UConn Professor of Law Richard D. Pomp and CrossBorder Solutions’ Director of R&D Tax Incentives Rahim Walji discuss the various R&D tax incentives offered throughout the U.S. and how you can take advantage.
Richard D. Pomp Explain How R&D Credits Vary State by State
Matthew DeMello: One of America’s greatest strengths is diversity. From state to state, all kinds of people, climates and cultures come together here to form a varied in magnificent nation. But one of the drawbacks of this strength, especially as one travels across state lines, is keeping track of the different rules and regulations each state has. And when it comes to R&D there’s just as much legislative diversity as there is of any other kind.
That’s why on today’s episode of The Fiona Show: R&D Tax Credit, we’ll be discussing just some of the ways R&D benefits vary across the nation. A recent example of this. In April 2021, the Texas Comptroller of Public Accounts put forward two rule amendments aimed at increasing research and development credits for sales and use taxes.
Delete our discussion on these rule changes and how they reflect larger issues in state-to-state R&D differences, I’d like to hand things off to director of R&D tax credits at CrossBorder Solutions, Rahim Walji. Rahim, you have the floor.
Rahim Walji: Thanks, Matthew. Really appreciate it. And I’d like to introduce our guest for today, Professor Richard D. Pomp, who is the Alva P. Loiselle Professor of Law at the University of Connecticut. Welcome, professor. How are you?
Richard D. Pomp: Thank you. And you’re about the only person who’s ever correctly pronounced Loiselle, so.
Rahim Walji: Thank you. I’ll take that as high praise.
Richard D. Pomp: Now, he’s long dead, so he’s not here to appreciate it, but you got it right.
Rahim Walji: Respect for the passed, right?
Richard D. Pomp: You’re correct.
Rahim Walji: Thank you very much. It’s a pleasure to have you here today and really looking forward to talking about R&D credits, of course, but some of the state variations that exist and some of the different principles, why some states have them, why they don’t. So really, really excited for the conversation today. So let’s kind of dive into the topic.
One way or another, state R&D credits are primarily based off of the U.S. federal credit. So can you set the stage for us with a brief overview of the history behind the federal credit before we dip down, if you will, to the state level?
Richard D. Pomp: Yeah. And that’s a great observation because no state wants to reinvent the Internal Revenue Code. And so the starting point is typically what’s the amount of your qualified R&D expenditures under the Internal Revenue Code?
Then the states come along and tweak those rules. So you’re quite right in, let’s do a quick dive into the history of the federal R&D tax credit.
Goes back to 1981 when the country was in an economic slowdown, job outsourcing became more commonplace, and people were simply worried that we were losing our edge and had to keep technical jobs within the country.
One of the ways the government did it was with the adoption of a tax credit for research and development, R&D. And almost immediately the credit became the subject of scandals when horror stories emerged about tax credits being claimed, successfully by the way, for such things as McNuggets and Gillette’s Lemon Lime shaving cream, and new fashions in clothing. Wasn’t exactly what people had in mind when they were talking about innovation, keeping technical jobs in the country.
Richard D. Pomp: From that time forward, the rules came and they went and they got tweaked and they finally have stabilized. In 2003 a very important change was made. Before then, to qualify for the credit you had to actually create something that was new to the world. Boy, that bar was set awfully high, new to the world? And that was replaced with a much lower bar.
No, no, just new to the taxpayer. And that was a watershed eventually, because that just opened the flood gates to more and more credits. And then something significant happened in 2015, the R&D credit became permanent.
Until that point in time, the credit came and went, it got reinstated, and that made it very hard for taxpayers to plan their research and development spending. You didn’t know whether the feds were going to be there with a credit or not. And so making it permanent was another one of the critical changes.
And a lot of money goes into this credit, about maybe $12 billion was the last estimate. And what’s so interesting about it is that it is not just the largest companies in the country. About 15% of companies claiming the credit had business revenues below $25,000. 45% had revenues below five million. I suspect a lot of people listening to this podcast fall into that group.
About half the companies that claim the R&D credit are what we would call middle-market companies or small businesses. And what’s a more shocking estimate, at least in my mind, is that maybe only 5% of the corporations eligible to take the federal R&D actually take it, only 5%. 95% are leaving money on the table.
