New businesses or start-up companies may be eligible to apply the R&D tax credit against their payroll taxes for up to five years.
The R&D credit permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. The bill included enhancements starting in 2016, including offsets to the alternative minimum tax and payroll tax for eligible businesses.
While the credit used to offset payroll taxes is based on eligible R&D expenses, it only applies to costs incurred after the bill was signed into law. The maximum benefit an eligible company can claim against payroll taxes each year under the PATH Act is $250,000.
When does the payroll-tax offset take effect?
The payroll-tax offset is currently available for qualified expenses incurred in 2017. The R&D credit must calculated and shown on a taxpayer’s 2017 federal income tax return. And with the portion of the credit applied to offset payroll taxes identified and elected when the return filed in 2018. The offset is then available on a quarterly basis beginning in the first calendar quarter after a taxpayer files their federal income tax return.
For example, taxpayers need to file their 2017 federal income tax return by June 30, 2018, to apply the payroll-tax offset to the third quarter. As a result, the earliest taxpayers are likely to see a benefit is October 2018 when they file their quarterly payroll tax return for the third quarter.
How quickly does a company need to move on this? When does it need to get started?
The current opportunity to offset payroll taxes based on 2017 expenses, which means companies can benefit from acting quickly to determine their eligibility under the new rules and start planning. This will help ensure companies understand what types of information will need to gathered at the end of the year.
This credit must specific, elected, and filed in the original 2017 tax return before it can use to offset payroll taxes. Under the current rules, taxpayers can’t take advantage of this opportunity on an amended return.
What companies qualify for the offset?
The new payroll-tax offset allows companies to receive a benefit for research activities even if they aren’t profitable. To be eligible for the credit, companies must meet these qualifications:
- Gross receipts for five years or less (interest income counts toward gross receipts)
- Less than $5 million in gross receipts in the year the credit is elected
- Qualifying research activities and expenditures
- Payroll-tax liability
How is $5 million in gross receipts defined?
A company must have less than $5 million in annual gross receipts to be eligible. For new businesses, the gross receipts must fall under the $5 million limit after being annualized for a full 12 months. The gross receipts of businesses that related or share common ownership need to calculate on a combined basis for purposes of determining eligibility under this provision.
The IRS issued interim guidance on the definition of gross receipts in March 2017. In the guidance, the IRS confirmed gross receipts include the following:
- Total sales—defined as the net of returns and allowances
- All amounts received for services
- Income from investments, including interest income
Although the gross-receipts limitation helps to define a company’s eligibility for the credit. It’s important to note the R&D credit itself isn’t based on gross receipts. The actual credit based on the company’s eligible R&D expenses.
What are eligible R&D expenditures?
Eligible R&D costs include these categories:
- Wages. W-2 taxable wages for employees offering direct support and first-level research supervision.
- Supplies. Supplies used in research, including so-called extraordinary utilities but not capital items or general administrative supplies.
- Contract research. Certain subcontractor expenses. If the subcontractor’s tasks would qualify, they instead being performed by an employee. These can include labor, services, or research, but payment can’t be contingent on results. In addition, the taxpayer must retain substantial rights in the results, whether exclusive or shared.
- Rental or lease costs of computers. This could include payments made to cloud service providers for the cost of renting server space. As longs as payments related to hosting software under development versus payments for hosting a stable software release.
What are some potential benefits of the offset?
Brand-new 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 federal payroll tax returns.
New businesses and start-up companies will see a benefit between 6% and 14% of their eligible R&D costs. For most companies that incur at least $300,000 in eligible R&D costs. The federal credit to offset payroll tax will equal to 10% of total R&D expenses.
For example, a company with $500,000 of eligible expenses. Let’s say engineering costs, that could receive a $50,000 credit. On the other hand, a company with over $2.5 million in eligible expenses in 2017 could receive a credit equal to the full $250,000 annual limitation.
If the amount of the credit exceeds a company’s Social Security tax, also known as the OASDI tax. Liability in any given quarter, the excess can carry forward to the next calendar quarter.
Social Security Tax
The payroll-tax offset can only apply to the Social Security portion of payroll taxes. Companies required to pay Social Security tax of 6.2% on up to $127,200 each employee’s salary in 2017. For example, a company that employs 50 employees with an average salary of $75,000 would pay approximately $232,500 in Social Security payroll taxes.
Accordingly, a company would need to have more than $4 million in annual payroll subject to Social Security tax. $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.
