Small business owners can save a significant amount each year by claiming tax credits. But you have to know which credits you qualify for and how you can claim them. We’ll walk you through everything you need to know about the research and development (R&D) tax credit which can help small businesses offset their R&D costs.
More specifically, we’ll answer your questions about filing Form 8974 for qualified small businesses. Let’s start by defining a qualified small business.
What Is a Qualified Small Business (QSB)?
To make a payroll credit election, your business must meet the criteria for a qualified small business. According to the PATH Act, a QSB is defined as:
- A partnership or corporation if:
- The gross receipts for the tax year are under five million dollars, and
- The business had no gross receipts for any taxable year before the five-taxable-year period prior to the current taxable year.
Let’s look at an example to clarify that definition. Assume that a business wants to use the R&D tax credit on its 2021 tax return. To make that election, the company must have under $5 million in gross receipts for the 2021 tax year. Additionally, to satisfy the five-year requirement of the PATH Act, the company would not be able to make the election if it had any gross receipts prior to 2017.
A business must also meet some aggregation rules set by the Path ACT to be considered a qualified small business. If your business involves controlled groups of corporations or groups of businesses or trades, it’s important to consult with a tax advisor; these rules may apply differently to your company’s specific situation.
What Is the R&D Tax Credit?
Simply put, it’s a dollar for dollar tax credit available for businesses to help offset their costs related to developing a new or improved business component, including:
Any activities or expenses that aim to improve the performance, quality, functionality, or reliability may qualify for the credit, including things like updating manufacturing processes, software development, and quality enhancements for techniques and products.
The R&D tax credit is available at both the state and federal levels. Only 36 states currently offer this credit, but any qualified business can claim the federal credit. While this credit is usually applied against a business’s income tax, startups that don’t have an income may apply for the R&D credit against their payroll taxes for five years.
Is Your Business Eligible For the Research & Development Tax Credit?
To be eligible for this tax credit, your business must meet these four criteria (and remember, if you’re filing Form 8974, you must also meet the above requirements of a qualified small business):
- Qualified purpose—Your research must have the purpose of either creating a new business component or improving an existing one. As we mentioned above, your research must improve the performance, quality, functionality, or reliability of the said business component.
- Process of experimentation—Any activities you submit must include some experimental processes like trial and error, testing, modeling, or simulation to qualify for the credit. Then, you must evaluate one or more alternatives to achieve the final result.
- Technological in nature—The process of improvement or development of the business component must use hard science and rely on scientific principles to achieve the final result. Hard sciences that are accepted include biology, physics, chemistry, engineering, and computer science.
- Eliminate uncertainty—You must show that your business has established activities and methods to eliminate any uncertainty about the creating or development of the business component. What does that mean? Your team must have confidence that they can achieve the desired result, or they must have an established design or process to achieve it.
Startups and the R&D Tax Credit
When the PATH Act passed in 2015, it expanded the R&D tax credit to startups that were not profitable yet and didn’t pay federal income tax. Any qualified companies that meet the requirement of producing less than five million in gross receipts and have no gross receipts for the previous five years can apply for up to $250,000 in R&D credits each year.
Startups still must meet the four criteria listed above, and the tax credit is set against the company’s payroll taxes, more specifically, the employer portion of social security tax.
Costs That May Qualify for the R&D Tax Credit
For an expense to qualify for the credit, the qualified activity must meet the four criteria listed above. Qualified expenses for qualified processes, activities, or products are qualified costs. Common qualified costs for the R&D credit include:
- The salary and wages for people who support, supervise, or perform R&D activities
- Supplies used in the R&D process
- Cloud servers that host software that’s under development
Qualified costs can range dramatically based on your business and R&D processes. If you’re unsure what to claim as qualified costs, a tax consultant can help ensure that you include any eligible expense.
How to Claim the R&D Tax Credit
Most importantly, you should maintain documentation and meticulous records of all of your company’s R&D activities. This documentation may include:
- Payroll records
- Expense details
- Lab results
- Project notes
- Emails and other communications about the R&D activities.
To claim the R&D tax credit:
- Complete and submit Form 6765—Credit for Researching Activities
- For qualified small businesses, you’ll also file Form 8974 once your credit is approved by the IRS.
- Also, for qualified small businesses, you’ll attach Form 8974 to Form 941 when you file.
Form 8974 FAQs
Here are the questions we see most about Form 8974, the R&D tax credit, and quarterly filing.
What is Form 8974?
Employers use Form 8974 to track the qualified small business R&D credit, including how much is generated, how much remains available to use against their company’s employment tax return, and how much of the credit gets utilized.
