Applying the R&D Credit to Payroll Taxes

Each day, businesses in nearly every industry conduct research and development work to improve their products and software. Unfortunately, many of them miss out on a valuable perk: the Research & Development (R&D) Tax Credit. The R&D credit is intended to incentivize and stimulate research and development activities, but many small businesses and start-ups neglect to claim the credit. Many times, it’s because they are unaware of it or think it doesn’t apply to them.

Prior to 2016, the R&D tax credit could only be used to offset a company’s income tax liability. Startups who were not yet profitable and thus had no income tax liability didn’t benefit from the credit. But the credit was expanded to allow qualified small businesses to claim the credit against alternative minimum tax or the employer’s Social Security portion of their payroll tax liability.

The new payroll tax offset is available only to companies that have:

  • Gross receipts for five years or less
  • Average gross receipts of no more than $5 million in the last five years

The maximum benefit a qualifying company is allowed to claim against payroll taxes each year is $250,000, but the credit can be carried forward for up to 20 years or carried back for one year by filing an amended return.

Some companies believe they aren’t eligible for the credit because they aren’t doing any groundbreaking work, but the credit does not require that R&D activity be groundbreaking to qualify, or even that the activity succeeded. It only requires that the activity attempts to develop or improve the functionality or performance of a product, process, software or other component.

The company’s activities must meet a four-part test:

  • Elimination of uncertainty. The activity is performed to eliminate technical uncertainty about the development or improvement of a product or process.
  • Process of experimentation. Activities include some process of experimentation performed through modeling, simulation, systematic trial and error or other methods.
  • Technological in nature. The process of experimentation replying on the hard sciences, such as engineering, physics, chemistry, biology or computer science.
  • Qualified purpose. Creating or improving a product or process that results in increased performance, function, reliability or quality.

Expenses that qualify for the credit include:

  • Wages for those who work directly on the innovation and first-level supervision
  • Legal fees for patents
  • US-based contractor fees
  • Supplies used in research
  • Rental or lease costs of computers

The R&D credit is calculated and shown on the company’s federal income tax return. If any portion of the R&D credit will be applied to offset payroll taxes, it needs to be identified and elected on that return. The payroll tax offset is then available beginning with the first calendar quarter that begins after a company files its federal income tax return.

To illustrate, a company would need to file their 2017 federal income tax return by March 30, 2018, to apply the payroll tax offset to their second quarter payroll taxes (Form 941).

The R&D credit is complex, so taxpayers should consult their tax advisor to discuss whether their business qualifies for the credit and what documentation is needed to calculate and apply the credit.

If you have any questions, contact us today!



Annie C. Olives, CPA

Annie is a Tax Supervisor with Brown Schultz Sheridan & Fritz.