by Evan Stephens, Senior Tax Manager at Sensiba San Filippo and Carlos Freitas, Director with Hull & Knarr LLP
Starting in 2016, Research and Development (R&D) tax credits can be used to offset payroll taxes. Previously, these credits could only be used to offset income taxes. Since many start-ups produce little to no profit in the first few years, there was no income tax for the R&D credits to offset, and therefore, no opportunity to use the research tax credit. However, all businesses with employees must pay payroll taxes (approximately 7.65% on gross wages paid by the business). Being able to offset these payroll taxes with the R&D credit means that start-ups can receive a benefit for their research activities even without being profitable.
The Federal R&D credit amounts to roughly 5% of the wages, materials, and outside contractor expenses in research activities related to product and software development, including:
- Product conceptualization and development
- Prototype development, materials expenses, and testing
- Manufacturing process development
- Software development and testing — including embedded, SaaS, PaaS, APIs, etc.
- Support of software development — including specialized equipment or services
Who qualifies for the R&D credit?
The R&D credit rewards businesses for creating or improving products, manufacturing processes, or software. The research activities must be technological in nature; in other words, they must rely on the sciences such as engineering, physics, chemistry, biology, computer science, etc. This means that marketing or management research activities do not qualify. Typical indicators of qualified research include:
- Degreed engineers, scientists, or software developers on staff
- Patentable products, software, or production methods
- Operating in an industry where prototyping is common
- Manufacturing products
- Developing software
It’s important to note that the research activity does not need to be revolutionary, as in “the first time ever developed.” The R&D credit rewards businesses for making evolutionary steps in any particular technology.
Who qualifies for the payroll taxes offset?
Start-ups in their first 5 years of existence and with less than $5 million in gross revenue for the taxable year likely qualify to use the R&D credit to offset payroll taxes. Therefore, start-ups formed in 2012 or earlier are unlikely to be eligible. This does not mean that the start-up cannot still generate the credits and use them in the future to offset income tax (the R&D credits can be carried forward for 20 years). It just means that the credit cannot be used to offset payroll taxes.
How much is available to offset payroll taxes?
The maximum benefit a business may claim against payroll taxes is $250,000 per year. It’s important to note that the use of the R&D credit to offset payroll taxes will not reduce the allowable deductions for the basic research expenses — you get your cake (tax deductions), and eat it too (tax credits).
When can the credit be used to offset payroll liabilities?
The credit is generated yearly and is applied against payroll taxes the quarter following the filing of income tax returns. For example, businesses filing their 2016 income tax returns in March 2017 will be able to use the R&D credit to offset payroll taxes in the next quarter — July 2017. If the credit amount is more than the payroll taxes due for the quarter, the unused credit may be applied in the succeeding calendar quarter. Note that the business will need to determine and report the R&D credit on a timely filed tax return (that is, not an amended return) to use the payroll tax election on the next quarter’s payroll.
How do I claim the R&D credit and use them to offset payroll taxes?
To take advantage of the tax credit, the business must first claim the R&D credit based on its research activities expenses. Next, an election must be made on their income tax return to convert a certain amount of its research credits into a payroll tax credit.
Taking advantage of this generous tax credit could mean big savings for start-ups. If you have any questions about the credit or want to know more about how it can impact your business, feel free to reach out to Sensiba San Filippo Senior Manager, Evan Stephens, at 408.286.7780 or at estephens@ssfllp.com. Additionally, for more information about the requirements and qualifying for the R&D credit, please contact Hull & Knarr Director, Carlos Freitas, at 317.889.2134 or at cfreitas@hullandknarr.com.
Evan Stephens is a Senior Tax Manager at Sensiba San Filippo. He specializes in tax planning and compliance for privately held companies, with particular specialization in construction and technology industries. Carlos Freitas is a Director with Hull & Knarr LLP, a firm specialized in R&D Tax Credits. He has an Electrical Engineering degree from Purdue University and an MBA from Indiana University — Kelley School of Business.
