The federal research and development tax credit was finally made permanent in late 2015 under the Protecting Americans from Tax Hikes (PATH) Act. With this legislation, Congress introduced changes to the research credit that are beneficial for taxpayers who previously may not have been able to take advantage of this incentive. For tax years beginning after December 31, 2015, the PATH Act added new Section 41(h) to the Internal Revenue Code, which provides qualified small businesses with a payroll tax offset and allows companies to receive a benefit for their research activities regardless of whether they are profitable.
Generally, many small startups and businesses operate at a loss and are unable to attain a current cash benefit from the federal research credit because the credit could be used only to offset federal income tax liability. With the new payroll tax offset, the R&D tax credit is now available to many small and mid-sized companies that had been effectively barred from using the credit. In 2017, qualified businesses began benefitting from the new payroll tax offset by utilizing 2016 R&D expenditures to offset a portion of their payroll taxes.
Payroll Tax Offset
Under Sections 41(h) and 3111(f) of the Internal Revenue Code, new or small businesses may be eligible to apply up to $250,000 annually of their research credit against the employer’s Social Security portion of their old-age, survivors and disability insurance (OASDI) payroll tax liability. Eligible small businesses can potentially claim the credit for up to five years with a maximum of $1.25 million in total credits claimed on their quarterly payroll tax returns filed with the federal government.
The new payroll tax offset represents a highly beneficial incentive for cash-strapped technology startups, which are typically not taxable and frequently uninterested in long-term carryforwards. Companies may be eligible to apply the R&D tax credit against their payroll tax beginning in the first full quarter after an income tax return is filed with the Section 41(h) election. However, these companies must meet the definition of a “qualified small business.”
On March 28, 2017, the IRS released Notice 2017-23 to provide interim guidance and clarify small business eligibility. The Notice indicates that to be defined as a “qualified small business,” a taxpayer must have (1) gross receipts of less than $5 million in the year in which it seeks to make the election and (2) no gross receipts for any tax year before the five years ending with the election year. As a result, a company that was in existence prior to the five years, but did not have gross receipts, could still qualify. Furthermore, gross receipts of over $5 million for any of the four years prior to the credit years are allowed.
Notice 2017-23 provides the following example to clarify the application of the payroll tax offset:
- Corp A, a calendar-year corporation, is not a tax-exempt organization under Section 501 or a member of a controlled group in taxable year 2016.
- Corp A has gross receipts of $1 million, $7 million, $4 million, $3 million, and $4 million for taxable years 2012, 2013, 2014, 2015, and 2016, respectively.
- Corp A did not have gross receipts for any taxable year prior to 2012.
- Corp A is a qualified small business for taxable year 2016 because it has less than $5,000,000 in gross receipts for taxable year 2016 and did not have gross receipts before taxable year 2012 (before the five-taxable-year period ending with 2016).
- Corp A’s gross receipts in taxable years 2012-2015 are not relevant in determining whether Corp A is a qualified small business in taxable year 2016.
- Because Corp A had gross receipts in taxable year 2012, Corp A is not a qualified small business in taxable year 2017, regardless of its gross receipts in 2017.
The Notice clarifies that “gross receipts” include total sales, net of returns and allowances, all amounts received for services, and any income from investments and other incidental or outside sources. This inclusive definition means that taxpayers with even small amounts of investment income or interest prior to 2012, if the tax year is 2016, may not elect the payroll offset. This is significant because it limits taxpayer eligibility, specifically for companies that had been in existence prior to 2012.
Payroll Tax Offset — Controlled Groups
Notice 2017-23 provides guidance for members of a controlled group regarding aggregation and allocation of the benefit. All members of a controlled group or a group of trades or businesses under common control, as defined in Section 1.41-6(a)(3)(ii), are treated as a single taxpayer. The aggregate gross receipts of all members of a controlled group for the taxable year must be considered when determining whether the requirements of the Notice are satisfied.
The special rules for consolidated groups would require each taxpayer to consider all related parties (foreign and domestic) that fit the ownership requirements for purposes of applying the gross receipts measurement. This could potentially limit the applicability of the payroll tax credit election for some taxpayers.
What Forms Are Required to Claim the Payroll Tax Offset for R&D?
