Smaller businesses have more ways to use the R&D credit than many owners realize. In particular, qualifying companies can claim the R&D credit against payroll taxes or the alternative minimum tax (AMT).
How the PATH Act expanded the R&D credit
The Protecting Americans From Tax Hikes Act of 2015 (PATH Act) helped businesses that spend money on qualified research. Most importantly, it made the research credit permanent. In addition, it let some businesses claim the credit against payroll taxes or AMT. Even today, many eligible businesses still miss these benefits.
Using the R&D credit against payroll tax
Before the PATH Act, businesses could carry an unused credit forward. However, many startups got no real benefit. They operated at a loss, so they had no income tax to offset. Yet many of them spent heavily on research.
To fix this, the PATH Act lets qualified small businesses (QSBs) elect to apply the credit against the employer share of Social Security tax. This option applies to tax years beginning after December 31, 2015.
Originally, the yearly limit was $250,000. Later, the Inflation Reduction Act raised it to $500,000 for tax years beginning after December 31, 2022. The extra $250,000 applies against the employer share of Medicare tax. Also, a business can make the election for no more than five tax years.
Who counts as a qualified small business?
A QSB must meet two tests. First, its gross receipts for the credit year must be under $5 million. Second, it can’t have had gross receipts in any year before the five-year period ending with the credit year.
For example, a business claiming the payroll credit for 2026 needs less than $5 million in gross receipts for 2026. In addition, it can’t have had any gross receipts in 2021 or earlier.
For this test, you reduce gross receipts by returns and allowances. You also annualize receipts for short tax years and include predecessors. For individuals, only receipts from their trades or businesses count. Finally, tax-exempt organizations under Section 501 can’t claim the payroll credit.
Using the R&D credit against AMT
Before the PATH Act, AMT also blocked many taxpayers from using the credit, because the credit couldn’t reduce AMT. Fortunately, the PATH Act lets eligible small businesses (ESBs) use the credit against AMT for tax years beginning after December 31, 2015.
Later, the Tax Cuts and Jobs Act repealed the corporate AMT for 2018 and later years. It also raised the individual AMT exemption and phaseout threshold. As a result, fewer owners face AMT today. Still, the offset can matter for owners of pass-through businesses.
Who counts as an eligible small business?
An ESB is a non-public corporation, a partnership or a sole proprietorship. In addition, its average annual gross receipts for the prior three years must be $50 million or less.
Related businesses under Sections 52(a), 52(b), 414(m) or 414(o) count as one taxpayer. So you combine their gross receipts. As before, you reduce receipts by returns and allowances, annualize short years and include predecessors. If the business existed for less than three years, you average over the years it did exist.
For partnerships and S corporations, each partner or shareholder must also meet the gross receipts test. Otherwise, the AMT offset doesn’t apply to them.
Common uses of the R&D credit
To use these rules, a business first identifies which projects qualify. Next, it documents the link between those projects and its costs. Then it figures a base amount under one of two methods, depending on the age of the business.
Many industries qualify. For example, these include software development, manufacturing, communications, engineering and pharmaceuticals. For more detail, see the IRS guide to the payroll tax credit for research.
Get help claiming the R&D credit
We help startups and growing companies find and document qualifying research. To learn more, visit our R&D tax credit page or book a free 15-minute call.