Most employers required to deposit their payroll taxes to the federal government on a monthly. Or semiweekly basis as well as file a quarterly payroll tax return via Form 941. However, the credit will be applied against the Social Security tax on the quarterly return. When it’s deposited monthly or semiweekly.
The IRS is still formulating a plan for how this process will formally implement.
Are there risks to claiming the R&D credit?
Once a company starts using this credit, they receive a much higher level of scrutiny from the IRS. R&D credits are often a high priority for the agency, which assembles industry-specific project teams with technical specialists that assist in reviewing R&D credit claims.
Even at the small business level, it’s common for IRS technical specialists to be involved in R&D credit examinations. In general, however, larger credits receive more scrutiny from the IRS and often require more review and documentation.
Although many companies in the technology industry likely engaged in activities that would otherwise be eligible for R&D credits, the rules surrounding the credit are complex and always changing. New legislation, regulations, court cases, and IRS guidelines have drastically shifted the landscape of R&D tax law over the past few years and will continue to do so in the future.
Considering these complexities and potential financial penalties, companies can benefit from having their activities analyzed by a CPA, attorney, or enrolled agent familiar with the tax law and accounting rules that govern the R&D credit as well as the IRS examination and appeals process.
To deter companies from claiming credits without the proper level of review and documentation, the IRS can impose penalties greater than 20% of the credit amount claimed. For example, if a taxpayer claims a $250,000 R&D credit and the credit is then audited by the IRS, it’s possible the agency could deny the entire credit and fine the company with accuracy-related penalties exceeding $50,000.
What should companies know about documentation?
It’s important companies have the right documentation in place. It’s also key to know there isn’t a one-size-fits-all approach to documentation. The level of documentation deemed to be adequate varies based on the size and scope of the credit amounts claimed.
Companies should expect a greater time commitment to get set up in the first year of claiming an R&D credit. They’ll also need to put the appropriate measures in place to completely use the credit going forward. Depending on the company, it’s possible any historic R&D spending incurred may need to evaluate.
Proving Nexus
Taxpayers often will need to provide a nexus between their R&D expenses and qualified research activities. This can be challenging—even for companies that have some level of project tracking in place. This is because time- and expense-tracking systems aren’t generally intend to track eligible R&D expense to business components or R&D activities.
The subjectivity and interpretation of the R&D rules make it difficult to develop the perfect software tool for tracking eligible expenses and documentation. Particularly when considering annual updates to tax law, regulations, and IRS guidance. For this reason, it’s important to note project-accounting and time-tracking systems aren’t a prerequisite to claim the R&D credit.
Meeting the Four-Part Test
At minimum, taxpayers’ qualitative documentation should demonstrate how their underlying activities meet the four-part test. Examples of adequate documentation can vary by industry, but it’s possible for companies to leverage documentation they generate in their day-to-day operations. Qualitative documentation may also require review and analysis of any contracts between companies and their customers, partners, or vendors.
Taxpayers who have some level of familiarity with the R&D credit should carefully evaluate their methodology and documentation standards with respect to R&D credits being used under the new rules.
Additional Guidance
Companies in the software and pharmaceutical industries especially encouraged to review the IRS audit guidelines applicable to their industries. These are available on the IRS website:
- Audit Guidelines on the Application of the Process of Experimentation for All Software
- Pharmaceutical Industry Research Credit Audit Guidelines
The payroll-tax offset is available to eligible new businesses and start-up companies for up to five years. Any unused R&D credits that aren’t elected to offset payroll taxes may carried forward for up to 20 years and used when the business becomes profitable. This length of time makes thorough documentation even more important.
We’re Here to Help
To learn more about the R&D payroll-tax offset, whether your business qualifies, or our other R&D tax services, contact your FTCG professional.
Alex Kwan has practiced public accounting since 2010. He provides R&D tax services to middle-market companies. Including S corporations and partnerships, and consults on federal and state R&D credits, R&D expense deductions, and IRS and state examinations of R&D credits. You can reach himat (415) 860-6288 or [email protected].
The material appearing in this communication is for informational purposes only and should not construed as legal, accounting, tax, or investment advice or opinion provided by Flex Tax and Consulting Group. This information is not intend to create, and receipt does not constitute, a legal relationship. Including an accountant-client relationship. Although these materials have prepared by professionals, the user should not substitute these materials for professional services. And it should seek advice from an independent advisor before acting on any information presented. Flex Tax and Consulting Group assumes no obligation to provide notification of changes in tax laws or other factors that could affect the information provided.
by Star Fischer, and Travis Riley
