Does your small business engage in qualified research activities? If so, you may be eligible for a research tax credit. And you can use R&D tax credit qualified expenses to offset your federal payroll tax bill.
This relatively new privilege allows the research credit to benefit small businesses that may not generate enough taxable income to use the credit to offset their federal income tax bills, such as those that are still in the unprofitable start-up phase where they owe little or no federal income tax.
Under the Protecting Americans from Tax Hikes Act of 2015, a qualified small business (QSB) can elect to use up to $250,000 of its research credits to reduce the Social Security tax portion of its federal payroll tax bills. Under the old rules, QSBs could use the credit to offset only their federal income tax bills. However, many small businesses owe little or no federal income tax. This especially applies to small start-ups that tend to incur significant research expenses.
For the purposes of the research credit, we define a QSB generally as a business with:
The allowable payroll tax reduction credit can’t exceed the employer portion of the Social Security tax liability imposed for any calendar quarter. Any excess credit can be carried forward to the next calendar quarter, subject to the Social Security tax limitation for that quarter.
To be eligible for the research credit, a business must have engaged in “qualified” research activities. To be considered “qualified,” activities must meet the following four-factor test:
1. The purpose must be to create new (or improve existing) functionality, performance, reliability or quality of a product, process, technique, invention, formula or computer software that will be sold or in use for your trade or business.
2. There must be an intention to eliminate uncertainty.
3. There must be a process of experimentation. In other words, there must be a trial-and-error process.
4. The process of experimentation must fundamentally rely on principles of physical or biological science, engineering or computer science.
Expenses that qualify for the credit include wages for time spent engaging in supporting, supervising or performing qualified research, supplies consumed in the process of experimentation, and 65% of any contracted outside research expenses.
The ability to use the R&D tax credit qualified expenses to reduce payroll tax is a welcome change for eligible small businesses. However, the rules are complex and we’ve only touched on the basics here. We can help you determine whether you qualify and, if you do, assist you with making the election for your business and filing payroll tax returns to take advantage of the new privilege.