And the interesting question is why? Why are 95% of eligible corporations not claiming this free money from the feds? And I think the answer is because of all the misconceptions that are floating around that we will put to rest in the next five minutes or so. One major misconception as I talk to my people, they always say, “Well, only scientists in lab coats are doing R&D.”
And it can’t be any further from the truth. We’re going to see in a minute how the IRS has defined R&D through a four-part test. And the definition is broad. And one of the reasons I think we have this misconception is the way businesses view themselves. Many of them don’t view themselves as R&D company companies. They’re manufacturers, they’re retailers, they’re in the food and beverage business, oil and energy, agriculture. They brew beer.
But as you do dive into the activities they are doing, you see that they actually perform activities that qualify for the R&D tax credit without realizing it. And so that’s an important misconception to put to bed right at the get-go.
The R&D tax credit does extend to applied science, but that’s something many companies perform on a daily business, creating new or improving existing materials, devices, products, or processes. And yes, the credit is very popular with the high tech sector, but it’s also applicable to other sectors. Manufacturing, agriculture, biotech, and brewing beer, one of my favorite examples.
So let’s just take a manufacturer that’s working to increase manufacturing speed while keeping quality consistent. It’s a goal of many manufacturers, probably R&D credit. Retrofitting an existing piece of equipment to use for a different function than it was originally intended for, R&D.
Overcoming hardware limits patients to achieve an aggressive performance target or lighter footprint, R&D. One takeaway from today is that you folks listening to this, you are doing R&D. You just don’t have that name, and it’s not your image of what it is you do.
Rahim Walji: Absolutely, absolutely.
Richard D. Pomp: Right. Another misconception. The R&D tax credit is only for companies working on groundbreaking innovation. And it is available to companies developing or improving existing products.
Materials, technologies, nothing necessarily groundbreaking rather than improving, tweaking. And that isn’t typically groundbreaking, but it certainly does qualify. If you are overcoming technological uncertainty, you don’t know what’s going to work. Do you go path A or do you go path B? You may well be qualifying for the R&D credit.
Another misconception, only large profitable companies can claim the R&D tax credit. We aren’t even paying federal income tax, so how can we qualify? Well, as of 2015 you can qualify, because in that year a change was made in the law to give R&D credits for startups essentially, qualifying small businesses. While they don’t have income taxes, they’re a startup, they’re operating at a loss. What good is the credit?
Congress extended the credit to their FICA taxes, their payroll taxes. Now they have people and therefore they’re paying payroll taxes. They may not be paying income taxes, but their R&D credit can offset their FICA taxes.
And these small businesses can take up to $250,000 per year with a lifetime cap of $1.25 million. So that was a very significant change, and a lot of small businesses were unaware of it. Because again, they say to themselves, “Well, we have no income tax. So why are we worried about the credit?”
One of the problems is that a company’s internal tax or finance or accounting folks don’t stay on top of some of this esoterica. They’re very good at what they do, but this is outside their comfort zone that the R&D credit, it’s a very technical project-based credit.
You have to identify projects, not just what’s our revenue, what’s our expenses, the kind of bread and butter that tax people do in-house. No, this is beyond that. It calls for a whole different skillset, and you really have to consult the pros that have experience with the R&D credit, because a false step can kill you.
Documentation and presentation is everything in this business, and it is beyond the capabilities of most in-house persons. And again, it’s not a criticism of them. They’re very good at what they do, but they’re not masters of everything.
And tax has become so specialized today, and the R&D credit is a nice example of that. Now, another misconception, “Well, you know, the R&D credit is really for people who are increasing their research.
But our R&D spend hasn’t increased at all.” Well, I’ll tell you why it’s a misconception. While the R&D credit does require an increase in research spend, the current year spend is compared to a base.
And the base is 50% of your average spend for the prior three years. So your company’s R&D spend could actually be decreasing as it might have been in 2020, but your company could still be eligible for the credit.
So again, you see there’s lots of traps for the unwary here in just falling into these common misconceptions. Another one, only projects with a successful outcome can be claimed. Nonsense, the regulations make it quite clear.
Success is not required in order to be eligible. Now, take advertising. The saying is, “Half of advertising is wasted, we just don’t know what half.” You’re going to get to deduct your advertising, even if it doesn’t work.
