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

Author: William Cooper, Shareholder

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. The IRS issued guidance earlier this year that explains how qualifying small businesses can now apply all or a portion of the 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 which have less than $5 million in gross receipts for the taxable year and have no gross receipts before 2012 can utilize the payroll tax offset.

What is the benefit of the payroll tax credit?

The maximum benefit a qualifying business is allowed to 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 – 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 made for computers and server space for hosting software under development.

It’s important to note, if you didn’t file for R&D tax credit on your 2016 return, you can still conduct an audit of 2016 R&D expenses and file an amended return by December 31, 2017. You must file the credit on your return before you can begin recognizing the offset on your payroll taxes. To better understand the R&D tax benefits work with your accountant to research approved activities and expenditures your business may incur through research.