With the new provision enacted in the PATH Act of 2015 (which addressed tax extender provisions that had expired in the past year), the Research & Development (R&D) tax became more of an option for small businesses in the process of developing a new product or service.
This expansion of Internal Revenue Code Section 41, also known as the R&D Tax Credit, became permanent and enables qualified small businesses (see the definition below) to offset their payroll tax obligations when there isn’t sufficient taxable income to utilize their R&D credit against income tax.
Why would taxpayers consider using their R&D credit against payroll taxes of just 6.2% instead of against their income taxes, which are much higher, ranging from 15% to 36%?
What you need to know
The R&D Credit gives you a dollar for dollar credit against your taxes. However, you must monetize this credit before it expires. By monetize, I mean actually collecting the tax offset from the Federal Government in the form of reduced taxes or a tax refund in the case of a carryback or prior return amendment.
But, there are some restrictions on timing for collecting on this benefit that you need to keep in mind. A general business credit, which this is, can be carried back one year or carried forward for 20 years. Most startup companies may also have net operating losses (NOL) in the first few years of operations, and these NOLs can be carried back two years or carried forward for 20 years. Startup businesses with significant R&D expenditures may find it more beneficial from a cash flow perspective to utilize the R&D Credit against payroll taxes instead of waiting to be able to use them against income tax in later years.
Let’s say that you have a new technology company that requires skilled labor to develop your product. That labor is expensive and to pay for it, you will require business capital or debt financing in your early stages of operation. So, although the R&D credit could be used several years down the road to offset your income taxes, it could also be used now during the loss years to ease the burden of paying the required payroll taxes.
Is your company eligible?
A qualifying small business may apply up to $250,000 of a qualified R&D Credit to their payroll tax in any given tax year. For the purposes of this election, a qualified small business is a partnership or a corporation (including S corporations) with gross receipts of less than $5 Million during the year of election and no gross receipts in any tax year preceding the five-tax-year period that ends with the tax year of the election.
For example, DEF Corporation had $3 Million in gross receipts in 2016. Their gross receipts in previous years were: $10 Million (2015), $8 Million (2014), $4 Million (2013) and $6 Million (2012). They had zero receipts in 2011 and in previous tax years. Even though DEF Corporation had receipts exceeding $5 Million in previous years, in 2016—the year of election—it had less than $5 Million in receipts, and it had no gross receipts in 2011 or any of the five -tax year period preceding 2012; therefore it is eligible for the election.
Beginning December 31, 2015, this election (i.e. using the R&D Credit against payroll taxes) may be done only five times for any five tax years and on an income tax filed in the year it is due. The application of the R&D Credit against payroll tax can then be used in the first quarter payroll return for the following year.
For example, Company XYZ, a calendar year corporation, will make an election on its 2016 income tax return due March 15, 2017. After that, it can offset the payroll liability computed for its first quarter payroll of 2017, due April 30, 2017. Any unused credit will carry forward to offset subsequent quarter’s payroll taxes for an indefinite period of time. There is no restriction of the time by which you have to use the credit. Once the election is made, it cannot be revoked without IRS approval. Furthermore, any amount elected to offset payroll taxes cannot later be used to offset income tax.
As with any tax credit, there are specific rules regarding the amount of the Credit that can be utilized and when. These restrictions vary depending on the type of taxpayer (i.e. Individual, C Corp, S Corporation or Partnership) and the taxable income the year of election as well as the other general business credits that are available to the taxpayer in any given year.
If you would like more information on how the credit works, here’s a quick video. Also, you can talk to an experienced, trusted tax advisor for help understanding whether or not your business is eligible for the R&D Tax Credit, and if so, how you can best take advantage of it.
McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by putting complex financial data into truly meaningful context. But deeper than dollars and data, our focus is on developing an understanding of you, your culture and your business goals. This approach enables our clients to achieve their greatest potential.