Maybe sales go down, maybe you blundered. It doesn’t matter. We don’t penalize losers under the Internal Revenue Code. You tried, that’s all that we ask. And the same thing with R&D. All right, maybe it doesn’t work out, but you tried, and that is good enough.
So let’s turn to the four categories that have to be satisfied. They’re broad, as you’ll see when I tell you about them. They’re all terms of art. They’re the kinds of things that make tax lawyers and tax accountants’ hearts palpitate because there’s so much room to maneuver here. The first, didn’t you attempt to develop a newer approved product, process, software, technique, invention, or formula?
Well, in many cases, the answer is obviously, “Yes, that’s what we’re constantly doing. We’ve got to be nimble. That’s how we stay ahead of the competition.” So the effort must attempt to increase performance, function, reliability, or quality. Exactly what businesses do routinely day in and day out. And of course, as I said, you don’t need to actually achieve improvement, or invention, a certain amount of efforts will always fail, but we’re not going to penalize you for that.
Second category is, is this involving hard science? And that refers to engineering, physics, chemistry, biology, computer science. So you take my favorite example of people who grew beer. Hey, that’s chemistry.
If you’ve ever made beer in the basement that is chemistry, and these craft beers, that is chemistry, and they are surprised, shocked when they hear, “Wow, we’re involved in research and development.” Of course you are. You’re coming up with that better-tasting non-alcoholic beer that there’s a niche market for. Well, you’ll be surprised to find maybe you’re going to get that federal R&D credit equal to 20% of your R&D expenditures.
Did your activities eliminate uncertainty? So the activities are intended to eliminate uncertainty concerning the capability or method of developing or improving what was sought out or the appropriate design of it.
In other words, a company might not know whether or how they can develop a product, not no design of it at the start, but their efforts should seek to clarify that direction. Well, that’s called innovation. Let’s see if this new design is going to actually be received well by the market. Will people like McNuggets? Will they like some of our newer meatless dishes? It looks like it qualifies for the R&D.
And do your activities require experimentation? They have to go through some experimentation to eliminate or resolve the uncertainty. Well, that’s what market research is all about, isn’t it? Focus groups and whatnot, modeling, simulation, trial, and error.
So you see, when you look at these broad categories, my goodness, what business isn’t involved in this? If they’re not, I don’t know how long they’re going to stay in business, because they’re a pretty dynamic marketplace today. And the race does go to the nimble. So that’s the overview. And now we can take a deeper dive into the states if you are ready.
Rahim Walji: Thank you so much. I can tell why you’re such a wonderful professor. You’re able to lay that out so well in terms of the various steps that are required from a compliance stand point. And thank you so much for talking about these misconceptions.
We often encounter so many taxpayers who have these misconceptions in how things need to work. So it was really, really nice to hear you talk through some of those key ones that are very helpful to dispel so that the audience understands, there is opportunity out there for them.
Richard D. Pomp: Oh, Rahim, I know you are one of the leaders of the artificial intelligence movement as applied to taxation. And my guess is there’s probably not a client you don’t interact with where you do more than pay for your time and effort many, many times over. There’s just so much low hanging fruit in this business.
Rahim Walji: Absolutely. And a lot of companies, to your point, their perspective on how they operate is not that they’re an R&D firm, right? It’s that they are a manufacturer of food and beverage or engineering firm.
And so I think those are really, really good points to make. But your overview now with the federal side, let’s definitely dive into the state side of things. So let’s start with the recent story that Matthew mentioned on R&D credit rules, sort of clarifiers. And we can break down the components and hopefully zoom in and out to see different or similar state policies, if you will.
So, let’s just catch everyone up on what these amendments affect. Could you, as you so well laid out, the federal overview, could you tell our audience a little bit about what a franchise tax credit is, and kind of how it relates in taxes, as well as sales and use taxes?
Richard D. Pomp: Sure. Let’s start with the sales and use tax. Until a recent Supreme Court case, I bet people listening were aware that they could buy things over the internet and the vendor would not collect the home states sales tax.
That all changed with a case called Wayfair. It got a lot of press. A couple of years ago the Supreme Court basically reversed the longstanding rule that said a vendor needed a physical presence in the state before we could ask them to collect the state’s sales tax.
Technically it was the state’s use tax. And I’ll explain how those two interact in a minute. The Supreme Court said, “No longer you need physical presence. You just really need to be doing business in a state with a substantial economic presence.”
