Research & Development Credit – Payroll Tax Offset for Qualified Businesses

The Inflation Reduction Act (IRA), which President Biden signed into law on Aug. 16, 2022, doubles the federal research and development (R&D) credit payroll tax offset for qualified small businesses.

Under prior law, small business startups were permitted to use their qualified R&D credits to offset the 6.2% employer portion of Social Security payroll tax liability, up to $250,000. The IRA doubles this payroll tax offset limit to $500,000, providing an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax liability. This payroll tax election may especially benefit eligible startup businesses that have little or no income tax liability by allowing them to receive a more immediate cash tax benefit from their R&D credit.

Changes in 2023

The IRA enacts the change to the R&D credit for taxable years beginning after Dec. 31, 2022, which will have the effect of increasing the amount of payroll tax offset available on 2023 federal returns and onwards.

Eligibility Requirements for the R&D Payroll Credit

The R&D credit offset of payroll tax liability is often overlooked by small businesses that have little or no income tax liability. However, it is a significant opportunity for taxpayers that meet the definition of a “qualified small business” (QSB). Specifically, a QSB is defined under Internal Revenue Code Section 41(h)(3) as a trade or business (partnership, corporation or person) that:

1. Is no more than five years past the period for which it had no gross receipts; and
2. And has gross receipts for the election year of less than $5 million.

A QSB’s payroll tax offset can apply against a QSB’s liability for the employer portion of social security tax of FICA (6.2%), also called Old Age, Survivors and Disability Insurance (OASDI) (up to $250,000) and Medicare tax (up to $250,000), as imposed by Section 3111(a) and (b). However, QSBs may not use the payroll tax offset against any other employment tax liability and is non-refundable. Any unused credits can be carried forward to the next year, i.e., where the payroll tax credit determined on Forms 8974 and credited on Form 941 exceeds the employer portion of the OASDI tax for a quarter, the excess is carried over to the next calendar quarter(s) subject to the same limitations for the subsequent quarter(s). How to claim the Payroll Tax Credit:

1. Complete Federal Form 6765 (Credit for Increasing Research Activities) on the income tax return.
2. In Section D (on Form 6765), elect the payroll tax credit option and chose what amount of the credit you would like to offset payroll taxes. Note: you can elect to have some of the R&D credit offset any income tax liability due for that tax year.
3. Taxpayer timely files their income tax return (including any extension).
4. The next calendar quarter, the taxpayer can start reducing their payroll tax payment by the amount of the credit when they file Form 941 “Employer’s Quarterly Federal Tax Return.”
5. All filers completing Section D of Form 6765 transfer the payroll tax credit to line 5 of Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. Part 2 of Form 8974 determines the amount of the payroll tax credit on the Form 6765 that is credited against the taxpayer’s payroll tax for the applicable quarter for which the Form 941, Employer’s Quarterly Federal Tax Return, is filed. Thus, line 6 reduces the amount of credit by the amount claimed in previous quarters, and line 11 reduces the payroll tax to the portion paid by the employer.

Many small businesses and start up companies use a professional employer organization (PEO) for their human resources, payroll, bookkeeping and tax compliance functions (TriNet, Insperity, Oasis Outsourcing, etc.).

Many times, these outsourced companies will actually complete the Form 941 for their clients. In those cases, taxpayers need to check with the PEO to make sure they have the proper certification to claim the payroll tax offset and to make sure they reimburse them for the reduction in payroll taxes due.

R&D credits may offset a company’s payroll taxes no earlier than the first quarter after the company files its tax return reporting its R&D credit. The chart below illustrates this with an example of a QSB that has $500,000 in payroll expenses per quarter, or $2,000,000 in payroll expenses per year. The potential credit benefit increase for the years before and after the enactment of IRA is shown:

As the chart shows, the expanded R&D credit payroll tax offset will provide startup businesses with increased cash savings by maximizing total R&D credit utilization prior to sustaining sufficient taxable income.

Note: Taxpayers should be aware that in some instances it may be more beneficial to compute a gross R&D credit and add back the amount to their deductions rather than compute a net credit under Sec. 280C. This can occur when the net credit does not meet or exceed the cap in place for the payroll credit. Since the maximum will double for tax years beginning after Dec. 31, 2022, more taxpayers may need to evaluate whether forgoing the Sec. 280C election could be more advantageous for federal and state tax purposes.

If you would like to discuss your company’s potential for saving on taxes, contact an Adams Brown advisor.