software development.
What isn’t IUS?
Although not substantively changing the definition, final regulations clarified that software is not
developed primarily for the taxpayer’s internal use if it is not developed for use in general and
for administrative functions that facilitate or support the conduct of the taxpayer’s trade or
business; and examples of software that are not regarded as IUS includes (1) software that is
developed to be commercially sold, leased, licensed or otherwise marketed to third parties and
(2) software that is developed to enable a taxpayer to interact with third parties or to allow third
parties to initiate functions or review data on the taxpayer’s system.
What if it’s both?
The final regulations maintain the presumption of internal use, when both IUS and non-IUS
software are being developed as part of an integrated system. Referred to as “dual function”
software in the regulations, taxpayers will have the burden of proof to overcome the
presumption of internal use for the non-IUS portion of the integrated functions of the software.
However, to the extent that the taxpayer can identify a subset of the dual function computer
software which is only non-IUS, then for that subset of the software development the
presumption of internal use does not apply. After identifying non-IUS subsets of the software
system, there may still exist dual function software. The IRS had provided a safe harbor
approach to dealing with this dual function software. In the final regulations, the proposed
regulations safe harbor rules were retained and favorably revised to be more industry specific.
The safe harbor rules for dual function software allow the taxpayer to include 25 percent of the
qualified research expenditures of the remaining dual function subset in computing the amount
of the taxpayer’s credit. However, the taxpayer must be able to substantiate that the use of the
dual function subset by third parties or by the taxpayer to interact with third parties is reasonably
anticipated to constitute at least 10 percent of the dual function subset’s use and that the
taxpayer’s research activities related to the dual function subset constitute qualified research.
The final regulations contain a taxpayer favorable change in this section, providing that any
objective, reasonable method within the taxpayer’s industry may be used for purposes of the
safe harbor.
Effective date
The IRS provides taxpayers with two options for applying the new regulations. First, taxpayers
may utilize them solely on a prospective basis, starting with the tax year beginning on or after
Oct. 4, 2016. Or second, for any taxable year that both ends on or after Jan. 20, 2015, and
begins before Oct. 4, 2016, the IRS will not challenge return positions consistent with all the
provisions of the final regulations.
Armed with these regulations and a permanent credit, taxpayers conducting software
development are in a much better position to plan for and document research credit claims.
These final regulations continue a recent line of “pro-taxpayer” legislation, regulation and court
rulings relating to the research credit, which will allow for the expanded utilization of this
incentive and reduce the controversy that has historically plagued taxpayers who have claimed
it.

8. CONCLUSION
“Be courageous! Whatever setbacks America has encountered, it has always emerged
as a stronger and more prosperous nation. … Be brave as your fathers before you. Have
faith and go forward!” — Thomas A. Edison
The culmination of the many favorable changes to the research credit at both the federal and
state level has created great opportunity for Virginia businesses this filing season and beyond.
The many businesses who have long taken advantage of the Virginia credit will see greater
opportunities available this year. For large businesses currently investing significant dollars into
R&D, changes to the credit allow more of their investment costs to be offset. While smaller
Virginia businesses will also have expanded opportunities to enhance their credit claims due to
the increased credit claim amount available this year. Further, smaller businesses limited by
AMT, can now utilize the federal credit to alleviate this burden.
And for the very first time, many Virginia businesses will find themselves able to take advantage
of the credit due to changes at the federal level. Many of Virginia’s growing startups that were
heavily investing in R&D but absent of income, hence paying no tax, will finally be able benefit
from the credit by offsetting payroll taxes.
One thing is certain, regardless of industry size or sector, Virginia businesses conducting R&D
have never had a better time than now to look toward the research credit for tax savings
opportunities.