So now many of us buying things on the internet find our state sales tax being collected on our behalf. Now, technically it is the use tax, and I’ll explain the difference. When sales taxes first were introduced in this country during the Great Depression in the 30s, the states needed money desperately. People were unemployed and so income taxes weren’t being collected.
Corporate income taxes weren’t being collected. People were reneging on their property taxes, states were in dire straits. And they knew that the Europeans had successfully used sales taxes, so it’s really a foreign import. And we start levying a sales tax. Initially on necessities because people were engaged in a lot of discretionary spending.
Here’s the problem. You’re the first state to adopt a sales tax. Your people will go to neighboring states, especially if you live in the Northeast where states are small and the borders are porous and you take a state like Massachusetts, it’s surrounded by a tax haven called New Hampshire.
They don’t have a sales tax. So when Massachusetts adopted its sales tax, it had to worry about people driving to New Hampshire and buying things free of a sales tax. The answer was a use tax and that’s where it makes its appearance.
That if you bought something in another state and bring it home for use in your in your home state, you owe the state a use tax. It is exactly that the same rate as the sales tax would have been had you bought that good in the state.
So you see what happens now. There’s no advantage in buying it in a neighboring state without a sales tax, because you’re going to pay the use tax. Should the other state have a sales tax, then we’ll give you a credit for it against the use tax. The only rub in this story is I’m sure you’re anticipating is, I have described a situation where it would be voluntary. I’m going to have to file a return. And I am going to have to figure out, “Well, what would I have paid on this item if I had bought it locally? What would the sales tax rate have been?”
Very few people did that. Politicians might have done it because they feared the embarrassment of it coming to light one day that they didn’t pay the use tax. But unless the vendor collected it, it was a tax that really wasn’t paid. It was on the books, but it wasn’t paid unless you bought something that had to be registered, like a car or a plane or a boat, in which cases use tax would be picked up at the time of registration.
Supreme Court, when it said, “You no longer need a physical presence,” ended up rewriting the rules. So now we have all these out-of-state vendors selling into a state and they are collecting the use tax on your behalf.
Texas is a very interesting story, because Texas has no personal income tax and they have no corporate income tax as you and I would recognize it. It is called the margins tax. It is a bastardized tax with elements of an income tax and elements of a turnover tax. No one knows quite what to make of it. It’s a kind of tax that would be adopted only by a state that didn’t have a personal income tax and didn’t have a corporate income tax.
Richard D. Pomp: So Texas wants to encourage research and development in the state and they have changed their law so that you get a credit now for research and development expenditures that as their starting points satisfy the federal definition, and you can take that credit against what they call their franchise tax. This margin tax. Not a tax anyone really would recognize as such, because it is such a hybrid.
When it comes to their sales and use tax, if you use something that qualifies for a research and development property, you will be able to exempt the purchase of that when you purchased it in Texas, in which case your exemption would be from the sales tax, or if you purchased it out of state and brought it back to Texas, in which case the exemption is against the use tax.
So they are one of the few states that extend this credit to the sales and use tax. And one reason they do is that they have a fairly hefty rate of sales and use tax to make up really for their lack of a personal income tax.
And then they tweak the rules on this. They have a lot of bells and whistles, and it’s quite interesting. I mean, all states will have bells and whistles. Their starting point is the federal definition of qualifying research expenditures, QREs you’ll see if you read the cases, but then they go ahead and they add their own requirements.
And one of the things that Texas makes quite clear is that this exemption that they’re giving you against the sales and use tax, or this credit against the margin tax is only for research and development that takes place in Texas. Because the feds don’t care what state the R&D takes place in, as long as it’s in the country. So the federal tax credit is not state-specific. You’ll get it, whether it’s Texas or Louisiana.
But when Texas decides to give a credit, they care very deliberately, “We’re not going to give you a credit for R&D you’ve done in another state.” So right from the outset, the states make an adjustment to the federal rules because they want to limit their credit to only state-specific research and development. And that’s what Texas does. That’s what almost every other state does. Alaska is the exception. Alaska gives you the credit for R&D as long as it takes place in the United States.
Texas goes further than that. Texas adds a whole bunch, I call them little tweaks, and they are interesting because you can ask the question as we always do as tax lawyers and accountants, “What in the world led them to make this adjustment or this clarification, why?”
