How To Offset Payroll Tax with R&D Tax Credits

R&D Tax Credit

income tax

Alex Pak
April 20, 2022

The Research and Development (R&D) tax credit can benefit startups and small companies through something known as the Payroll Tax Credit. The R&D payroll tax credit became available to qualified small businesses through the Protecting Americans from Tax Hikes Act of 2015 (The PATH Act). This tax law created an opportunity for qualified small businesses to offset all or a portion of their contribution to payroll tax using federal R&D tax credits for up to five years. Prior to this time period, businesses could only take the research credit against their income tax liability.

When it comes to determining how to offset payroll tax with R&D tax credits, business owners and executives interested in saving valuable payroll tax dollars need to understand the following key points.

What is a Qualified Small Business?

For 2016 and subsequent tax years, businesses can use their R&D tax credits to offset payroll tax providing they meet the following requirements

  • Gross receipts 1 for 5 years or less, which means total revenue returns and allowances, including all amounts received for services, income from investments, bank interest, and all other incidental or outside sources.
  • Less than $5 million in gross receipts in the year the R&D credit is claimed.
  • Qualifying research activities and expenditures.

The Payroll Tax Credit cannot be claimed on amended returns. For amended claims, taxpayers can only generate credits to offset income tax liability. However, unused Payroll Tax Credits can be carried forward and applied against payroll tax in subsequent quarters until exhausted, or for 20 years, whichever comes first.

Industries That Can Claim the R&D Payroll Tax Credit

Businesses in multiple industries looking to reduce their Federal and State income tax liability can benefit from the R&D payroll tax credit.

  • Architecture/Engineering,
  • Aerospace
  • Blockchain
  • Construction & MEP
  • Contract Manufacturing
  • Consumer Products
  • Chemical Companies
  • Financial Industry
  • Gaming
  • Metal Fabrication Companies
  • Mortgage Banking
  • Pharma / Nutraceutical/ Bioceutical
  • Plastics Industry
  • SaaS Platform
  • Software Development
  • Tool and Die

What is the Maximum Benefit My Business Can Claim?

Research and development tax credits are applied against quarterly payroll tax payments for up to as many as five years. In any given year, a company can apply up to $250,000 against its contribution to the Social Security tax of 6.2% of each employee’s salary (up to a maximum of $128,400 per employee in 2021).

Example 1: A start-up gaming company claimed a $65,000 R&D tax credit on its 2020 federal return – all of which could be used to offset its payroll taxes in 2021.

Example 2: An early-stage software company claimed a $270,000 R&D tax credit in 2020. They applied $250,000 to payroll taxes and chose to carry forward the remaining $20,000 to the next year.

What Documentation Is Needed to Claim the R&D Payroll Tax Credit?

For a business to claim the R&D payroll taxes credit, you’ll need to have documentation that shows proof of a permitted purpose, technological uncertainty, the process of experimentation, and being technological in nature.

  • Permitted Purpose: This means the purpose of the research activity was to improve the performance, reliability, functionality, or quality of a product (or software).
  • Technological Uncertainty:There is uncertainty relating to how the product (or software) should be developed or designed.
  • Process of Experimentation: There is a trial and error period to attempt to eliminate the above-mentioned uncertainty.
  • Technological in Nature: The activity must be determined by principles of one or more of the following: Engineering, physical sciences, biological sciences, or computer science.

How To Claim the R&D Payroll Tax Credit

Claiming the R&D payroll tax credit as a qualified small business requires you to elect to apply the research credit against payroll tax liability by completing and submitting Form 6765 to a timely-filed business income tax return. The IRS provides the below steps for claiming the R&D tax credit on payroll taxes:

  • STEP 1 - Complete Form 6765, Credit for Increasing Research Activities and make the election for payroll tax credit and attach the completed form to your timely-filed business income tax return.
  • STEP 2 - Claim the payroll tax credit by completing Form 8974. You must attach this form to your payroll tax return, for example, your Form 941, Employer’s Quarterly Federal Tax Return.

The payroll tax offset is available on a quarterly basis beginning in the first calendar quarter after a taxpayer files its federal income tax return. Taxpayers can carry unused credits forward to subsequent quarters.

Can the R&D Credit be Applied to the First Payroll Payment of a Quarter?

Yes. the IRS issued Memorandum AM2017-003 on July 31, 2017. This was in response to questions regarding timing issues concerning the payroll tax offset. The advice cannot be used or cited as precedent, but it does offer useful guidance on how and when employers can use R&D Tax Credits to offset their payroll tax.

The memorandum includes instructions on how to complete Form 941 using this process. Employers can apply their R&D Tax Credits against payroll deposits rather than filing for a refund at the end of the quarter.

What if My Company Uses a PEO?

PEOs are Professional Employer Organizations that pay wages to individuals as part of services provided to a client. If your company uses a PEO payroll provider service, the PEO is able to claim the payroll tax credit on behalf of a qualified small business.

The qualified small business will need to have elected to apply its R&D credit against the payroll tax on its federal government return for the previous tax year.

How We Can Help is powered by Source Advisors, a leading tax consulting firm providing R&D tax credits for almost 4 decades. Source Advisors can assist your small business with:

  • Identifying your qualifying development activities and expenses
  • Computing your R&D tax credits
  • Advise what supporting documents you need to retain
  • Assisting with the payroll tax offset

Founded on the basic principle that the R&D tax credit should be available to companies of all sizes without fees burdening the benefit, the automated software platform is backed by 350+ years of collective R&D tax credit experience. This is what sets us apart from any other platform. Our people and our experience.

Now is a good time to reexamine prior, current, and future R&D activities in order to take advantage of the R&D tax credit, regardless of industry. If you think your company might be performing work that qualifies, don’t let the potential tax savings go unclaimed. Source Advisors can help you uncover vital tax savings to reinvest in your business and fuel your next big project.

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