If a business dedicates resources to creating or improving products, processes or software, it may be eligible for substantial federal tax credits for “increasing research activities.” There’s just one catch: To enjoy the benefits, the company must have sufficient federal tax liability against which to offset the credit. Historically, that meant income tax liability, but qualifying small businesses may now elect to apply some or all of their research credit against up to $250,000 in payroll taxes. This article details how to claim a research payroll tax credit. A sidebar explains how a business can claim the credit on their 2016 return.
If your business dedicates resources to creating or improving products, processes or software, it may be eligible for substantial federal tax credits for “increasing research activities.” There’s just one catch: To enjoy the benefits, you must have sufficient federal tax liability against which to offset the credit. Historically, that meant income tax liability, but qualifying small businesses may now elect to apply some or all of their research credit against up to $250,000 in payroll taxes.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 not only made the research credit permanent but created the payroll tax election for the research credit (often referred to as the “research and development,” “R&D” or “research and experimentation” credit). IRS Notice 2017-23 provides interim guidance on claiming research credits against payroll taxes.
In addition to clarifying the eligibility requirements and outlining the procedures for making the election, the IRS allows companies that failed to make the payroll tax credit election on their 2016 return to take advantage of the credit by filing an amended return on or before December 31, 2017. (See “Not too late for 2016.”)
Is your business eligible?
Research payroll tax credits are intended to provide relief to smaller businesses, particularly start-ups, which often invest heavily in research and development but have little or no income tax liability. Although unused credits may be carried forward up to 20 years, payroll tax credits allow these businesses to enjoy the benefits of research credits when they need them most, rather than wait until they begin to generate taxable income.
The PATH Act makes payroll tax credits available to “qualified small businesses,” defined as those with 1) less than $5 million in gross receipts in the current taxable year, and 2) no gross receipts for any taxable year preceding the five-taxableyear period ending with the current taxable year. (For example, a business making the payroll tax credit election for 2017 must not have had any gross receipts before 2013.)
Notice 2017-23 clarifies that, for purposes of determining whether a corporation (including an S corporation) or partnership (including a limited liability company taxed as a partnership) is a qualified small business, gross receipts include:
- Total sales, net of returns and allowances,
- All amounts received for services, and
- Income from investments and other incidental or outside sources.
For businesses other than corporations and partnerships, gross receipts include all of a person’s aggregate gross receipts from all trades or businesses.
The IRS doesn’t, as many had hoped, establish a “de minimis” test for gross receipts. So, unless the IRS provides additional guidance, a business with minimal gross receipts prior to the five-year period — even a small amount of bank interest — is ineligible.
The IRS also requires members of a controlled group, or a group of businesses under common control, to aggregate their gross receipts for purposes of the $5 million threshold.
How to claim payroll tax credits
To take advantage of payroll tax credits, you must make the election by filing Form 6765, “Credit for Increasing Research Activities,” with your timely filed business income tax return. You may elect to apply some or all of your research credit against the employer portion of Social Security taxes.
After you make the election, you may use your research credit to offset payroll taxes on a quarterly basis, starting with the first calendar quarter that begins after you file your federal income tax return. To claim the credit, you must file Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities,” with your Form 941, “Employer’s Quarterly Federal Tax Return,” for that quarter.
The maximum payroll tax credit is $250,000 per year (with special rules for allocating that amount among members of a controlled group). In addition, you may not make a payroll tax credit election in more than five tax years. To the extent that your credit exceeds your Social Security tax liability in a given calendar quarter, you may carry the excess forward and use it as a credit against Social Security tax in the succeeding calendar quarter (subject to the annual five-tax-year limits).
The payroll tax credit is a valuable tax break for businesses that wouldn’t otherwise benefit currently from the research credit. The IRS may provide additional guidance that affects your eligibility for the credit, so be sure to monitor future guidance on the subject.
Sidebar: Not too late for 2016
If your business didn’t make a payroll tax credit election on its 2016 return, it’s not too late. But you need to act quickly. IRS Notice 2017-23 offers relief to qualified small businesses that filed their 2016 returns on time but didn’t make the election, provided they make the election on an amended return filed on or before December 31, 2017. (Because December 31 falls on a weekend and January 1 is a federal holiday, an amended return filed on January 2, 2018, will be considered timely.)
To qualify for the extension, your business must include Form 6765, “Credit for Increasing Research Activities,” with its amended return and either 1) indicate at the top of the form that it is “FILED PURSUANT TO NOTICE 2017-23,” or 2) attach a statement to Form 6765 that the form is filed according to Notice 2017-23.