And the answer sometimes is because A, there was a case that they either won or lost and they are responding to that case, or probably just as likely someone lobbied for this. We may never learn of the identity of that person. We can infer it by asking, “Well, who would really care about this particular tweak in the law? How many people would care about that?”
Now we can kind of work backwards and say, “Oh, well, there’s only a couple of companies that manufacture computers in Texas, maybe that was for Dell.” And anyone who’s a major employer is going to be hurt in Austin, at the capital. So that’s often the case. There are head-scratchers. Now you read it, you say, “Why do they care? What’s that all about?” And that is true of Texas.
They made a number of changes that you don’t find elsewhere. Again, this is the stuff for which tax lawyers and accountants drool, because we know we live in a world of grays and shadows like radiologists. And you give us something that doesn’t exist somewhere else and that’s open season on our interpreting it. Texas is a recent adoptee. Why Texas? What are they worried about? They seem to be doing very nicely, but in 2014, they introduced an R&D credit. And again, why do the states care?
Rahim Walji: That’s a good point, right? So let’s make that transition. So how do these types of taxes factor into the Texas state credit? I think you’re going there, but you’ve talked about sales and use tax. You talked about franchise tax, and as you mentioned, Texas seems to be doing well, at least from what you hear in the news. We introduced, I say we, because I’m based out of Houston, we introduced the R&D credit in 2014, but how do these types of taxes and these ideas we’re talking about factor into all this?
Richard D. Pomp: Yeah. Well, you are certainly a firsthand witness to the enormous growth of Texas. I think it is one of the states with the highest in-migration, as opposed to my home state of Connecticut, that actually is shrinking, states like Texas are growing. My students are finding jobs in Houston and Dallas at decent starting salaries, low cost of living. And they like not having to shovel snow in the winter.
So why Texas? And I am not privy enough to the politics to just wonder, “Did they feel they needed this to keep their edge?” Their neighboring states have R&D credits. Where they’re getting flack. Were there corporations that said to the governor and the leaders in the House and Senate, “We would like to move our business to Texas, or we would like to expand our business in Texas. The only problem is, you don’t have an R&D credit and the places that we are thinking of moving to or expanding in do. And that’s a game-changer for us.”
Now, does someone like Dell go to the Capitol and say, “We’re thinking about putting a new manufacturing plant somewhere outside of Texas. It really hurts us to say this. We, after all, Dell himself went to University of Texas, started assembling these things in his dorm room. And gosh, I’m a Texan through and through. It pains me to even think of leaving the Lone Star State. But I have shareholders I answer to. And so I’m afraid I am thinking of expanding elsewhere.”
Now, this is totally fanciful. Except one of the things I have done is cost out the tax consequences of relocating plants. So I know how the game is played, and just because someone costs out what it would mean to move doesn’t mean they’re serious about moving, but you want to have that information available to use as it fits you. So I could imagine what I just said actually happening, not necessarily with Dell, but maybe someone out of state who says, “God, Texas is so hot.
We’d like to use it for our commercial domicile. Very favorable tax structure, but other states have a favorable tax structure and they have the R&D. So what do you think? Can you help us out because that’s really the deal-breaker.”
And again, I have no idea if it happened that way or not. I just have found that I always fell out of the kind of odd there’s Texas, one of the hottest states in the country, coming to a party late. A lot of these states had R&D credits from the ’80s when the feds adopted, the ’90s. So Texas [was] a little late to the party. And what really was the driving force for them? I don’t know. You’d have to really figure out who sponsored the bill and why. I guess it’s knowable. I just don’t know it except I’ve seen the dynamic at work.
Rahim Walji: Absolutely. And I think that’s a great point that there’s probably a multitude of reasons why it happened. And part of that is when you hear a lot of people are moving to Texas because there’s the income tax, right? That’s one less thing to worry about.
Then you have now companies that want to move. And to your point, I think there’s sort of two different ways to play it, right? There’s a sales and use tax exemption on property that’s directly used in research.
And then there’s the franchise tax credit, which is based on those QREs you were talking about, those qualified research expenses. And so I think it’s a way to try to entice the businesses, that if you’re going to have those types of facilities here, there is a benefit, not only at the federal level that you can claim, as you mentioned earlier, in any state that you’re in, but there is a state benefit as well that hopefully it’s enticing to have businesses continue to build R&D facilities and things like that in.