What is Form 941?
Employers use Form 941 to report income taxes, Medicare taxes, and Social Security taxes that get withheld from employees’ paychecks. This is how employers pay their part of the taxes, and it’s also the form that Form 8974 is attached to when it’s time to file.
When do I file for the R&D credit?
Your R&D credit will always be established by filing for the credit on Form 6765, which your company files with its income tax return. Following the filing, you’ll establish the available credit for payroll taxes by filing both Form 8974 and Form 941. How you file these forms depends on your payroll provider.
When do I get the money from the credit?
You’ll start to see the benefits from your R&D tax credit for the quarter that starts after filing your income tax return containing the credit. The timing is dependent on how quickly the IRS works through the filings to process payments. That said, you’ll likely see the refund around 6-8 weeks from when you file Form 8974 and 941. Alternatively, your business may be able to offset the employer portion of social security tax in real-time depending upon what payroll company you use.
How will I get the credit?
How you receive the credit will vary depending on which payroll provider your business uses. With some providers, you’ll be able to offset employer social security taxes in real-time, and with others, you might receive a check from the IRS. We recommend speaking with your payroll provider directly because the process varies from provider to provider.
What if my payroll provider doesn’t support the credit?
Some popular providers like Quickbooks don’t support the R&D tax credit. In this situation, you’ll need to file manually. Because it’s a complicated process, we recommend working with your tax consultant or accountant if you have to file for the R&D credit manually.
How do I know the R&D credit was applied correctly?
If you’re unsure if you’re receiving your R&D credit, it’s best to reach out to your payroll provider. However, you can check yourself by looking at line 11a of your Form 941. To fill it out, you’ll need to enter the credit amount from line 12 of your Form 8974.
What if I changed payroll providers?
Even if you changed payroll providers, it shouldn’t affect your ability to use your R&D tax credit. The best thing to do is simply reach out to your new provider and have them confirm that it’s being applied to your payroll.
Can I offset income tax liability with carryforwards?
If you have R&D credits that you established on an income tax return for a prior year but didn’t utilize all of it, the leftover amount will carry over for you to use against income tax liability. Any portion of that credit that doesn’t get used after being carried forward for 20 years will expire.
Can I offset payroll tax liability with carryforwards?
If you made a valid payroll credit election for a prior year but didn’t use all of the credit during the first quarter after the quarter you filed the credit, the remaining amount will carry over for you to use against any future payroll tax liabilities.
What if it’s the first quarter that I have payroll liability but not my first quarter filing?
You can begin to offset your payroll taxes with the credit in the first quarter after the quarter you filed an income tax return with relevant R&D tax credits. If you miss it, you’ll typically need to go back and amend your quarterly payroll filing for the first quarter.
For example, if your R&D credit was filed on your 2020 return, and that return was filed in Q2 of 2021, here’s what you’d have to do:
- Establish the R&D tax credit for Q3 of 2021 (typically by October 31st)
- If you don’t include the credit in that quarter, you can’t establish it in the next quarter (Q4 in this example). You have to go back, file Form 8974, and amend your Form 941 for Q3.
What if we changed EINs?
First, you need to understand that there are situations where one company files for the credit on Form 6765, but another company utilizes the R&D credit against its payroll. Typically, this scenario happens when a company gets acquired after generating payroll credit and making the election, but all of the credit didn’t get utilized.
Form 8974 accommodates scenarios like this by letting you track the credits generated, the generating company’s EIN, the amount of credit, how much of it has been used, and how much remains.
What if my business closed or got acquired?
There are some situations where if a company stops operations before using all of the R&D credit, it will be lost. But successor companies will typically have the ability to utilize the credit carryforwards associated with the acquired company.
What if we stopped running payroll?
If you elected to take the R&D credit and stopped running payroll, you wouldn’t have tax liabilities to offset. While you can’t immediately use the credit, it will roll over for use in a future quarter.
What if I forget to file Form 6765?
If you didn’t file this form with your annual 1120, you can amend your tax return to claim the R&D credit, but you cannot elect to utilize the tax credit against payroll taxes. However, if you filed an extension, then you can file a superseding 1120 and proceed to file Form 6765 provided the extension deadline has not passed yet.
What if I didn’t file Form 8974 in the quarter following Form 6765?
Typically, it’s not a big deal. The credit won’t expire; you’ll just have to use it in a different quarter.
Have more questions about Form 8974 or claiming the R&D tax credit? Parachor Consulting is here to help. Get in touch with our R&D tax consultants today.