Federal R&D Tax Credit: Federal Payroll Tax Offset
Federal R&D Tax Credit: Payroll Tax Offset Background
In addition to making the research and development (R&D) tax credit permanent, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), provides key incentives to eligible small businesses for taxable years beginning on or after Jan. 1, 2016. Although an unused portion of an R&D credit can be carried forward, prior to the PATH Act, many small startups were unable to realize any benefit, as they operated at a loss and thus had no income tax liability to offset (prior to new 80% net operating loss (NOL) deduction limitations per the Tax Cuts & Jobs Act of 2017; see Tax Cuts & Jobs Act of 2017).
To resolve this situation, the PATH Act allows qualified small businesses (QSBs) for tax years beginning after Dec. 31, 2015, to elect to claim (1) all or a portion of the R&D tax credit against the employer portion of Social Security taxes due or (2) an eligible small businesses with gross receipts less than $50 million averaged over the past 3 years may apply the credit against AMT liability.
Below specifically outlines the procedures and criteria to claim the R&D credit against payroll taxes. For additional information on the AMT offset for QSBs, see "Other R&D Tax Considerations - Protecting Americans From Tax Hikes Act of 2015" - Tax Cuts & Jobs Act of 2017 link for additional background.
Companies Qualifying for the R&D Tax Credit Payroll Offset (up to $250K annually)
The new payroll-tax offset allows companies ("qualified small business") to receive a benefit for research expense activities even if they aren’t profitable. A qualified small business may elect to claim up to $250,000 of R&D tax credits annually as a payroll tax credit against its employer share of Social Security old age, survivors, and disability insurance (OASDI) taxes. The payroll tax credit is not limited to R&D employees but rather can be used to offset the employer’s share of OASDI taxes for all employees. The maximum amount of the credit that can be elected to offset payroll taxes in a given year is $250,000, and the election can only be made for five tax years. The payroll tax credit is enabled by IRC sections 41(h) and 3111(f).
To be eligible for the R&D tax credit payroll offset, companies must meet these qualifications:
Gross receipts for five years or less (e.g. interest income counts toward gross receipts)
Less than $5 million in gross receipts in the year the credit is elected
Qualifying research activities and expenditures
May elect the payroll tax credit in an amount not to exceed $250,000 per year, for a maximum of five years.
Any excess above the $250,000 may be utilized traditionally (offset income tax liability) in current or future years subject to carryforward limitations as an additional benefit.
Organizations exempt from tax under Sec. 501 (e.g. non-profits") are not eligible to claim the payroll tax credit.
Must make an election in section D of Form 6765 on an originally filed return to claim the payroll tax credit on or before the due date of the tax return, including extensions
Form 6765 permits the taxpayer to elect the amount they wish to be designated as the payroll tax credit
Any amount not included in this election would be eligible for the standard R&D credit carryback period of one year carryback and carryforward period of 20 years
If the taxpayer elects the payroll tax credit in an amount greater than their payroll tax liability for the following calendar quarter, the remaining credit shall be carried forward to the subsequent quarter(s) to be used against payroll taxes. Any payroll tax credit election made is irrevocable without consent of the Secretary
Gross Receipts Limitations
To qualify for this payroll tax credit, a QSB is a taxpayer with gross receipts for the tax year of less than $5 million that did not have gross receipts for any tax year preceding the five-tax-year period ending with the credit year. For example, a taxpayer claiming the R&D tax credit payroll tax offset for the 2019 tax year must have had less than $5 million in gross receipts in 2019 and could not have had gross receipts in 2014 or prior. As such, companies aren’t eligible if they generated gross receipts prior to 2015 for the 2019 tax year. However, companies that existed prior to 2015 but didn’t receive gross receipts may still qualify.
Although the law is intended to benefit small businesses, larger businesses could potentially still profit. For example, a significant percentage of life-sciences companies have no gross receipts for long periods of time because they’re waiting for their drug to receive approval from the US Food and Drug Administration.
For purposes of the gross receipts test, gross receipts are reduced by returns and allowances and must be annualized for short tax years, and predecessors are taken into account. For any person other than a corporation or partnership, only the aggregate gross receipts of the person in carrying on all of that person's trades or businesses are considered.
All members of a controlled group or a group of trades or businesses under common control, as defined in section 1.41-6(a)(3)(ii), are treated as a single taxpayer. Thus, the aggregate gross receipts of all members of a controlled group for the taxable year must be considered when determining whether the requirements are satisfied. As such, this would require each taxpayer to consider all related parties (foreign and domestic) that fit the ownership requirements for purposes of applying the gross receipts measurement. This could potentially limit the applicability of the payroll tax credit election for some taxpayers.
How are "Gross Receipts" defined for purposes of applying the five-year and $5M limitations?