Richard D. Pomp: Yeah. And you know what’s interesting? Let’s look at the states that don’t have R&D credits and try to figure out why don’t they have R&D credits. One that pops out is Michigan and there they are home to, at least historically big three car manufacturers and involved in a lot of R&D. And you wonder whether the cost of an R&D credit would have been just prohibitive.
And what would the state gain in return? They’re already here, so it’s not like you’re trying to attract someone to Michigan. You’ve got your major manufacturing base pretty much set, at least before they did become a little footloose and fancy-free. Maybe you couldn’t incur revenue hit. Texas can, of course, they can handle the hit from the credit or the exemption.
But a state maybe like a Michigan says, “We’re not going to gain anything. We’re going to lose a lot of revenue. And so we’ll pass, thank you. We’re not under any pressures to adopt it or not.”
Alabama doesn’t have one. Has it stopped car manufacturers from going to Alabama? No, it certainly doesn’t seem to. So maybe a state makes a decision opposite that of Texas that says, “We’re a pretty hot state. We’ve got a lot of people moving in.
We’ve got a lot of manufacturing that’s relocating here. Salaries are low. We’re not a union state. People like the quality of life. We don’t have to do anything else, we’re doing okay the way it is. And an R&D credit would just cost us money. We don’t think we’re going to get enough in return.”
Now, politicians are somewhat skeptical of the use of all these tax incentives, by the way. They’re almost forced to play the game because no politician wants to run for reelection with the blood of a runaway plant on his or her hands.
But when you talk to them socially off the record, they are very skeptical that these things really make a difference. There are so many other factors starting with cost of labor, cost of energy, weather, costs of housing, quality of life, crime rates, all of that, that enter into the calculus that you just don’t think changing the third place in an internal rate of return calculation is really going to make a big difference to this company.
But again, I’ve not been there at the table. I’ve helped companies make presentations, but I’m not there when the decision gets made. And again, politicians are a little gun shy about not playing the game. What we really need is just a federal statute that says, “Essentially, you can’t play this game.”
But they will never do it with the R&D credit, because after all the feds have sponsored that one, and it’ll be a little hypocritical for them to say, “Hey, this is great for us, but not for you.” But they could do it and stop this kind of race to the bottom that we see. But anyway, I suppose each state that doesn’t have an R&D credit probably has its own story if you were privy enough and close enough to the politics to kind of unbundle it.
Rahim Walji: Yeah. There’s so many different aspects. As you mentioned, it could be budgetary reasons. It could be adding an administrative workload to different departments. It could be lost revenue that is already here, marked for other things.
You think about the TCJA and the sunsetting of expensing full deductions in the year versus amortizing over five. Things were done for budgetary reasons, right? And so you start to see how that may come through.
In terms of, I do want to kind of close the loop on Texas side. So one of the things that the amendment did was redefining or better defining certain terms as well as the credit qualifications. Why is that an important aspect?
Is that because as you mentioned earlier, some of these things are very, very broad and difficult to quantify sometimes to some of those misconceptions you were talking about, can you opine there?
Richard D. Pomp: Yes. I mean, those four categories, the big four as sometimes referred to in the trade, they are broad and those terms are not self-defining and they lead to litigation and McNuggets won the litigation.
But imagine what a waste of resources in fighting over whether McNuggets ought qualify for a research and development credit. That’s the kind of burning social issue we should be involved in, in this country.
An attempt to add some flesh to the skeleton is always good I think from a tax administration perspective and from a tax planning perspective. Because it lets you know what the game is that you are playing. And if it can stop needless wasted, legal resources and accounting resources down the road, better to know it now than after 10 years of litigation. Whether you win or lose it, that’s 10 years of the client’s money and time.
Rahim Walji: Sure, sure.
Richard D. Pomp: Better right to understand what’s the game we’re playing. And maybe some of that went into the Texas elaboration on some of the federal concepts.
Rahim Walji: What are some scenarios that might benefit a state to alter certain aspects of the law, as opposed to just following the internal revenue code tax? I think about certain states that have refundable credits, certain states that have caps. Can you talk maybe through some of the scenarios about why those would be beneficial to a state?
Richard D. Pomp: Yeah. Well, I think you just nailed a couple of the biggies. A state that is worried about the loss in revenue will use a cap, at least in the early days, until they get a better feel about what their exposure is.
