Startups Rejoice! R&D credits now offset payroll taxes:
Historically, startups that were not paying federal income taxes could claim R&D Tax Credits, but would need to carry them forward on their corporate and/or shareholder returns until they could offset their income tax liabilities (aka until they were profitable in the eyes of tax authorities). But now small businesses can apply the R&D tax credit against their payroll tax as well!
The R&D credit was permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. With that change came additional enhancements in 2016, including offsets to alternative minimum tax and payroll tax for eligible businesses. The credit is still based on credit-eligible R&D expenses, but offsets apply to only costs incurred beginning in 2016. The new payroll tax offset allows companies to receive a benefit for their research activities regardless of profitability. The maximum benefit an eligible company can claim against payroll taxes each year under the new law is $250,000.
The new payroll tax offset is exclusively available to companies that have:
- Gross receipts for five years or less (A company isn’t eligible if it generated gross receipts prior to 2012.)
- An average of $5 million in gross receipts or less within the last five years
- Qualifying research activities and expenditures
Understanding the New R&D Tax Credit Benefits
When does the new payroll tax offset take effect?
The payroll tax offset will be available for qualified expenses incurred in 2016. The credit must be calculated and shown on a taxpayer’s 2016 federal income tax return, and the portion of the R&D credit that will be applied to offset payroll taxes will need to be identified and elected when that return is filed in 2017.
The payroll tax offset will be available on a quarterly basis beginning in the first calendar quarter that begins after a taxpayer files their federal income tax return. Taxpayers would need to file their 2016 federal income tax returns by March 30, 2017, to apply the payroll tax offset to the second quarter. As a result, the earliest taxpayers are likely to see a benefit is July 2017, when they file their quarterly payroll tax returns for the second quarter (Form 941).
How quickly does a company need to move on this?
Because the opportunity to offset payroll taxes is based on 2016 expenses, companies should act quickly to determine their eligibility under the new rules. It’s best to start planning in the current year so you’ll know what types of information you will need to gather at the end of the year. Once more, under the current rules, taxpayers won’t be able to take advantage of this opportunity on an amended return. This means the credit must be specified, elected, and filed on the original 2016 tax return before you can begin to offset payroll taxes in 2017.
What companies qualify?
The new payroll tax offset is available only to companies that have gross receipts for five years or less, so a company is not eligible if it generated gross receipts prior to 2012. Additionally, the company must have less than $5 million in gross receipts in 2016 and for each subsequent year that the credit is elected. The company must also have qualifying activities and research expenditures to be eligible. Each of these requirements is further clarified below:
How the IRS defines having gross receipts for five years or less:
The new payroll tax offset is only available to companies that have gross receipts for five years or less, so a company isn’t eligible if it generated gross receipts prior to 2012. However, a company that existed prior to 2012 but didn’t receive gross receipts could still qualify.
Although the law is intended to benefit small businesses, larger businesses could also benefit from the rules as they’re written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives U.S. Food and Drug Administration approval.
How the IRS defines $5 million in gross receipts:
A company must have less than $5 million in annual gross receipts in 2016 to be eligible. For businesses that are just starting in 2016, their gross receipts must fall under the $5 million limit after being annualized for a full 12 months. The gross receipts of businesses that are related or share common ownership will need to be calculated on a combined basis to determine eligibility.
Gross receipts are generally characterized as those reported on Line 1c of the company’s federal income tax return; however, the IRS and Treasury Department have been instructed to create new regulations that should provide further guidance on the definition of gross receipts for purposes of the payroll tax offset as well as the overall implementation of the credit.
Although the gross receipts limitation helps to define a company’s eligibility, it’s important to note that the R&D credit itself isn’t based on gross receipts. The actual credit is based on the company’s eligible R&D expenses.
How do businesses benefit from this credit?
Brand new businesses could potentially claim the credit for up to five years with a maximum of $1.25 million in total credits claimed on their quarterly payroll tax returns filed with the federal government.
For example, a company with $500,000 of eligible expenses—let’s say for software engineering costs—could credit $50,000 or more, while a company with over $2.5 million in eligible expenses in 2016 could have a credit subject to the full $250,000 annual limitation. If the credit amount exceeds a company’s social security tax (OASDI tax) liability in any given quarter, the excess will be carried forward to the next calendar quarter.
Social Security Tax:
Companies are required to pay Social Security tax of 6.2%on up to $118,500 of each employee’s salary in 2016. This means a company that employs 50 employees with an average annual salary of $75,000 per person would pay approximately $232,500 in Social Security payroll taxes in 2016. Because the credit can only be applied to the employer’s Social Security portion of payroll taxes, they would need to have more than $4 million in annual payroll social security taxes and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year.
Most employers are required to deposit their payroll taxes to the federal government on a monthly or semiweekly basis and also file a quarterly payroll tax return (Form 941). The credit will be applied against the Social Security tax on the quarterly return, not when payroll taxes are deposited. It’s important to note, however, that the IRS is still formulating a plan for how the process will be formally implemented.
Important to note:
While the payroll tax offset may be available to new businesses and startup companies for up to five years, any unused R&D credits that are not elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.
At Indago we help leverage the R&D credits companies are entitled to depending on their tax planning goals. With the launch of this new legislature, we are already seeing unprofitable companies with over $4 million in payroll planning to take advantage of both avenues.