A company must have less than $5 million in annual gross receipts to be eligible. For new businesses, the gross receipts must fall under the $5 million limit after being annualized for a full 12 months. The gross receipts of businesses that are related or share common ownership need to be calculated on a combined basis for purposes of determining eligibility under this provision.
The IRS issued interim guidance on the definition of gross receipts in March 2017. See Notice 2017-23. In the guidance, the IRS confirmed gross receipts include the following:
Total sales—defined as the net of returns and allowances
All amounts received for services
Income from investments, including interest income
The term “gross receipts” means gross receipts as determined under § 448(c)(3) (without regard to § 448(c)(3)(A)) and § 1.448-1T(f)(2)(iii) and (iv) of the Income Tax Regulations. IRS Notice 2017-23 clarifies the definition of gross receipts under § 41(c)(7) and § 1.41-3(c) does not apply for purposes of § 41(h). IRS Notice 2017-23 also does not provide a "de minimis test" in regards to gross receipts. As it is written, a company receiving minimal gross receipts in the form of bank interest or a dividend in any year prior to the five year period referenced above would be ineligible to elect the payroll tax credit.
§ 448(c)(3) and § 1.448-1T(f)(2)(iii) define "gross receipts" to include the following:
total sales (net of returns and allowances) and all amounts received for services;
any income from investments, and from incidental or outside sources;
For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade of business.
Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221 (1), (3), (4) or (5);
With respect to sales of capital assets as defined in section 1221, or sales of property described in 1221 (2) (relating to property used in a trade or business), gross receipts shall be reduced by the taxpayer's adjusted basis in such property.
Gross receipts do not include the repayment of a loan or similar instrument (e.g., a repayment of the principal amount of a loan held by a commercial lender); and
Gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts shall include the amounts received that are allocable to the payment of such tax.
Although the gross-receipts limitation helps to define a company’s eligibility for the credit, it’s important to note the R&D credit itself isn’t based on gross receipts. The actual credit is based on the company’s eligible R&D expenses.
Social Security Tax
The payroll-tax offset can only be applied to the Social Security employer portion of payroll taxes. The OASDI tax rate for wages paid in 2019 is set by statute at 6.2% for employees and employers, each. Thus, an individual with wages equal to or larger than $132,900 would contribute $8,239.80 to the OASDI program in 2019, and his or her employer would contribute the same amount. For example, a company that employs 50 employees with an average salary of $75,000 would pay approximately $232,500 in Social Security payroll taxes.
To maximize the R&D tax credit payroll benefit each year, a company would generally need to have more than $4 million in annual payroll subject to Social Security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the PATH Act.
Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis as well as file a quarterly payroll tax return via Form 941. However, the credit will be applied against the Social Security tax on the quarterly return (not when it’s deposited monthly or semiweekly).
R&D Tax Credit Payroll Offset: Timing and Procedures to Elect and Claim
On March 30, 2017, the Internal Revenue Service (IRS) issued interim guidance in the form of Notice 2017-23 that describes how eligible small businesses can apply all or part of their research credit against their payroll tax liability pursuant to the Protecting Americans From Tax Hikes Act that was first made available to qualified small businesses filing 2016 federal income tax returns. The notice explains whether your business is a qualified small business, eligible to elect to apply part or all of your research credit against your payroll tax liability, instead of your income tax liability. Before 2016, taxpayers could only take the research credit against income tax liability. This guidance focuses on the definition of gross receipts, aggregation rules, including the time and manner of making the election to claim the payroll tax credit.
The payroll tax credit can apply only against your qualified small business’ liability for the employer portion of social security tax, as imposed by section 3111(a) of the Internal Revenue Code. You may not use the payroll tax credit as a credit against any other employment tax liability and the credit may not be refunded in the absence of liability for your employer social security tax.
Procedures for an Employer To Claim the R&D Payroll Tax Credit on Form 943 or Form 944
Note, the IRS recently provided notice regarding employers who report their payroll taxes on an annual basis (Forms 943 and 944) may need to adjust the amount reported on Form 8974, line 11, because the qualified small business payroll tax credit for increasing research activities can’t be claimed until the first calendar quarter that begins after the date on which you file your income tax return that makes the election to take the credit against payroll taxes.
See IRS update link for additional details: Clarification of Procedures for an Employer To Claim the Qualified Small Business Payroll Tax Credit for Increasing Research Activities on Form 943 or Form 944 (4/24/2018)
Qualified Small Business Employer Filing Under Own EIN
The election must be made on or before the due date of the taxpayer's income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities, submitted with the return, and can be revoked only with consent. For partnerships and S corporations, the election is made at the entity level. The credit is claimed against payroll taxes on the taxpayer's Form 941, Employer's Quarterly Federal Tax Return, for the first quarter that begins after the income tax return making the election was filed.