So as you examine the state law and as the introduction to our podcast so nicely pointed out, this diversity, as you cross state lines, it’s exciting and it’s the bane of lawyers’ existence too. Because every time you cross state lines, you’re entering a whole separate legal regime that has to be mastered. And you can’t assume you know what you don’t know.
One of the things we don’t know is what’s the revenue exposure of the credit. And as you point out, some states will cap the amount, the federal credit is unlimited, but capping it is a very risk-averse position to take.
Sometimes the cap is relaxed as time goes forward and the state has a better feel, and sometimes it is left in place. So that’s a good one from the state’s perspective. Some states require that the R&D take place in designated areas of the state, like an enterprise zone. Now these states lack investment in rural areas. I’m sure that’s true in a big state like Texas.
You probably don’t need more development in a place like Houston or a Dallas. Certainly last time I was in Austin traffic was unbearable. So I’m not sure you really want more development. You need transportation infrastructure. But you want your development out in the rural areas in sort of exurbia. Long commute from the central cities, but that’s the next area where people are going to have to find reasonable housing. And so you want to encourage a research and development laboratory in that part of the state.
So you do find states that will put geographic limits on it. Some, as you point out, some make the credit refundable. The federal credit is not refundable. Now, this is costly and not to be taken lightly, because you’re giving back money to this taxpayer as more of a credit than they can use.
And you’re going to write them a check for the excess, that’s serious stuff. It’s not all that common, it’s a risky approach, but states do that. States have different rules from the feds on carrying over unused credit.
See, that’s an alternative to making it refundable is say, “Okay, we could carry it over.” The first carry over to 20 years. The states never have a period greater than 20 years. Oftentimes it’s less than 20 years. Same thing for carry-backs.
Some states make you apply for the state R&D. It’s not as a matter of right. They want to look over, what’s your plan? Where is he going to be? We don’t know whether this fits in with our overall vision for the state.
And so we will decide whether we’re going to give you the R&D credit for that. So, that’s another big difference. I think between you and me we’ve really hit the major differences. Oh, and I’ll tell you one that’s very interesting I think for some of the startups.
There’s a few states that will allow a credit to be taken against the withholding taxes. So imagine this now. You have collected taxes from your employees, which through withholding, that’s a prepayment of their income taxes.
And in the normal course of events you turn that over to the IRS. And I, as the employee get credit for that. Well, there’s some states that allow you to use your R&D credit against the withholding tax.
So you’re going to keep money now, which would normally have gone to the state. The employee will still get credit as if the money did go to the state. So the employee doesn’t know what’s going on, but you’ll be able to keep some of those withheld taxes cashed in your pocket. That’s pretty good. That’s a pretty fast way to get money to a corporation.
Rahim Walji: Absolutely, absolutely.
Richard D. Pomp: And it could be expensive. So it’s not all that common. So there’s another example of the diversity we see at the state level.
Rahim Walji: Yeah, there are definitely a few out there that have unique opportunities. I remember a couple that are sort of first come first serve, right? You got to get your application in. It opens January 2nd at midnight.
And you’ve got to submit as soon as you can. And there’s a cap and sometimes a couple of big companies would come in and take a few. I remember that happening a few years back.
I think they definitely made some changes since then. But in terms of changes, we’ve been talking a little bit and there’s a lot in the news right now about R&D and there has been for the last year or so, and what’s some potential changes that may be coming with certain proposals, but as a point of order, how do changes to state-level law differ from the process of federal law? And how does that impact maybe how companies view R&D at the state level?
Richard D. Pomp: Yes. Another great question. If I were hired as a lobbyist, I would much prefer lobbying at the state level than at the federal level. At the state level a major employer simply has much more clout than when they are one of thousands of employers of a midsize payroll, because they just get lost in the masses.
But at the state level, if you are the major employer in town, and I show up making a case on your behalf with computer printouts and economists and all of that, I just going to be listened to, I have access, for the one thing.
My client may be a major contributor. At the state level it doesn’t always take that much money to be a major contributor, unlike at the federal level. And so there’s access, there’s clout, things move faster. You have less hoops to go through, less staff to have to convince.
