Startup Companies: Can the R&D Payroll Tax Credit Help You?

For many startup companies, the first several years of business can be a period of heavy research and development (R&D) activity, as the founders work to bring the business’ products or processes to market. Unfortunately, this period is also often marked by heavy expenses and minimal revenue, resulting in operating losses for the company. Even the most successful startup business may take several years before it is able to finally show a net taxable profit.

On the one hand, accumulating losses in these years result in no tax liability to the company or its owners for the business’ activities. On the other hand, with no tax liability to offset, these losses have historically rendered the potentially valuable research tax credit relatively useless.

The research credit is non-refundable, so there has been no means to get cash value for the credit when there has been no tax liability. This result was particularly troublesome because the research credit was intended to incentivize new R&D activity by mitigating a portion of the inherent risk and high costs associated with R&D work.

About the Payroll Tax Credit

Effective as of Dec. 31, 2015, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) provided that certain small startup companies may elect to use the research credit to offset the employer’s portion of the Social Security (OASDI) payroll tax liability. As a result, qualifying startup companies may be able to monetize the federal research credits they have earned and see benefits much sooner than otherwise possible.

Qualified Small Business

To be eligible to make a payroll tax credit election, a business must be a “qualified small business” (QSB) which is defined in the PATH Act as either:

1. A corporation or partnership, if:
   1. The gross receipts of the entity for the tax year is less than five million dollars, and
   2. The entity did not have gross receipts for any taxable year preceding the five-taxable-year period ending with the current taxable year.
2. Any person other than a corporation or partnership meeting the requirements in part (1)
   1. By substituting “person” for “entity,” and
   2. By only taking into account the aggregate gross receipts by such person in carrying on all trades or businesses of such person.

For example, assume a business is considering using the payroll tax credit election on its 2017 tax return. In order to make the election, the company must have less than five million dollars of gross receipts in the 2017 tax year. Additionally, in order to satisfy the PATH Act’s five-year requirement, the company would be unable to make the election if it had gross receipts prior to 2013.

In order to be considered a QSB, a business must also meet certain aggregation rules imposed by the PATH Act. If a business involves controlled groups of corporations or related groups of trades or businesses, it would be best to consult a tax advisor to determine how these rules may apply to the specific company situation.

Credit Limitations

Although the new rule established by the PATH Act allows an eligible taxpayer to make a payroll tax credit election, the amount of credit that may be used to offset the payroll tax is limited to $250,000. Additionally, the payroll tax election cannot be made by a taxpayer who has previously made the payroll tax election for the preceding five taxable years.

Making the Election

The payroll tax credit election must be made on Form 6765, Credit for Increasing Research Activities, and attached to the taxpayer’s timely filed return for the tax year to which the election applies. This means the election may not be made on an amended return or late return. When making the election, the taxpayer must specify the amount of the research credit for which the election applies. For a partnership or S corporation taxpayer, the election must be made at the entity level and not at the owner level.

Claiming the Credit

After the payroll tax credit election has been made, a QSB may claim the payroll tax credit on its employment tax return for the first quarter following the date the election was made. The election is deemed to have been made on the day the income tax return reporting the election is filed with the IRS. For example, if a QSB files its 2017 income tax return on April 5, 2018 – the second quarter of 2018 – with a properly completed payroll tax credit election, then the business would be entitled to claim the payroll tax credit on its Form 941, Employer’s Quarterly Federal Tax Return, for the third quarter of 2018.

A business filing an annual employment tax return would claim the credit on the annual employment tax return which begins with the first quarter after the election is made. For example, assume the same QSB files its 2017 income tax return on April 5, 2018, but, instead of filing quarterly employment tax returns, the business files an annual employment tax return. In this case the business would claim the credit on the annual employment tax return which begins on Jan. 1, 2019.

When claiming the credit on its employment tax return, a QSB must attach a completed Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, to the employment tax return.

Credit Carryovers

The payroll tax credit claimed may be used as a credit against the employer’s portion of the Social Security (or OASDI) tax on wages paid to all employees of the business during the quarter in which the credit is claimed, not just the wages of employees performing research activities. However, the payroll credit claimed on an employment tax return is limited to the employer’s portion of tax. If the elected amount of payroll credit exceeds an employer’s portion of tax, then the excess payroll credit is carried forward to the next employment tax return filed by the employer.

Election Analysis

In prior years, a business may not have been able to use the research credit for several years, if at all. The election to use the research credit to offset the employer’s share of payroll taxes can be a valuable tool for allowing startup companies to immediately reap the benefits of the credit. Please consult a KSM advisor to determine if your business is eligible for the payroll tax credit election and whether making the election on your income tax return would be advantageous for your company.