While there are many tax benefits available for small businesses and technology companies, the challenge is how to take advantage of them in the early years when there is no taxable income to offset. The 2016 changes in the research and development (R&D) credit solve this problem by allowing start-up companies to use up to $250,000 of credits against their payroll tax liability, not just their income tax liability. Another 2016 change allows businesses to use the R&D credit against their alternative minimum tax (AMT) liability. Technology companies, with their significant R&D activities related to software development, technology and engineering stand to benefit the most from this change.
Permanent Credit with Payroll Tax Offset
The PATH Act of 2015 permanently extends the R&D credit, enabling companies to plan for the use of this credit. Beginning in 2016, the credit can be used by smaller businesses–those with yearly gross receipts of less than $5 million–against the employer’s 6.2% portion of the social security payroll tax. (The credit is not allowed against the Medicare tax or the employee’s portion of social security tax.) Previously, the credit could be used only against income tax liability. This change allows companies, like tech start-ups, to translate the credit into real dollars even before they start showing a profit. Below are some more details of the payroll tax offset.
Are You a ‘Qualified Small Business’?
You must be a “qualified small business” to take the payroll tax offset. This is measured by the company’s average annual gross receipts for the previous three years, which must be less than $5 million. Note that taxpayers must aggregate all of their trades or businesses when measuring gross receipts. In addition, the company cannot have gross receipts prior to the last five years. For example, if a taxpayer wants to use the credit against payroll taxes in 2016, the taxpayer cannot have had gross receipts in any years before 2012. The effect of this rule is to allow the payroll tax credit for the first 5 years only. This is how Congress targeted the credit to start-ups.
Double-Dipping Allowed, Election Required
Even if your company elects to use the credit against employer payroll taxes, you can still claim a business expense deduction for those same taxes. To get the payroll credit, you must make an election on the company’s tax return and specify the amount of the credit you are electing to use against payroll taxes. For partnerships and S Corporations, the election is made at the entity level. You can elect to use part of the current-year R&D credit, all of the current-year credit, or even a carryforward credit against payroll tax.
The timing works this way. The R&D credit can be used to offset payroll taxes due in calendar quarters after the small business files the election on its tax return. From that point forward, your company can use the amount elected against quarterly payroll tax payments.
Change Helps Cash Flow in Early Years
Without this provision, start-ups had no choice but to carry the credits forward to profitable years. The R&D credit can be carried forward for 20 years. Now, being able to use the credit against payroll taxes will enable start-up companies to take advantage of this important tax incentive in the first few years, when it can be crucial to the success of the company.
AMT Offset for Expanded Group
Also starting in 2016, an expanded group of small businesses will be able to use their R&D tax credits to offset their AMT liability. For this provision, an “eligible small business” is defined as a business with average gross receipts for the three preceding years that do not exceed $50 million. This change especially benefits passthrough entities, such as partnerships and S Corporations, whose owners can now use the credit against their AMT liability.
These changes to the R&D credit are enormously beneficial for small businesses. It is important to move fast to start documenting and tracking your qualified costs so you can take advantage of the payroll tax offset and the new AMT offset.
Have questions? The professionals at Frazier & Deeter can advise you on how best to get started.