The research and development (R&D) tax credit (Section 41 of the Internal Revenue Code) has been a valuable incentive for many taxpayers for more than 35 years. However, until recently, the credit was purely an income-tax-based credit, meaning that companies operating at a tax loss (and therefore paying no federal income tax) could not receive an immediate benefit from the credit. This greatly limited the impact of the R&D credit for start-up companies since few of them are profitable and paying income taxes.
Effective January 1, 2016, however, the potential for start-ups to benefit from the R&D credit improved drastically. Rules enacted under the Protecting Americans from Tax Hikes Act of 2015 now allow start-ups to claim their R&D credits against payroll taxes (specifically, the employer portion of social security tax as reported on Form 941), thus providing an immediate cash tax benefit from the credit.
Activities That Qualify as R&D
There are four basic requirements that a taxpayer’s development activities must meet in order to qualify for the credit:
- Permitted purpose: The activities must relate to the development or improvement of a product or process that results in increased functionality, performance, reliability, or quality.
- Technological in nature: The activities must rely on the principles of hard science (e.g., engineering, chemistry, physics, computer science/software engineering).
- Technical uncertainty: The activities must be undertaken to eliminate technical uncertainty as to how the product or process is to be developed or improved.
- Process of experimentation: A process of experimentation (e.g., design iterations, simulations, trial and error) must be undertaken in order to resolve the technical uncertainties mentioned above.
Although it may surprise some, the ultimate success or failure of the product or process is irrelevant when qualifying for the credit.
Spending That Qualifies as R&D Expense
The three primary categories of qualified expense that go into the credit calculation are:
- Wages of employees performing, supporting, or supervising R&D work.
- Outside contractors used in the performance of R&D work.
- Materials and supplies used in the R&D process.
Who can claim the payroll tax offset?
The election is available to taxpayers in any industry and to all entity types (other than tax-exempt entities) that meet the qualified small business (QSB) criteria. A QSB is a taxpayer that incurs qualified R&D expenses (as outlined above), and:
- Has less than $5 million in gross receipts for the tax year in which the R&D credit is being claimed and
- Has not earned gross receipts for more than four years preceding the credit year.
How much is the payroll tax offset?
A QSB can elect the portion of its R&D credit it wishes to be applied to its payroll tax. However, the amount elected cannot exceed $250,000 for a given tax year.
When can the payroll tax offset be used?
The portion of the R&D credit elected to offset payroll tax will be applied beginning in the first quarter following the quarter in which the QSB’s federal income tax return is filed. So, if an eligible taxpayer files its 2017 income tax return on March 15, 2018, it could start applying the payroll credit on its Form 941 beginning in the second quarter of 2018. Any portion of the elected credit that is not used during the quarter may be carried forward and used in succeeding quarters.
How is the election made?
The election is made on Form 6765, Credit for Increasing Activities, with a timely filed income tax return (including extensions). Thereafter, the payroll credit will be claimed on Form 941. Additionally, a new form (Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities) is now required to be filed with the Form 941.
The Key Takeaway for Start-up Businesses
The new payroll tax credit is a powerful tool in helping incentivize start-ups to innovate and improve their products and processes while improving their cash flows. Considering payroll tends to be the greatest expense for start-ups, the ability to reduce payroll taxes dollar for dollar and reinvest in your company is a major benefit that should not be overlooked.
To discuss this opportunity in more detail, please contact Michael DePrima at email@example.com or 303-740-9400.