The Protecting Americans from Tax Hikes (PATH) Act, enacted in 2015, provides unique incentives to eligible small businesses beginning with the 2016 tax year. In addition to making the Federal Research and Development (R&D) tax credit permanent, it allows the use of R&D credits to offset the employer’s portion of OASDI payroll taxes for qualified small businesses who elect to apply its research credit in such manner.
A taxpayer is considered an eligible taxpayer for the first five years beginning with the first year it has gross receipts. If the first year the taxpayer had gross receipts was 2012, year 2016 would be year five of the business, and it would only be able to take advantage of the new rule for 2016. If the company first had gross receipts in 2016, it would be able to take advantage of this rule from 2016-2020 unless it exceeded the $5 million gross receipts test (discussed below). A special transition rule allows taxpayers who did not initially make such an election with their 2016 tax return to obtain the benefits of this provision by filing an amended return by December 31, 2017. The rules for the new payroll tax credit are covered in IRC sections 41(h) and 3111(f).
Gross Receipts Test
A partnership or a corporation (including an S corporation) is a qualified small business for a tax year if its gross receipts are less than $5 million in the tax year the election is made. Also, the partnership or S Corporation must not have had any gross receipts in any tax year preceding the five-year tax period that ends with the year of the election. A similar rule applies to individuals (such as those with income reported on a Schedule C) except that the gross receipts tests apply to all trades or businesses carried on by the taxpayer. Additionally, all members of a controlled group must aggregate their gross receipts for the gross receipts test.
Since gross receipts are a limiting factor for a small business to take this credit, special attention should be paid to how gross receipts are determined for this provision. Under code section 448(c)(3), gross receipts are determined by taking into account all receipts received by the taxpayer in carrying on all of its trade or business. This is to include total sales, all receipts received for services, as well as all income from investments. Furthermore, gross receipts are reduced by returns and allowances made during the tax year.
The amount of the R&D credit available to offset payroll taxes is limited by IRC section 41(h)(2) to the lesser of the following amounts:
- An amount, not to exceed $250,000 specified by the taxpayer in its election;
- The R&D credit amount determined for the tax year; or
- For a qualified small business other than a partnership or S corporation, the amount of the general business credit carryforward (after carryback) under Section 39 from the tax year of the election determined without regard to the election made.
The credit may not exceed the taxpayer’s 6.2% portion of the payroll tax liabilities and may be carried forward indefinitely against future liabilities. It is important to note that once a taxpayer designates all or a portion of its research tax credit as a payroll tax credit, that portion can be used only to offset current or future payroll taxes. The payroll tax credit portion cannot be treated as a general business credit that may be carried forward and applied against regular and AMT liabilities in future tax years.
The $250,000 credit limit is allocated to each person treated as a single taxpayer. In the case of a controlled group of entities treated as a single taxpayer, the $250,000 credit amount will be allocated to each member in proportion to the member’s qualified research expenses. The credit does not reduce the tax deduction for payroll taxes so it effectively monetizes the R&D credit for taxpayers who claim the credit.
The election to claim the payroll tax credit is made on Schedule D of Form 6765, which should be filed with the qualified small business’ timely filed income tax return. Taxpayers may begin offsetting their payroll tax liabilities in the first calendar quarter beginning after the date on which the taxpayer files its income tax return. For example, for a 2017 income tax return filed on April 15, 2018, the first quarter available to use the credits to offset payroll taxes would be the calendar quarter spanning July-September, 2018.
To calculate the portion of the qualified small business tax credit to be claimed on an applicable payroll tax return (generally Form 941), the taxpayer should use Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. Form 8974 should be filed with the payroll tax return on which the credit is claimed. Internal Revenue Code Section 3111(f) allows the carryforward of unused payroll credit which is applied to the payroll tax liability in succeeding quarters.
Late Elections for 2016
IRS Notice 2017-23 created a special transition rule for taxpayers who did not make the election on their originally filed 2016 income tax return. These taxpayers are allowed to make the election on an amended return filed no later than December 31, 2017. The taxpayer must attach a statement to Form 6765 on which the late election is being made, pursuant to Notice 2017-23. This represents a planning opportunity for companies that may not have been aware of the payroll tax credit or were unable to prepare the necessary election by the original due date of their tax returns. In this way, a taxpayer may be able to obtain a credit which can be used against their first quarter payroll tax obligation for 2018.
We Can Help
Taxpayers who were not able to fully use the R&D tax credit in the past should reassess their eligibility for the credit. If you have questions, please contact your Elliott Davis tax advisor or contact us at firstname.lastname@example.org.