Apply the Research Tax Credit Against Payroll Tax
Many smaller businesses that engage in research and development haven’t been able to use the research tax credit because they pay little or nothing in income tax. That’s changed. In March 2017, the IRS issued guidance (Notice 2017-23) that provides information on the ways eligible small businesses can take advantage of this valuable credit. This guidance focuses on the definition of gross receipts, aggregation rules, and the time and manner of making the election to claim the payroll tax credit. Eligible businesses are now able to apply the research tax credit against the employer’s portion of social security (or payroll) tax, rather than applying it against their income tax liability.
By making the credit permanent and allowing the credit to be taken against payroll tax by small start-ups, Congress has significantly increased the number of businesses that will be able to benefit.
How Do You Qualify?
To qualify, a business must have generated less than $5 million in gross receipts for the year it’s claiming the credit. It can’t have generated gross receipts for more than five years before the year in which it’s claiming the credit — though the business can have been in existence before that.
Similarly, the payroll tax credit itself can be used for five years. Of course, the business also must have qualifying research activities. Please note that related businesses or businesses under common control must aggregate their gross receipts. In addition, gross receipts for any taxable year of less than 12 months must be annualized by multiplying the gross receipts for the short period by 12 and dividing the result by the number of months in the short period.
The amount of the credit is based on the company’s eligible R&D expenses. This can include the following:
- Taxable wages for employees who perform or directly supervise or support qualified activities.
- Cost of supplies used in qualified activities, including extraordinary utilities, excluding capital items or general administrative supplies.
- 65%-100% of contract research expenses for qualified activities, provided the taxpayer retain substantial rights to the activity’s results and must pay the contractor whether it succeeds or fails.
- Rental or lease costs of computers used in qualified activities, payments to cloud service providers for the cost of renting server space to develop or improve a component.
To qualify for the credit, the research generally should satisfy each requirement of a “four-part test” and not be excluded.
- Qualified purpose. Involve activities incurred in connection with the company’s trade or business and represent research and development costs in the “experimental or laboratory sense.” That is, the activities are intended to eliminate uncertainty concerning the development or improvement of a product.
- Technological in nature. Seek to discover information that is technological in nature.
- Technological uncertainty. Strive to gain new technical knowledge useful in developing a new or improved “business component,” such as a product, process, computer software technique, formula or invention that will be sold, leased, licensed or used by the firm performing the research.
- Process of experimentation. Entail a process of experimentation aimed at developing a product or process with “a new or improved function, performance, reliability or quality.”
The research typically satisfies these four criteria if it’s intended to develop a new or improved function for a business component or to improve its performance, reliability or quality. In contrast, research undertaken to modify the style or cosmetic design of a component usually won’t qualify.
Some activities are excluded because they aren’t likely to incentivize increased R&D in the domestic activities:
- Conducted outside the U.S.
- Relying on the social sciences, arts or humanities, as opposed to engineering or the physical, biological, or computer sciences.
- To collect routine data or ordinary testing for quality control of existing components.
- Market research, management, consumer preference testing.
- “Funded” by an unrelated third party, i.e., for which the taxpayer doesn’t either retain rights to the results of the activity, or necessarily have to pay for the activity because an unrelated third party is contractually obligated to pay for it, even if the activity fails to produce the desired result.
- To develop or improve software originally intended primarily for the taxpayer’s use.
What’s the Amount?
The payroll tax credit portion is equal to the lesser of:
- an amount specified by the taxpayer that does not exceed $250,000;
- the research credit determined for the tax year; or
- in the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under Code Sec. 39 from the tax year (determined before the application of Code Sec. 41(h) to the tax year). (Code Sec. 41(h)(2)).
The credit itself can be calculated in different ways, some of which get rather involved. Businesses that had no qualified research expenses in any one of the three previous years can use the simplest calculation. That is, they can take 6% of such expenses for the tax year in which they’re claiming the credit.
Another method is the alternative simplified credit. This equals 14% of qualifying research expenses for the year, above 50% of the average qualified research expenses for the three preceding tax years.
Finally, the credit can be 20% of any excess of qualified research expenses for the tax year over a base amount that’s calculated separately. In addition, businesses that contract with some nonprofit organizations, such as universities, can claim payments for qualified basic research above a base amount. Similarly, they may claim a tax credit of 20% of expenditures on qualified energy research done by some entities.
How Do You Benefit?
The PATH Act made the research credit permanent. Some small businesses will be able to use the credit even if they’re not profitable. Your accounting professional can help you determine if your company would benefit from applying the R&D credit against its payroll tax liability.
Sidebar: Claiming the Credit
Form 6765, “Credit for Increasing Research Activities”, and Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities”, should be used by qualified small businesses to report and claim the credit.
The payroll tax credit can be used on a quarterly basis, starting in the first calendar quarter beginning after the business filed its federal income tax return and elected to take the payroll tax credit. The rules differ slightly for 2016. If a business failed to claim the payroll tax credit on its return, it can do so by filing an amended return by the end of 2017. The business must either indicate at the top of its Form 6765 that the form is filed “pursuant to Notice 2017-23” or attach a statement to Form 6765 indicating the form is filed pursuant to Notice 2017-23.
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