Many smaller businesses that engage in research and development (R&D) haven’t been able to use the research tax credit because they pay little or nothing in income tax. That’s changed. In March 2017, the IRS issued guidance (Notice 2017-23) that provides information on the ways eligible small businesses can take advantage of this valuable credit. Rather than applying it against their income tax liability, they are able to apply the research tax credit against the employer’s portion of Social Security (or payroll) tax. This change stems from the Protecting Americans from Tax Hikes (PATH) Act, which was enacted in 2015.
How do you qualify?
To qualify, a business must have generated less than $5 million in gross receipts for the year it’s claiming the credit. In addition, it can’t have generated gross receipts for more than five years before the year in which it’s claiming the credit — though the business can have been in existence before that. Similarly, the payroll tax credit itself can be used for five years. Of course, the business also must have qualifying research activities. Please note that for members of a controlled group the aggregate gross receipts of all members must be taken into account.
The amount of the credit is based on the company’s eligible R&D expenses. This can include wages, materials and supplies, the cost of leased computer time, and some expenses related to contract research.
To qualify for the credit, the research generally must do the following:
- Involve activities incurred in connection with the company’s trade or business and represent research and development costs in the “experimental or laboratory sense.” That is, the activities are intended to eliminate uncertainty concerning the development or improvement of a product.
- Seek to discover information that is technological in nature.
- Strive to gain new technical knowledge useful in developing a new or improved “business component,” such as a product, process, computer software technique, formula or invention that will be sold, leased, licensed or used by the firm performing the research.
- Entail a process of experimentation aimed at developing a product or process with “a new or improved function, performance, reliability or quality.”
The research typically satisfies these four criteria if it’s intended to develop a new or improved function for a business component or to improve its performance, reliability or quality. In contrast, research undertaken to modify the style or cosmetic design of a component usually won’t qualify.
What’s the amount?
The payroll tax credit can’t exceed the lesser of $250,000 or the business’s calculated research credit. If the credit exceeds the business’s payroll tax liability, the excess can be carried forward. Note that, for qualifying small businesses other than partnerships or S corporations, the payroll tax credit is limited to the amount of the business credit carryforward.
The credit itself can be calculated in different ways, some of which get rather involved. Businesses that had no qualified research expenses in any one of the three previous years can use the simplest calculation. That is, they can take 6% of such expenses for the tax year in which they’re claiming the credit.
Another method is the alternative simplified credit. This equals 14% of qualifying research expenses for the year, above 50% of the average qualified research expenses for the three preceding tax years.
Finally, the credit can be 20% of any excess of qualified research expenses for the tax year over a base amount that’s calculated separately. In addition, businesses that contract with some nonprofit organizations, such as universities, can claim payments for qualified basic research above a base amount. Similarly, they may claim a tax credit of 20% of expenditures on qualified energy research done by some entities.
Claiming the credit
To claim the research and development credit, businesses must complete Form 6765, “Credit for Increasing Research Activities,” and attach it to their income tax returns.
The payroll tax credit can be used on a quarterly basis, starting in the first calendar quarter beginning after the business filed its federal income tax return and elected to take the payroll tax credit. Businesses claiming the credit on their employment tax returns must complete Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities.” They’ll also attach this to their employment tax returns.
The rules differ slightly for 2016. If a business failed to claim the payroll tax credit on its return, it can do so by filing an amended return by the end of 2017. The business must either indicate at the top of its Form 6765 that the form is filed “pursuant to Notice 2017-23” or attach a statement to Form 6765 indicating the form is filed pursuant to Notice 2017-23.
How do you benefit?
The PATH Act also made the research credit permanent. And some small businesses will be able to use the credit — even if they’re not profitable. Your accounting professional can help you determine if your company would benefit from applying the R&D credit against its payroll tax liability.