That permanent staff at the federal level of some awfully smart people. You look at who Biden brought in in the treasury department. The one I’m most familiar with, some of them my colleagues from teaching, very, very smart people, sophisticated. Many of them have been with other administrations. You’re not going to bamboozle them so easily. At the state level where you have, which I have experienced much more of a turnover.
Don’t even talk about term limits, but you have much more of a turnover in staff. They’re younger. Taxes, as we all know, just so complicated. And many of my former students who work at the legislature here in Connecticut, man, they don’t want to see anything having to do with tax. They took basic tax because it was essentially required, and that’s the last tax course they ever want to take in their life. They panic essentially.
So I come in as a lobbyist and I start walking them through how this will affect tax planning, tax code, et cetera. I’m the only game in town now. They don’t know enough to push back.
You show up at one of the subcommittees in Congress, and you’re going to be meeting with someone who seemed the likes of you before. And they’ve heard the spiel and they know where the soft spots are. That’s a much harder lift federally than it is at the state level, in my experience. So much rather lobby at the state level, which is why I think we see a little bit more craziness sometimes in what the states do in the tax arena, because we can get our way a little easier. Our threat is more credible.
So look, we’re not going to be the first corporation to leave this state. As you know, you’ve already lost three major Fortune 50 corporations through mergers and acquisitions. They moved out of the state.
General Electric moving out of Connecticut to Boston. Raytheon moving out of Connecticut to Massachusetts. So there’s a fear. There’s a real fear. “Oh my goodness. That’s the last thing we need is another merger and acquisition where we lose the commercial domicile.”
So legislators run scared. And I think that just gives us a leg up when we represent a client at the legislature. Whereas the feds, who is so big that it would disrupt the workings of the federal government if they were to outsource some of their employment. We know they outsource right now, so much offshore. So I just think the politics dynamics, very different
Rahim Walji: No great points. And I think the comparison of how the process works a little bit quicker and the relationship are a little bit more consistent in terms of how people interact and communicate that it goes a really good point as well. So before we wrap up, let’s talk about what circumstances might lead states to adopt R&D tax rates or improve the ones they have? What might incentivize the states to do this? Would perhaps some changes at the federal level incentivize states? Are there any other things that might do so? What are your thoughts there?
Richard D. Pomp: I think the state of the economy post-COVID is going to be the driving force. We see states that are much flusher than they ever thought they would be, such as California. The stock market has been great for California’s revenue.
It’s been great in Connecticut. We went from major deficits being projected to having a surplus. No one is feeling desperate today in states that are flush. The federal stimulus payments helped, stock market helped, all of that.
But let’s take a state that really is facing a severe deficit and they’re feeling desperate. And they are being told, “Gee, if you adopt an R&D credit, you’re going to see employment increasing. People will be doing more R&D in this state and you can’t lose.
Because what you’re giving up with the credit, you’re going to make back many times over through increased employment, personal income tax, and increased corporate profits through the corporate income tax.” And therefore it’s a supply-side kind of argument. We reduce our taxes, but in the end, we’re better off. And so there is such a thing as a free lunch. Sounds too good to be true and it probably is in many states.
But I think there’s going to be a certain desperation that sets in after the stimulus funds have been received and spent, and they’re looking at cutbacks and education and some of the social net. The state may be more receptive to tax incentives than it would have been earlier.
Rahim Walji: Good point. And hopefully, with things like the Endless Frontier Act that’s looking to create focus areas and hubs, but that’s, as you mentioned, federal level funding that’s going to go in. But perhaps those states can enhance their state benefits as well. So that you can have a further incentive for businesses and growth in that area.
Richard D. Pomp: Well, you know what? Yeah, I think if you were lobbying on behalf of a client, that’s exactly the argument that you would make. I mean, you’re somewhat of a visionary on this because I’ve not heard anyone else even focus on the connection, but I think you’re right that there is a connection and it’s an opening, isn’t it? They’re making the argument, “Let’s reinforce what the feds are doing. There’s synergy here. Let’s build on that synergy and jumpstart this economy.” I’ve not heard the argument made yet, but you’re ahead of the curve.
Rahim Walji: I’ll try my best to stay there. But, professor, it has been an absolute delight speaking with you, learning from you, getting your input and expertise on the state’s topics and all these different variations, yet still some of that rooted at the end of the day in the federal side of things. So it was a pleasure to have you speak with us today. Thank you so much.
Richard D. Pomp: Yeah, my pleasure. Thank you.