Start-up companies will soon begin to realize one of the more significant tax law changes under the 2015 Protecting Americans from Tax Hikes (“PATH”) Act: a credit against payroll tax liability. Any start-up entity with R&D activities should immediately analyze this tax incentive.
Since the inception of the research and development (“R&D”) tax credit in 1981, critics of the credit have argued that a credit aimed at incentivizing innovation provided little benefit to the true innovators in the marketplace. Most start-up companies operate at a net operating loss for several years before generating a taxable profit. As a result, the R&D tax credit has not provided these companies with immediate tax savings. The only value the credit has provided such companies is a credit carryforward against future taxable income. Due to the effort required to calculate and document the credit, many start-up companies have not claimed the credit.
However, for tax years beginning after December 31, 2015, a qualified small business that generates an R&D tax credit can make an election to utilize the credit against its payroll tax liability. Consequently, start-up companies with R&D activities should immediately reanalyze the R&D tax credit opportunity.
More Than a Tax Credit
Payroll tax liability is generally an operating expense included in a company’s SG&A expense. Consequently, the ability to utilize the credit against payroll tax expense will decrease operating expenses and improve the company’s cash position. This will benefit companies focused on attracting investment from outside sources who focus on a company’s cash-flow position.
The Internal Revenue Code (“IRC”) defines a “qualified small businesses” as a corporation, partnership, or person with current tax year gross receipts of less than $5M, and no gross receipts for any taxable year preceding the five-taxable-year period ending in the applicable tax year. Therefore, if a company’s 2016 tax year gross receipts were below $5M, and it did not generate gross receipts prior to 2012 (assuming no intermediate short tax years), it constitutes a “qualified small business”.
The maximum credit a taxpayer can elect to claim against its payroll tax liability is $250,000. All persons or entities treated as a single taxpayer under IRC § 41(f)(1) shall be treated as a single taxpayer for purposes of the maximum credit. Each of the persons treated as a single taxpayer may make the election separately. The $250,000 maximum credit is allocated to each of the persons treated as a single taxpayer on a proportionate basis to its share of the aggregate qualified research expenses.
The credit utilization will be allowed against the payroll tax to be paid in the first calendar quarter which begins after the date on which the taxpayer files its federal income tax return. The R&D tax credit will offset the employer portion of the OASDI element of the FICA excise tax imposed by IRC § 3111(a). The credit can be used against the calculated excise tax based on the wages paid with respect to the employment of all employees, not just those involved in R&D. Excess credit not utilized in that quarter will carry forward to the next quarter.
The credit will not affect any deduction a taxpayer may claim for the payment of the employer’s portion of the OASDI element of the FICA tax. However, the taxpayer will need to consider the impact of IRC § 280C when calculating the credit.
As an example, Company X qualifies as a qualified small business for the 2016 tax year. During that year, it generated a net operating loss, and thus did not have taxable income. Following an analysis of its R&D activities, it is determined that it incurred $200,000 of qualified research expenses which produce a $13,000 R&D tax credit. On its 2016 tax return filing in Q1 of 2017, Company X elects to utilize all of the calculated R&D tax credit against its payroll tax liability.
In Q2 of 2017, Company X employs 15 employees with an average salary of $50,000. Consequently, Company X’s “employer share” of the OASDI element of the FICA tax for Q2 of 2017 is approximately $11,625. Company X applies its R&D tax credit against this tax liability and saves $11,625 in Q2 of 2017. It will also have $1,375 of additional credit for use against its payroll tax liability in Q3 of 2017. Company X will thus save $13,000 in operating expenses in 2017, which it can repurpose for company growth and innovation.
Process to Utilize the Credit against Payroll Tax Liability
A qualified small business makes an election on its 2016 income tax return to utilize the R&D tax credit against its payroll tax liability. If the qualified small business is a partnership or S corporation, the election is made at the entity level. The election is effectuated by the taxpayer filing Form 6765 as part of its 2016 income tax return. Form 6765 now includes a Section D in which the taxpayer will make the election and identify the portion of the calculated credit that it will utilize against its payroll tax liability. Prior to completing Section D of Form 6765, the taxpayer, other than partnerships or S-corporations, must complete Form 3800 which includes identification of any prior tax year credit carryforward.
If the taxpayer files its 2016 federal income tax return by March 31, 2017, it will have the option to utilize the R&D tax credit against its payroll tax in Q2 of 2017. It will claim the credit against its payroll tax liability by completing two forms: Form 8974 and Form 941. The IRS has released draft versions of each form. Form 8974 is a new tax form that provides for the calculation of the amount of the elected credit to be used against that quarter’s payroll tax liability. The calculated amount will then be claimed on line 11 of an updated version of Form 941, and taxpayers will attach Form 8974 to Form 941 when filing the quarterly payroll forms.
Payroll processing companies are still finalizing their processes for integrating credit claims into quarterly payroll tax filings. An industry leading payroll-company indicated that it plans to prepare the Form 8974 as part of its clients’ payroll tax filings. Taxpayers will provide the company with a PDF copy of the Form 6765 filed with the income tax return, which the payroll company will utilize to complete Form 8974 and Form 941.
The R&D tax credit now provides an immediate tax savings opportunity for start-up companies. The utilization of the credit against the payroll tax liability reduces operating expenses and improves after-tax cash flow.
Critical factors for the new credit opportunity include:
- Meeting the definition of a qualified small business;
- Qualifying activities under the tax code definition of R&D;
- Electing the payroll tax liability offset opportunity;
- Calculating the credit; and
- Filing for the payroll tax liability offset.
FGMK is already working with clients to document how their activities meet the tax code definition of R&D and to calculate this new benefit opportunity. If you have questions or would like to discuss how this credit can generate cash savings for your company, please contact Dan Laughlin (firstname.lastname@example.org; 312-638-2916).
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.
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 Per IRC § 39, the R&D credit can be carried back one year or carried forward 20 years until utilized.
 IRC § 41(h)(3).
 IRC § 41(h)(4)(B). This section also limits a taxpayer to use of the credit against payroll tax liability for no more than five tax years.
 IRC § 41(h)(5)(A).
 IRC § 41(h)(5)(B)(i).
 IRC § 41(h)(5)(B)(ii).
 IRC § 3111(f)(1).
 The Federal Insurance Contributions Act (“FICA”) is a federal payroll tax imposed on employees and employers to fund Social Security and Medicare. IRC § 3111(a) imposes the excise tax on an employer at a rate of 6.2% of its employees’ wages for the purpose of Old-Age, Survivors, and Disability Insurance (“OASDI”), which funds the Social Security portion of the FICA tax.
 IRC § 3111(f)(2).
 IRC § 3111(f)(3).
 IRC § 3111(f)(4)
 IRC 41(h)(1) (Per IRC § 280C(c), the taxpayer must either reduce deductions by the amount of the gross credit or elect a reduced credit).
 The R&D tax credit can be calculated under multiple methods. Most qualified small businesses will utilize the start-up calculation method. IRC § 41(h)(1) provides for the application of IRC § 280C which requires a taxpayer to reduce its deductions by the gross amount of the credit or to claim a reduced credit. This example illustrates the credit as if the taxpayer elects the reduced credit under the start-up method. The default base amount (50% of tax year qualified research expenses) will likely exceed the calculated base amount (3% multiplied by prior four tax years’ gross receipts) for most qualified small businesses.
 IRC § 41(h)(4)(C).