For example, if a taxpayer made a payroll tax credit election on a timely filed Form 1120, U.S. Corporation Income Tax Return, that was filed on Oct. 15, 2019, the payroll tax credit would be claimed on the taxpayer's quarterly payroll tax return for the first quarter of 2020. This is accomplished through completing and filing Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, along with the quarterly payroll tax return. Any credit amounts that cannot be used on that quarter's payroll tax return are carried forward to future quarters.
As a qualified small business with qualifying research expenses, you can apply up to $250,000 of your research credit against your payroll tax liability by taking the following steps:
Step 1: Complete Form 6765, Credit for Increasing Research Activities, make the payroll credit election (Section D), and attach the completed form to your timely-filed business income tax return.
Step 2: Claim the payroll tax credit by completing Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. You must attach this form to your payroll tax return, for example, your Form 941, Employer’s Quarterly Federal Tax Return.
Aggregate Filers Filing On Behalf Of Clients/Customers
All persons or entities required to be treated as a single taxpayer under the R&D tax credit aggregation rules in Sec. 41(f)(1) are also treated as a single taxpayer for purposes of the payroll tax credit. For example, a startup company formed in 2018 cannot make a payroll tax credit election for the 2018 tax year if a related company with which it is treated as a single taxpayer under the aggregation rules had gross receipts in 2013 or prior. Similarly, a startup company cannot make a payroll tax credit election if a related company with which it is treated as a single taxpayer made a payroll tax credit election in five preceding tax years. Additionally, the $250,000 of potential payroll tax credit that can be elected in a year is allocated among taxpayers treated as a single taxpayer, in proportion to the percentage that each taxpayer's qualified research expenses used in calculating the R&D tax credit is of the group's aggregate qualified research expenses.
Taxpayers should coordinate with their Professional Employer Organization (PEO), e.g. TriNet, ADP, JustWorks, etc., to claim the payroll tax credit. Note, some PEOs provide online portal access to its users (taxpayers) to update the election to claim the R&D tax credit offset against payroll taxes. However, in general, the PEO is responsible for filing Form 941 (Employer’s Quarterly Federal Tax Return) on behalf of the taxpayer, it will also be responsible for filing Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities). The PEO will designate the amount of payroll tax credit elected by the taxpayer in Sec. D of the taxpayer’s Form 6765 by including the taxpayer’s EIN and election amount on the Form 8974 as filed. The instructions for Form 8974 states that a certified PEO is responsible for completing with Form 941, a Schedule R (Allocation Schedule for Aggregate Form 941 Filers), which shows a list of all of the PEO’s clients. The instructions further state that the PEO is responsible for attaching a Form 8974 for each client that elects the qualified small business payroll tax credit.
If you are a Section 3504 agent or a Certified Professional Employer Organization (CPEO), you may claim the payroll tax credit on behalf of a qualified small business client that elects to apply the research credit against payroll tax liability. For you to claim the credit, your client must be a qualified small business and must elect to apply the research credit against payroll tax liability by attaching Form 6765 to its timely-filed business income tax return. To claim the credit on behalf of a client:
Step 1: Claim the Qualified Small Business Payroll Tax Credit for Increasing Research Activities on a Form 941 filed under the Section 3504 agent’s or CPEO’s Employer Identification Number (EIN).
Step 2: Complete and attach Schedule R (Form 941), Allocation Schedule for Aggregate Form 941 Filers, when filing an aggregate Form 941.
Step 3: Attach a Form 8974 for each qualified small business client opting to apply the research credit against payroll tax liability.
If you are a Non Certified PEO (including CPEO applicants not yet certified) that pays wages to individuals as part of the services provided to a client pursuant to a service agreement, such as collecting, reporting and/or paying or depositing employment taxes with respect to such wages, you may claim the payroll tax credit on behalf of a qualified small business client. For you to claim the credit, your client must be a qualified small business and must elect to apply the research credit against payroll tax liability by attaching Form 6765 to its timely-filed business income tax return. To claim the credit on behalf of a client:
Step 1: Claim the Qualified Small Business Payroll Tax Credit for Increasing Research Activities on a Form 941 filed under the PEO’s EIN.
Step 2: Complete and attach Schedule R (Form 941) listing those clients electing to claim the Qualified Small Business Payroll Tax Credit for Increasing Research Activities and report the corresponding credits and all other amounts allocated to the listed clients. Check the ‘Section 3504 Agent’ box for ‘Type of filer’ at the top of the Schedule R. Enter the total wages and taxes paid for all other clients not separately listed on Schedule R and for your own employees on line 13 of Schedule R, so that the totals shown on line 14 match the amounts reported on the corresponding lines on Form 941.
Note: This required step for Non-Certified PEOs provides the necessary substantiation to enable the IRS to apply each client’s research credit against the payroll tax liability reported on Form 941 under the PEO’s EIN.
Step 3: Complete and attach Form 8974 for each client listed on Schedule R (Form 941).