Don’t Miss This Payroll Tax Break for R&D Expenses

Normally, businesses may claim the research and development (R&D) credit for qualified expenses to offset their annual income tax liability. This credit can benefit well-established business operations generating millions — or even billions — of dollars a year. But what about smaller companies? A tax return election that helps small and midsized businesses has largely flown under the radar.

This R&D credit was authorized by the Protecting Americans from Tax Hikes (PATH) Act of 2015 (and took effect in 2016). It offsets payroll taxes and can represent sizable savings for eligible companies.

A Closer Look

The R&D credit had expired and been reinstated several times before the PATH Act made it permanent. Generally, the credit equals the sum of:

• 20% of the excess of qualified research expenses for a year over a base amount,
• 20% of the basic research payments (known as the university basic research credit), and
• 20% of the qualified energy research expenses undertaken by an energy research consortium.

For this equation, the base amount is a fixed-base percentage (not to exceed 16%) of average annual receipts from a U.S. trade or business, net of returns and allowances, for the four years prior to the year of claiming the credit. The credit can't be less than 50% of the annual qualified research expenses. In other words, the minimum credit is equal to 10% of qualified research expenses (50% x 20% credit).

Alternatively, a business could use a simplified credit. This is equal to 14% of the amount by which qualified expenses exceed 50% of the business's average qualified expenses for the three preceding tax years.

Three Requirements

The R&D credit is only available for qualified expenses that meet three requirements:

1. It meets the definition of a research and experimentation expenditure under Section 174 of the tax code,
2. It relates to research performed to discover information that's technological in nature, and the application of it is intended to be useful in developing a new or improved business component, and
3. Substantially all of the activities of the research constitute elements of a process of experimentation that relates to new or improved functionality, performance, reliability or quality.

Special Election

Under the PATH Act, a special election can be claimed by businesses against as much as $250,000 of payroll taxes if they have less than $5 million in gross receipts over the last five years and no gross receipts before the five-year period. Essentially, it's applicable to startups or young businesses. The credit amount is applied against the Social Security tax component of payroll tax owed by an employer. For 2021, the employer's share of Social Security tax is equal to 6.2% of each employee's wages up to a "wage base" of $142,800.

Shortly after the PATH Act created this tax break, the IRS issued Notice 2017-23 with guidance. Among other aspects, the Notice provides several clarifications:

• Only certain "gross receipts" qualify for the election. Amounts that can't be excluded relate to returns or allowances, receipts from the sale or exchange of capital assets under Section 1221, repayments of loans or similar instruments and returns from a sale or exchange not in the ordinary course of business.
• To make a payroll tax credit election, the IRS requires a qualified small business to attach a completed Form 6765 to a timely return for the appropriate tax years.
• Interim relief is available for qualified small businesses that filed returns for tax years after 2015 in a timely fashion but failed to make the payroll tax credit election.

Furthermore, the Notice states that qualified small businesses can claim the credit for the first calendar quarter beginning after the business makes the election by filing Form 6765. Similarly, if a business files annual employment tax returns, it may claim the credit for the return including the first quarter beginning after the date on which it files the election. A completed Form 8974 must be attached to the quarterly return.

Form 8974 applies the Social Security tax limit to the payroll tax credit (as elected on Form 6765) to determine the amount of the credit the business can claim on its quarterly employment tax return. If the payroll tax credit elected exceeds the employer's share of the Social Security tax for that quarter, the excess determined on Form 8974 is carried over to the next quarter, subject to the applicable Social Security tax limit.

Leave it to the Professionals

It's enough to know that the R&D tax election may be available to offset your business's payroll taxes. Calculating the actual credit, on the other hand, is usually best left to tax professionals. Contact us for help.