The tax credit for increasing research activities, often referred to as the research and development (R&D) credit, offers a valuable incentive to eligible businesses.
In addition to the credit itself, there are two features especially favorable to small businesses:
- Businesses with $50 million or less in gross receipts may claim the credit against their alternative minimum tax (AMT) liability.
- The credit can be used by certain smaller startup businesses against the employer’s Social Security and Medicare payroll tax liabilities.
Let’s look at the second feature. Subject to limits, you can elect to apply all or some of any research tax credit against your payroll taxes instead of your income tax. This payroll tax election may influence your decision to undertake or increase your research activities.
Why the Election Is Important
Many new businesses, even if they have some cash flow, net positive cash flow, or a book profit, pay no income taxes and won’t for some time. In these cases, there’s no amount against which business credits, including the research credit, could be applied.
On the other hand, every wage-paying business has payroll tax liabilities.
Therefore, the payroll tax election is an opportunity to get immediate use out of the research credits you earn. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in a company’s start-up phase.
Eligible Businesses
To qualify for the election, a taxpayer must:
- Have gross receipts for the election year of less than $5 million, and;
- Be no more than five years (or tax periods) past the period for which it had no receipts (the start-up period).
In making these determinations, the only gross receipts that an individual taxpayer considers are from the individual’s businesses. An individual’s salary, investment income, or other income aren’t considered. Also, note that an entity or individual can’t make the election for more than five taxable periods in a row.
Limits on the Election
The election must be made on a live, timely-filed return (including extensions), not on an amended or late filing. The credit can then be claimed on the payroll filing starting the quarter after the tax return is filed. If a taxpayer filed their 2022 return on April 15, 2023 (during Q2), they could start using the amounts in Q3 2023.
Starting with the 2023 tax year, limits on the amount of research credit for which the election can be made can’t exceed $500,000, doubling the $250,000 limit in place before 2023. The payroll tax offset can be elected in any amount up to the amount of total credits generated or the statutory maximum.
Another change that started in 2023 is that the research credit for which the taxpayer makes the payroll tax election can be applied to the employer side of Social Security and Medicare, not just the Social Security portion of FICA taxes.
The above are just the basics of the R&D payroll tax election. Keep in mind that identifying and substantiating expenses eligible for the research credit itself is a complex area. Contact us about whether you can benefit from the payroll tax election and the research tax credit.
