For up to five years, new firms and start-ups may be able to claim the R&D tax credit against their payroll taxes.
As part of the Protecting Americans from Tax Hikes (PATH) Act of 2015, the R&D credit was permanently extended. The bill includes modifications, such as offsets to the alternative minimum and payroll tax for qualifying businesses.
The payroll tax credit is based on qualifying R&D spending, but it only applies to costs incurred after that bill was signed into law. Under the PATH Act, a qualified corporation can claim a maximum benefit of $250,000 per year against payroll taxes.
Table of Contents
When Can You Apply For R&D Payroll Tax Credits?
For eligible expenses spent during the previous tax year, the payroll tax offset is available. You must calculate and report the R&D tax credit on a taxpayer’s federal income tax return with the percentage of the credit used to offset payroll taxes identified and chosen when filing the return.
Starting in the first quarter following the filing of a taxpayer’s federal income tax return, the offset is available quarterly.
When applying the payroll tax credit to the second quarter, taxpayers must file their 2020 federal income tax return by June 30, 2021. As a result, the earliest taxpayers will notice a benefit is in October 2021, when they file their second-quarter quarterly payroll tax return.
Who Qualifies For the Payroll Tax Offset?
Thanks to the payroll tax offset, companies can benefit from research efforts even if they aren’t profitable.
Companies must meet the following criteria to be eligible for the credit:
- Have gross receipts for no more than five years
- Accumulate $5 million or less in gross receipts during the year they take the credit
- Conduct qualifying R&D activities and expenditures
- Have payroll-tax liability
$5 Million Gross Receipts Defined
To be qualified, a company’s yearly gross receipts must be less than $5 million. In addition, gross receipts for new firms must fall below the $5 million limits after being annualized for a full year. To evaluate eligibility under this section, gross receipts for firms that are related or share common ownership must be calculated on a combined basis.
In March 2017, the IRS published interim advice on the definition of gross receipts. The IRS affirmed that gross receipts include the following items in their guidance:
- Total sales—the net of allowances and returns
- Any amount received for services
- Income from investments and interest
Although the gross receipts limitation aids in determining a company’s credit eligibility, it’s crucial to emphasize that the R&D credit is not based on gross receipts. The company’s qualified R&D expenses determine the credit amount.
Eligible R&D Expenditures
Eligible R&D costs include:
- Wages. Employees that provide direct support and first-level research supervision earn W-2 taxable earnings.
- Supplies. Research materials, such as “special utilities,” but not capital items or basic administrative supplies.
- Contract research. If the subcontractor’s tasks qualify, the company may deduct the subcontractor’s expenses. These can involve labor, services, or research, but they cannot be paid based on the outcome. Furthermore, whether exclusive or shared, the taxpayer must retain considerable rights in the results.
Computer rental costs. These costs might include payments to cloud service providers for the cost of renting server space, as long as the expenses related to hosting software under development rather than payments for hosting a finished product.
Benefits of the R&D Payroll Tax Offset
New businesses can claim the credit for up to five years, with a total credit limit of $1.25 million on their quarterly federal payroll tax returns. As a result, new firms and start-ups will most likely experience a benefit ranging from 6% to 14% of their qualified R&D costs.
The federal credit to offset payroll tax will equal 10% of total R&D spending for most companies with at least $300,000 in qualifying R&D costs. For example, a corporation with $500,000 in qualified expenses, such as engineering fees, would be entitled to a $50,000 credit. A corporation with more than $2.5 million in eligible expenses in 2019 could earn credit equivalent to the maximum $250,000 yearly limit.
In any given quarter, if the credit exceeds a company’s Social Security tax payment (also known as the OASDI tax), the excess can be carried forward to the next calendar quarter.
Claiming the R&D Payroll Tax Credit: Risks
Potential risks include:
- IRS exam. An R&D credit claim may be scrutinized by the IRS, just like any other tax claim. Original tax returns with R&D credit positions have not been scrutinized any more frequently than those without R&D credit positions. Amended tax returns claiming R&D credits that were used in the audited years were more likely to be scrutinized. R&D credits may be awarded or prohibited in whole or in part if they are investigated. Whether credits are granted, the IRS may look at the taxpayer’s other tax positions to see if there is any additional tax due, but only to the extent that the credit can be offset.
- Disallowed credits. It’s possible that the IRS will look into the R&D credits and invalidate some or all of them. In general, credits that have been properly identified and supported are accepted. Credits for ambiguous or unverified activity are frequently denied.
- IRS penalty and interest. If the IRS disallows a credit, it may levy a penalty if it determines that the credit was claimed negligently or in violation of rules or regulations, or if the credit resulted in a significant understatement of income tax. In most cases, the penalty is equivalent to 20% of the credit denied, i.e., the tax the IRS feels was underpaid. The IRS may also charge interest on that 20% from the day the tax was supposed to be paid.
We’re Here to Help
For up to five years, the payroll-tax offset is available to eligible new firms and start-ups. Any excess R&D credits that aren’t used to offset payroll taxes can be carried forward for up to 20 years and used when the company starts to make money. Contact the R&D tax credit experts at Parachor Consulting to learn more about the R&D payroll-tax offset and find out if your company qualifies.