Using the R&D Credit to Offset Employer Payroll Tax Obligations

You don’t have to be a large or established company to realize the credit.

By Jason Jones

Key Takeaways

• Qualified small businesses can now leverage the R&D Tax Credits to offset employer-side payroll tax obligations.
• Three factors determine whether your company is considered a Qualified Small Business and thus, eligible to make the payroll tax election.
• Make sure you have an experienced partner to guide you through the R&D tax credit process.

The Research and Development (R&D) Tax Credit, introduced in 1981, has been a highly beneficial incentive for many companies over the years. But, until recently, the R&D Credit was only available to larger, more established organizations that had actual income tax liability.

Thanks to the Protecting Americans from Tax Hikes (PATH) Act of 2015, however, qualified small businesses can also take advantage of the R&D tax credit. If eligible, your company can elect either to offset its income tax obligations, or it can elect to use the credit against the employer portion of its Social Security taxes (OASDI)–up to $250,000 per year (commonly referred to as the “payroll tax offset”).

An employer’s OASDI obligation is 6.2 percent of all employees’ wages up to $132,900 in maximum taxable earnings per employee.

Now more companies than ever can take advantage of the R&D tax credit and realize an immediate cash benefit—even if they don’t have income tax obligations. In order to do so, however, a company must be considered a “Qualified Small Business” as defined by the Internal Revenue Code section on R&D Tax Credits (I.R.C. §41(h)(3)(A)).

For more information about qualifying for the R&D credit, see my colleague Chris Bird’s recent post The R&D Tax Credit: Not Just for Engineers and Tech Startups

In order to meet the standard and make the payroll tax election, a company must meet three important criteria below:

1. A company must have no more than $5 million in gross receipts in the tax year of filing.
2. A company must have no gross receipts for any taxable year preceding the five-taxable-year period ending with the current taxable year—i.e. the company must be less than five years old.
3. The payroll tax election must be made on a timely filed tax return–it cannot be made on an amended tax return.

Example

A three-year-old venture capital backed software company has not yet released its product, so it has no gross receipts. The young company is incurring $1 million a year in qualified research expenses and has $1.5 million in total taxable wages for its employees. This means its payroll tax obligation (at 6.2%) is roughly $93,000 per year.

Prior to 2016, if this company chose to generate its R&D tax credit, it would have to take advantage of the carry-forward option and apply those savings toward future income tax obligations. Under the new rules, however, because the R&D tax credit typically runs 6% to 10% of qualified expenses, they can take their estimated $60,000 to $100,000 R&D tax credit and offset their payroll tax obligations.

Mechanics of the Payroll Tax Offset

Once a company has gone through an R&D tax credit study and made its payroll tax election, a few moving parts must be coordinated before it can receive the benefit (see below). In terms of timing, a company can begin receiving the benefit in the quarter after it files its tax returns. S-Corps, LLCs and partnerships that timely file by March 15th, can begin receiving its offset in the second quarter of the filing year.

C-corps that timely file by April 15th can begin receiving their offset in the third quarter. For extenders and companies that don’t follow a year-end calendar, the quarter to be eligible for the offset will vary based on their filing deadline.

Each quarter, the company (usually via its payroll provider) must file a Form 941 with the IRS that outlines its payroll information, including taxes. Companies that have generated an R&D tax credit and are electing to offset payroll obligations must also file a Form 8974 along with their Form 941. Once this has been done, there are two ways to realize the payroll tax offset benefit:

1. Generally, the notation of the credit on the Form 941 along with the attached Form 8974 will trigger the IRS to issue the company a refund check (usually within 8 to 10 weeks of the end of the quarter).
2. Alternatively, for companies more focused on cashflow, many payroll providers will allow the company to claim the credit in “real time” and will deduct the available credit from payroll during processing of each payroll cycle.

There are many factors at play in navigating these choices and Tri-Merit has worked with several companies and their payroll providers to achieve the best tax credit solution.

Conclusion

Using the R&D credit to offset employer payroll tax obligations has enabled several start-up ventures and otherwise qualified companies to realize the benefit of doing an R&D tax credit study.

Tri-Merit Specialty Tax Services has extensive experience working with companies to leverage these and other tax saving opportunities. If you or your clients have questions about qualifying for R&D tax credits, don’t hesitate to contact us.

Jason Jones is a Director at Tri-Merit, a professional services firm specializing in the calculation, documentation, and substantiation of R&D tax credits and other specialty tax services for companies of all sizes and across all industries. The firm’s partners conduct training at CPA firms across the country and speak often at accounting industry trade shows and conferences to help educate the profession. Contact Jason at jason.jones@tri-merit.com or 847 637 5677 x135.