Applying the R&D Credit to Payroll Taxes
Updated September 2023
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.
How the R&D Credit Can Offset Payroll Tax Liabilities
In 2022, the Inflation Reduction Act increased the maximum amount that a qualified small business can use from the R&D credit to offset certain payroll tax liabilities from $250,000 to $500,000 for tax years beginning after December 31, 2022. It also allowed taxpayers to use up to $250,000 against the 1.45% employer portion of the Medicare payroll tax liability.
The R&D credit is a nonrefundable general business credit and can be carried forward for up to 20 years or carried back for one year by filing an amended return. The Protecting Americans from Tax Hikes (PATH) Act of 2015 enacted provisions that allow qualified small businesses (QSB) to elect to apply their R&D credits against payroll taxes instead of income taxes, up to a specified cap to Federal Insurance Contributions Act taxes. For a corporation or partnership to be considered a QSB, they must meet the following:
- The gross receipts of the entity are less than $5 million
- The entity did not have gross receipts for any tax year preceding the five-tax year period ending with the current tax year
How to Qualify for the R&D Tax Credit
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:
- Technological in nature. Research must be intended to develop a new or improved business component, such as a product, process, computer software, technique, formula or invention.
- 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.
- 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
How to Claim the Payroll Tax Offset
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 annual election must be made on or before the due date of the taxpayer’s income tax return (including extensions) on Form 6765. The payroll tax offset is then available beginning with the first calendar quarter that begins after a company files its federal income tax return.
The R&D credit can be complex, 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 regarding the R&D tax credit, contact BSSF today!