Understanding How the R&D Tax Credit Can Offset Payroll Taxes

Start-ups and small businesses customarily incur expenditures that may qualify for Research & Development (R&D) tax credits, but generally, these businesses don’t have the taxable profit needed to take advantage of the credit. Qualifying small businesses can apply all or a portion of this popular credit against their payroll tax liability, including social security taxes. Below we’ve answered some of the key R&D questions and whether your business is eligible for offsetting payroll tax.

Do I qualify for the payroll tax credit?

Businesses with qualifying research activities and expenditures with less than $5 million in gross receipts for the taxable year and have no gross receipts or interest income dating back more than five years can utilize the payroll tax offset.  For example, a taxpayer making this election for 2020 must not have had any gross receipts in a tax year preceding 2016.

What is the benefit of the payroll tax credit?

The maximum benefit a qualifying business can claim against their payroll taxes each year is $250,000, with a maximum of $1.25 million over five years.

What are qualifying R&D activities?

A company’s activities must pass what is known as the four-part test to be eligible for R&D credits:

  • Elimination of uncertainty – a demonstration that an attempt has been made to eliminate uncertainty in the development or improvement of your product or process.
  • Process of experimentation –  activities such as modeling, simulation, systematic trial, and error demonstrate a process to address uncertainty in your product development.
  • Technological in nature – This experimentation process must rely on hard science, such as engineering, physics, biology, chemistry, or computer science.
  • Qualified purpose – Research must be for the purpose of creating a new or improved product or process that results in increased performance, function, reliability, or quality.

What costs are eligible under R&D?

Eligible R&D costs include wages, supplies, contract research, and rental or lease of computers. Taxable wages would apply to employees who provide direct supervision of the research. Supplies used in the research would include extraordinary utilities but not administrative supplies. Contract research would apply to any subcontractor expenses, including labor, services, and research. Lastly, payments were made for computers and server space for hosting software under development.

When do I claim the payroll tax credit?

You can begin to benefit from the payroll tax credit in the first calendar quarter after filing your income tax return.

For example, companies need to file their federal income tax returns by March 30 to apply the payroll tax credit to the second quarter. As a result, the earliest taxpayers are likely to see a benefit in July, when they file their quarterly payroll tax returns for the second quarter (Form 941).  If you extend your income tax return, you’ll be able to take advantage of the credit in the quarter after you file your federal return: file the return by June 30; take credit on the October 31, Form 941 filing; file return by September 30; and take credit on January 31, Form 941 filing.

To better understand the R&D tax benefits, work with your accountant to research approved activities and expenditures your business may incur through research.