The research and development (R&D) credit, a credit for increasing research activities, is a valuable tax break for eligible businesses. Claiming the credit requires complex calculations. However, in addition to the credit itself, there are two elements that are particularly beneficial to small businesses:
- Small businesses with gross receipts of less than $50 million are eligible to claim the credit against alternative minimum tax (AMT) liability.
- The credit can be applied to an employer’s Social Security payroll tax bill, even if the business is a small startup business.
Let’s look at the second feature in detail. You can choose to apply all or part of any R&D credit you earn against your payroll taxes rather than your income taxes, subject to certain limitations. This payroll tax election may encourage you to start or expand your research efforts. On the other hand, if you’re doing research (or planning to do so) without thinking about the tax implications, you might be eligible for some tax savings.
How the R&D Credit and the Payroll Tax Election Work Together
Even if a new business has some cash flow, or even net positive cash flow and/or a book profit, many do not pay income taxes and will not for some time. Thus, there’s no amount against which business credits, including the research credit, can be applied. Payroll taxes, on the other hand, are owed by every wage-paying business, even if it is brand new. As a result, using the payroll tax election allows you to put your R&D credit to immediate use. Because every dollar of credit-eligible spending can result in a 10-cent tax credit, it’s a tremendous benefit in the early stages of a company’s life — when it’s most needed.
How to Qualify for the Payroll Tax Election
A taxpayer must meet the following criteria to be eligible for the election:
- Have gross receipts of less than $5 million for the election year and
- It must have been no more than five years since it had no receipts (the start-up period).
An individual taxpayer’s gross receipts from his businesses are the only ones taken into account while determining these calculations. Salary, investment income, and other income are not considered. It’s also worth noting that no entity or individual can make the election for more than six years in a row.
R&D Credit Limits
The research credit for which the taxpayer makes the payroll tax election can be applied only against the Social Security portion of FICA taxes. It cannot be used to reduce the employer’s liability for the “Medicare” part of FICA taxes or any other FICA taxes withheld and remitted on behalf of employees.
The maximum amount of research credit for which an election can be made per year is $250,000. It’s also worth noting that an individual or C corporation can only make the election for those R&D credits that would otherwise have to be carried forward if no election was made. In other words, a C corporation can’t make the election for the R&D credit that the taxpayer can use to reduce current or past income tax liabilities.
The above are only the basics of the payroll tax election. Keep in mind that identifying and substantiating expenses eligible for the R&D credit is a difficult task. Our tax professionals can help you determine if you qualify for the payroll tax election or the R&D credit. Contact us for more details.