- Form 6765, Credit for Increasing Research Activities with 41(h) and 280C elections. Note that for purposes of the payroll tax offset, the taxpayer will not want to choose the 280(C) election on Form 6765.
- Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities
- Form 941, Employer’s Quarterly Federal Tax Return
- Forms 6765 and 8974 must accompany Form 941
The portion of the R&D credit that is applied to offset payroll taxes needs to be identified and elected when the tax return is filed. The payroll tax offset is available on a quarterly basis beginning the first calendar quarter that begins after a taxpayer files their federal income tax return.
Taxpayers have the option of making a reduced credit election under Section 280C(c)(3) in lieu of adding their research credit back to taxable income in the form of a reduced Section 174 deduction. This is important because if the 280C reduced credit election is made before the 41(h) election, taxpayers will be denied the full value of their $250,000 credit against OASDI payroll tax liability. For purposes of Section 41(h), the payroll tax offset is allowed before the election, so most taxpayers should not elect 280C when claiming the payroll tax offset.
Notice 2017-23 further explains that if the R&D tax credit exceeds the payroll tax due on a quarterly filing, the excess may be carried over to succeeding calendar quarters until the credit is used or the $250,000 limit is reached. In addition, the Notice enables taxpayers who failed to elect the payroll offset on their original returns for 2016 to take advantage of the provision by filing an amended return on or before December 31, 2017.
Professional Employer Organizations
Many companies use a professional employer organization (PEO) to streamline their payroll function. The IRS created a voluntary certification program for PEOs and provides guidance stating that once certified, PEOs may process the payroll offset claims for their clients. It is important to note that it is the company conducting qualified research, and not the PEO, that receives the payroll offset.
Alternative Minimum Tax
As part of the PATH Act, Section 38(c)(4)(B) was amended to allow “eligible small businesses” to use their research credit as a “specified credit” to offset Alternative Minimum Tax (AMT). Under this legislation, the research credit is now available to taxpayers falling under the AMT regime. Generally, the amount of R&D credit taxpayers can claim in any given year is limited by the amount of tentative minimum tax they owe. However, the PATH Act permits eligible small businesses to use credits to fully offset their tax liability without regard to the tentative minimum tax.
To be considered an eligible small business, a taxpayer must be a non-publicly traded corporation, partnership or sole proprietorship, and cannot have average annual gross receipts in the three preceding tax years in excess of $50 million. The credit amount is limited to 25 percent of the taxpayer’s net regular tax liability in excess of $25,000. As a result, taxpayers will not be able to take their tax liability all the way down to zero.
Non-taxable startups are typically not concerned about a 20-year carryforward that might never result in cash tax savings. However, deducting $250,000 of payroll tax liability beginning with the 2016 tax year is a different story. Section 41(h) provides a clear benefit to startups founded within the last five or six years that otherwise might not be able to take advantage of — or perhaps see any value in claiming — the R&D tax credit.
The new AMT offset rules under Section 41(h) provide relief for slightly more mature startups, small to mid-sized companies, and owners of passthrough entities that, but for the AMT regime, might not otherwise be taxable.
Companies that can claim the payroll and AMT offset come from a variety of industries, all of which are designing new products or making incremental improvements. These industries include the biotech, chemistry, agriculture, technology, software, manufacturing, wine, oil & gas, aerospace subcontracting, pharmaceutical, and pre-release medical device industries. This credit provides a cash benefit that should be claimed by every eligible company.
Alvarez & Marsal Taxand Says:
With the new interim guidance, taxpayers have more certainty in electing R&D tax credits to offset their payroll tax starting in 2017. However, issues such as timely filing and the precise definition of gross receipts contribute to uncertainty with respect to successfully claiming the R&D benefits provided by the PATH Act. Taxpayers that are considering claiming these credits should carefully consider timely filing (i.e., file by the end of the quarter). Due to Social Security tax limitations, most companies pay a greater amount of tax in their earlier quarters than later ones. Therefore, the smaller the company (i.e., the smaller its annual payroll), the quicker that company must file its returns in order to obtain the full $250,000 benefit in a given year.
Although the law is intended to benefit small businesses, larger businesses could potentially benefit under the rules as they are currently written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives U.S. Food and Drug Administration approval. If you think your company might be performing work that qualifies for the R&D tax credit, don’t let the potential tax savings go unclaimed.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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