A highlight of 2015 for research and development (R&D) was the passing of The Protecting Americans from Tax Hikes (“PATH”) Act of 2015, which saw the R&D Tax Incentive become permanent. Essentially, taxpayers that couldn’t utilize or take full advantage of the tax credits in the past should now reassess their eligibility and possibly take advantage of this lucrative incentive.

However, there are a lot of questions surrounding the new rules of the permanent R&D Tax Credit, in particular, the new payroll tax offset.

Previously, start-ups that qualified for the federal R&D tax credit but weren’t yet paying taxes had the option to carry forward the credit to use in later years when they did have a tax liability. However, the new R&D tax credit now allows qualified small businesses to elect to use a portion of their R&D tax credit now to offset payroll taxes, instead of waiting to use the credit. This is essentially what the Payroll Tax Offset is.

In Summary, the Payroll Tax Offset:

• Allows a payroll tax offset for start-up businesses (under $5 million in gross receipts). These companies can take a credit against FICA taxes only – other payroll taxes are excluded.

• Maximum credit was originally capped at up to $250,000 per year for up to five years. However, The Inflation Reduction Act of 2022 increased this limit to $500,000 for tax years beginning after December 31, 2022, for qualified research activities.

• Effective for taxable years beginning after December 31, 2015. The payroll tax offset election must be made on a timely filed entity tax return. You cannot amend a tax return to elect the payroll tax offset.

To elucidate the above, these companies can now take a credit against the employer’s portion of FICA taxes (6.2%).

The FICA tax is the Federal Insurance Contributions Act tax and is a United States federal payroll (or employment) tax imposed on both employees and employers to fund Social Security and Medicare. However, the Payroll Tax Offset only encompasses FICA taxes, other payroll taxes are omitted.

Changes Introduced by The Inflation Reduction Act of 2022:

Starting in the first quarter of 2023, the payroll tax credit is first used to reduce the employer share of social security tax up to $500,000 per quarter. If any credit remains after reducing the employer share of social security tax, the remaining amount then reduces the employer share of Medicare tax for the quarter.

Any remaining credit, after reducing both the employer share of social security tax and the employer share of Medicare tax, is then carried forward to the next quarter.

This enhancement significantly increases the benefit for eligible small businesses, allowing them to maximize the credit’s impact on their payroll tax obligations.

Additional Details:

• The maximum credit is now capped at $500,000 per year, a substantial increase from the previous $250,000 limit, making the credit even more valuable for small businesses engaging in qualified research activities.

• The payroll tax offset continues to be effective for taxable years beginning after December 31, 2015, but remains unavailable for 2015 or earlier periods.

• It is important to note that the total of payroll tax credit claimed does not decrease the amount of deductions permitted for payroll taxes on the tax returns. Furthermore, any unused credit may be carried forward to offset against future payroll tax liabilities.

Definition of a Qualified Small Business:

A “Qualified Small Business” is described as a business with under $5 million in annual gross receipts and has no gross receipts exceeding five years. Hence, this is particularly valuable for start-up companies, who, the majority of the time, will produce R&D expenses but won’t have a taxable income and aren’t paying federal income taxes.

Case Study Example:

A small company was founded in 2015. It had acquired substantial R&D and payroll expenses; however, no revenue was produced. Since it worked at a loss, the small company did not chase any R&D Tax Credit in 2015.

Moreover, the small company expects 2023’s activities to be comparable with a payroll tax liability of $200,000 and will be eligible for $300,000 of R&D Tax Credit. Due to the new Inflation Reduction Act of 2022, the small company should secure the $300,000 of R&D Tax Credit in 2023. It can elect to offset it against the $200,000 of payroll tax liability (first against social security tax, then Medicare tax), and carry forward the remaining $100,000 to offset against future payroll tax liability.

Importance for Businesses:

Bear in mind that the R&D Tax Credit incorporates a diversity of activities (both basic and applied research) and also various industries. Consequently, it is important that business owners involve the assistance of professionals to decide not only the businesses’ eligibility for R&D Tax Credit but also which R&D activities qualify.

Swanson Reed is a specialist R&D tax credit firm that offers expertise across a wide assortment of industries and has helped many clients achieve tax cash savings under the R&D tax credit scheme. Contact us today to find out more.