Beginning with their 2016 returns, small business startup companies can choose to apply all or part of their research credit against their social security payroll tax liability. Before 2016, the research credit could only be taken against income tax liability. The option to elect a payroll tax credit may especially benefit any eligible startup that has little or no income tax liability in its early years. Note, however, that the credit cannot be taken against any portion of the Medicare or hospital insurance liability.
The benefit is targeted to newer companies only, those with no gross receipts for any taxable year before a five-year lookback period. This effectively limits the credit to a business’s first five years. In addition, only small businesses can use this option, those with gross receipts in the current year of less than $5 million. The $5 million limit only applies to the year the credit is claimed. (See example below.) A small business meeting these requirements can apply up to $250,000 of its research credit against its payroll tax liability. The election may not be made for more than five consecutive years.
If your company already filed and failed to choose this option, there is still time to make the choice. Under a special rule for tax-year 2016, you can file an amended return by December 31, 2017, and still get the offset. For 2016, your business can not have had gross receipts before 2012. The IRS describes the election process in Notice 2017-23. The research credit is claimed on Form 6765, Credit for Increasing Research Activities, and the payroll tax credit is filed on Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. This form must be attached to the payroll tax return, usually Form 941, Employer’s Quarterly Federal Tax Return.
Corporation A has gross receipts of $1 million in 2012, $7 million in 2013, $4 million in 2014, $3 million in 2015, and $4 million in 2016. Corp A did not have gross receipts for any taxable year before 2012. Thus, Corp A is a qualified small business for taxable year 2016 because it has less than $5,000,000 in gross receipts for taxable year 2016 and did not have gross receipts before taxable year 2012. Therefore, Corp A qualifies for the payroll tax offset in 2016. Corp A’s gross receipts in taxable years 2012-2015 are not relevant in determining whether Corp A is a qualified small business in taxable year 2016.
R&D Tax Credit Basics
The existing research credit has four discrete components:
- a regular research credit of 20%,
- an alternative simplified credit (ASC) of 14%,
- a basic research credit of 20% for payments made to universities, and
- a 20% credit for energy research.
Each credit is non-refundable, meaning that you only get the credit if you have a tax liability for the year. In any tax year, taxpayers may claim no more than the basic and energy research credits, plus either the regular credit or the ASC. To prevent taxpayers from benefiting twice from the same expenditures, any research tax credit claimed must be subtracted from deductible research expenses.
The key to the credit is the definition of “qualified research expenditures.” While there are a number of exclusions, such as research done to adapt an existing business component to a specific customer’s needs, many broad categories of activity qualify for the R&D credit. The credit applies not only to product development, but also to new manufacturing processes, environmental improvements, software development, and quality improvements.
The credit can offset regular income tax liability or alternative minimum tax liability. Only businesses with less than $50 million in gross receipts may use the R&D credit against AMT liability. Small startups, those with less than $5 million in gross receipts, also can offset payroll tax liability for the first five years they have gross receipts.