Understanding the Payroll Tax Credit for R&D

The payroll tax credit is a special provision under the R&D tax credit (Section 41 of the tax code) that allows qualified small businesses (QSBs) to use their R&D tax credits to offset payroll taxes instead of income taxes. This is particularly beneficial for startups and small businesses that may not yet have income tax liability but still incur payroll taxes. Here’s a more detailed look at how it works:

What is the Payroll Tax Credit?

• The payroll tax credit allows QSBs to apply their R&D tax credit against the employer’s portion of Social Security taxes (Old Age, Survivors, and Disability Insurance, or OASDI).
• This is a game-changer for startups and small businesses that are pre-revenue or not yet profitable, as it provides immediate cash flow benefits by reducing payroll tax obligations.

Who Qualifies as a Qualified Small Business (QSB)?

To be eligible for the payroll tax credit, your business must meet the following criteria:

• Gross Receipts Test:
  • Your business must have less than $5 million in gross receipts for the tax year in which you’re claiming the credit.
  • Additionally, your business must have no gross receipts in any tax year before the five-year period ending with the current tax year.
  • Example: If you’re claiming the credit for 2023, you must have had no gross receipts before 2018.

• Entity Types:
  • The credit is available to corporations, partnerships, sole proprietorships, and S corporations.
  • Tax-exempt organizations (like nonprofits) do not qualify.

How Much Can You Claim?

• The payroll tax credit is capped at $250,000 per year.
• If your R&D credit exceeds $250,000, the unused portion can be carried forward to future years.
• For businesses that are part of a controlled group (e.g., parent and subsidiary companies), the $250,000 limit applies to the entire group, and the credit must be allocated among the members.

What Expenses Qualify for the Payroll Tax Credit?

The same expenses that qualify for the regular R&D tax credit also apply to the payroll tax credit. These include:

• Wages: Payments to employees directly involved in R&D activities or supervising/supporting such activities.
• Supplies: Costs of materials used in R&D (e.g., lab supplies, prototypes).
• Contract Research: 65% of payments made to third-party contractors for qualified research.
• Computer Costs: Expenses for computer usage in R&D activities.

How Does the Payroll Tax Credit Work?

Here’s a step-by-step breakdown of how the payroll tax credit process works:

Step 1: Determine Your R&D Credit

• Calculate your R&D credit using Form 6765 (Credit for Increasing Research Activities).
• You can choose between the regular credit method (20% of qualified expenses over a base amount) or;
• the alternative simplified credit method (14% of qualified expenses over 50% of the average of the prior three years’ expenses).

Step 2: Elect the Payroll Tax Credit

• On Form 6765, complete Section D to elect the payroll tax credit.
• Specify the amount of the credit you want to apply to payroll taxes (up to $250,000).

Step 3: Apply the Credit to Payroll Taxes

• Use Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) to calculate the amount of the credit that can be applied to your payroll taxes.
• Attach Form 8974 to your Form 941 (Employer’s Quarterly Federal Tax Return) for the quarter in which you want to claim the credit.

Step 4: Carry Forward Unused Credits

• If the credit exceeds your payroll tax liability for the quarter, the unused portion can be carried forward to future quarters.

Key Rules and Limitations

• Five-Year Limitation:
  • A business can only elect to use the payroll tax credit for five tax years.
  • Once you’ve made the election for five years, you can no longer use the credit against payroll taxes (but you can still use it against income taxes).

• Controlled Group Rules:
  • If your business is part of a controlled group (e.g., parent and subsidiary companies), the $250,000 limit applies to the entire group.
  • The credit must be allocated among the members based on their share of qualified research expenses (QREs).

• No Double-Dipping:
  • You cannot deduct the same expenses for both the R&D credit and as regular business expenses. Section 280C(c) prevents this by requiring you to either reduce your deductions by the amount of the credit or claim a reduced credit.

Why This Matters for Startups

• Cash Flow Boost: Startups often operate at a loss in their early years, meaning they don’t have income tax liability.
• Encourages Innovation: By offsetting the costs of R&D, the credit helps startups invest more in innovation, which is critical for growth and competitiveness.
• Easy to Claim: While the rules may seem complex, the process of claiming the credit is straightforward with the right guidance.

Common Mistakes to Avoid

• Not Tracking Expenses: Failing to properly document and track R&D expenses can lead to missed opportunities or issues during an audit.
• Overlooking Eligibility: Many businesses assume they don’t qualify because they don’t conduct “traditional” research.
• Missing Deadlines: The election to use the payroll tax credit must be made on a timely filed tax return (including extensions).

How to Get Started

1. Review Your Activities: Identify which of your business activities might qualify as R&D under the IRS guidelines.
2. Document Expenses: Keep detailed records of wages, supplies, and contractor costs related to R&D.
3. Work with a Professional: Consult a tax advisor or R&D credit specialist to ensure you’re maximizing your credit and complying with all rules.
4. File the Right Forms: Complete Form 6765 and Form 8974 to claim and apply the credit.

Real-World Example

Conclusion

The payroll tax credit is a powerful tool for startups and small businesses engaged in R&D. By reducing payroll taxes, it provides much-needed cash flow to fuel innovation and growth. If your business is investing in new products, processes, or technologies, don’t miss out on this opportunity. Work with a tax professional to ensure you’re taking full advantage of the R&D tax credit and its payroll tax offset option.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.