New Businesses or Start-Ups: Get Ready for the New Research and Development Credit Payroll Tax Offset
The passing of the Protecting Americans from Tax Hike (PATH) Act of 2015 introduced many exciting changes related to the Research and Development (R&D) Tax Incentive program. In addition to making the credit permanent and allowing the credit to offset the Alternative Minimum Tax (AMT) for certain taxpayers, PATH now allows qualified small business start-ups to elect to use the R&D tax credit to offset payroll taxes, instead of waiting to use the credit to offset income taxes. This benefit is referred to as the Payroll Tax Offset.
The new payroll tax offset allows companies to receive a benefit for their research activities regardless of profitability. This new provision, effective as of January 1, 2016, is particularly valuable for start-up companies that generate R&D expenses but won’t have a taxable income or pay federal income taxes.
For purposes of this credit, a qualified small business start-up is defined as a company that has:
- Gross receipts for five years or less. A company isn’t eligible if it generated gross receipts prior to 2012.
- Less than $5 million in gross receipts in 2016 and for each subsequent year the credit is elected.
- Qualifying research activities and expenditures.
The definition for qualifying R&D costs has not changed under these new rules. The credit is based on a company’s eligible R&D expenses. A company must meet the following requirements to potentially be eligible for this credit. These are known as the Four-Part Test:
- Activities must eliminate technical uncertainty about the development or improvement of a product or process.
- Activities should include some process of experimentation to eliminate or resolve a technical uncertainty.
- The process of experimentation relies on the hard sciences, such as engineering, biology, physical sciences or software development.
- The purpose of the activity must be to create a new or improved product or process that results in increased performance, function, reliability or quality.
The rules were made permanent in December 2015, and the payroll portion of the credits has the same qualifications as an income tax credit. All qualifying activity, wages, and consulting fee activity must also be performed in the U.S.
The credit is based on eligible expenses, but only expenses incurred beginning in 2016 will be eligible to offset payroll taxes. The credit must be calculated and reflected on a qualifying company’s 2016 federal income tax return, and the portion of the R&D credit that will be applied to offset payroll taxes will need to be identified and elected when that return is filed in 2017.
The payroll tax offset will be available on a quarterly basis beginning in the first calendar quarter that begins after a company files its federal income tax return. Taxpayers will need to file a 2016 federal income tax return by March 30, 2017, in order to apply the payroll tax offset to the second quarter in 2017. As a result, the earliest that taxpayers are likely to see a benefit is July 2017, when they file their quarterly payroll tax returns, Form 941, for the second quarter. (The corporation return can be extended, but that would result in the refund offset benefits being recognized later).
Taxpayers seeking to obtain payroll tax offset benefits in early 2017 will need to file business returns by March 31, 2017.
Companies can take advantage of this payroll offset credit against FICA taxes only; other payroll taxes are excluded. (Employer FICA withholding is 6.2%).
The initial election is made by using R&D Form 6765 and is included within the federal income tax filing. The form has been revised to include a new Section D, where the election will be made. The election can be made on an extended return as noted above. This election will be included in the company’s business tax return filing. Payroll form 941 includes a new line for the credit. In addition, payroll forms must include a new form 8974 – Qualified Small Business Payroll Tax Credit for R&D, which looks like a short version of the R&D form. (Copies of both new forms can be found online).
As the opportunity to offset payroll taxes is based on 2016 expenses, businesses will need to determine eligibility under the new rules and, likely, prepare an R&D report to support the expenses and the analysis of the qualifying costs. This credit must be specified, elected, and filed on the original 2016 tax return before a company can begin to offset payroll taxes in 2017. (Under the current rules, taxpayers won’t be able to take advantage of this opportunity on an amended return).
The maximum benefit an eligible company is allowed to claim against payroll taxes each year under the new law is $250,000. Brand new businesses could potentially claim the credit for up to five years, with a maximum of $1.25 million in total credits ($250,000 times five years) claimed on quarterly payroll tax returns.
The program allows for a credit refund to offset Social Security on the payroll return. If the amount of the credit exceeds a company’s social security tax (OASDI) liability in any given quarter, the excess will be carried forward to the next calendar quarter. The credit can only be applied to the employer’s Social Security portion of payroll taxes. (To max out under the $250,000 threshold, a company would need to have more than $4 million in annual payroll subject to Social Security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law).
Most employers are required to remit their payroll taxes to the federal government on a monthly or semiweekly basis and also to file a quarterly payroll tax return (Form 941). The credit will be applied against the Social Security tax on the quarterly return, not when it’s deposited monthly or semiweekly. Once the credit is applied to payroll tax, it can only be applied to future payroll tax and not income tax.
As with all R&D credit programs, pursuant to Code Section 41, the IRS will continue to require documentation to support all aspects of the credit. Companies should have R&D activities analyzed by their CPAs with expertise in this area, to ensure proper documentation of the qualified expenses and activities.
Should you have any questions about this change in the R&D credit or how the payroll tax offset may benefit you or your business, please contact a member of the Marcum Research and Development Tax Group.