Signed into law on Aug. 16, 2022, the Inflation Reduction Act, P.L. 117- 169, included a package of tax credits intended to encourage investment in domestic energy and innovation. The Inflation Reduction Act increased the maximum amount that a qualified small business (QSB) can use from the Sec. 41 research credit (R&D credit) to offset certain payroll tax liabilities from $250,000 to $500,000 for tax years beginning after Dec. 31, 2022. This can be particularly valuable for startup companies that currently have net operating losses for federal tax purposes and would like to monetize the R&D credit in the near term. Under the Protecting Americans From Tax Hikes (PATH) Act of 2015, P.L. 114-113, taxpayers were only allowed to use the payroll tax offset against the 6.2% employer portion of the Social Security payroll tax liability. The Inflation Reduction Act now also enables taxpayers to use up to $250,000 against the 1.45% employer portion of the Medicare payroll tax liability. This item highlights the opportunity, procedural considerations, potential pitfalls, and observations. Note that the election must be made on an originally filed return.
THE RESEARCH CREDIT AND QSBs
Sec. 41 allows taxpayers to claim a credit for increasing research activities. In most cases, to qualify for the R&D credit, activities must meet a four-part test. Under this test, activities must be technological in nature; research must be intended to develop a new or improved business component (i.e., product, process, computer software, technique, formula, or invention); there must be uncertainty related to the capability or methodology for developing the business component or the design of the business component itself; and substantially all the research must constitute elements of a process of experimentation. In some situations where the activity is related to development of the taxpayer’s internal-use software, heightened criteria must be met in addition to the four-part test. Also, specific activities are excluded from the definition of qualified research, including research performed outside the United States or research funded by another entity. Eligible qualified research expenditures include taxable wages, supplies, computer lease or rental costs (including cloud computing), and third-party contractor costs. Taxpayers may also include costs for individuals directly supporting or directly supervising the performance of qualified research.
While the R&D credit is a nonrefundable general business credit, which is carried back one tax year and carried forward 20 tax years, the PATH Act enabled QSBs to apply credits in excess of income taxes, up to a specified cap, to Federal Insurance Contributions Act (FICA) taxes. A corporation or partnership meets the definition of a QSB if (1) the gross receipts of the entity for the tax year are less than $5 million and (2) the entity did not have gross receipts for any tax year preceding the five-tax-year period ending with the current tax year. In addition, the election cannot be made if there was a payroll tax election in five or more prior tax years.
CLAIMING THE PAYROLL TAX OFFSET
Notice 2017-23 provides interim guidance on how QSBs can apply all or part of the R&D credit against their payroll tax liability. The notice provides guidance on the definition of a QSB and whether a business is eligible to elect to apply all or part of the R&D credit against its payroll tax liability instead of its income tax liability. The notice also provides information on gross receipts, aggregation rules, and the time and manner for making the election to claim the payroll tax credit.
As outlined in Notice 2017-23, the annual election must be made on or before the due date of the taxpayer’s income tax return (including extensions) on Form 6765, Credit for Increasing Research Activities. A taxpayer electing the payroll tax offset must complete Section D of the form as well as Section A or B, which reflects the R&D credit computed for the tax year. This form must be submitted with the return and can be revoked only with consent. For partnerships and S corporations, the election is made at the entity level. The credit is claimed against payroll taxes on the taxpayer’s Form 941, Employer’s Quarterly Federal Tax Return, for the first quarter that begins after the income tax return making the election was filed. This is accomplished through completing and filing Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, along with the quarterly payroll tax return. For example, if a taxpayer files the return that includes the election for payroll tax offset during the taxpayer’s second quarter, the taxpayer may begin using the payroll credit against its third-quarter payroll taxes. Any credit amounts that cannot be used on that quarter’s payroll tax return are carried forward to future quarters.
Below are some of the common pitfalls that taxpayers will have to navigate when evaluating if there is an opportunity to use an R&D credit to offset a payroll tax liability. To reiterate a point in the section above, taxpayers must make an annual election to use the R&D credit against payroll tax on the originally filed tax return (including extensions). Failure to properly make the election could create several issues with the taxpayer’s income and payroll taxes.
Another challenge relates to the aggregation rules under Sec. 41(f). Specifically, if a taxpayer is a member of a controlled group or is part of a group under common control, then the QSB rules must be met at that aggregated group level to qualify for the payroll tax offset. Taxpayers should carefully review all members of the same controlled group or group under common control, which are treated as a single taxpayer, as it may impact a taxpayer’s ability to use the payroll tax offset.
Additionally, unlike the regular credit rules, Notice 2017-23 does not provide an exception for a de minimis amount of gross receipts. This means that no matter how small the amount, a taxpayer may have income that could result in its not being eligible for the payroll tax offset. Additionally, gross receipts for purposes of computing the R&D credit and evaluating the $5 million limitation include several sources of income including gross receipts or sales, royalties, and interest, among others. Taxpayers must consider all types of gross receipts as included in the definition when evaluating if the taxpayer falls below the threshold. In other words, it is possible for a taxpayer to have “gross receipts,” as reflected on line 1 of its federal filing, below $5 million, but when other relevant items are included, the taxpayer’s gross receipts may exceed the maximum amount. The years in which a taxpayer has gross receipts should also be evaluated.
If a taxpayer uses a professional employer organization (PEO), it should coordinate with the PEO to claim the payroll tax credit. While a PEO may provide online portal access to the taxpayer to update the election to claim the R&D tax credit offset against payroll taxes, the PEO is typically responsible for filing the appropriate payroll forms on behalf of the taxpayer. These filings would include the amount of payroll tax credit elected by the taxpayer on its timely filed return that included Form 6765. The instructions for Form 8974 provide filing requirements for PEOs, including specific instructions where PEO customers claim the payroll tax credit.
Taxpayers should be aware that in some instances it may be more beneficial to compute a gross R&D credit and add back the amount to their deductions rather than compute a net credit under Sec. 280C. This can occur when the net credit does not meet or exceed the cap in place for the payroll credit. Since the maximum will double for tax years beginning after Dec. 31, 2022, more taxpayers may need to evaluate whether forgoing the Sec. 280C election could be more advantageous for federal and state tax purposes.
Taxpayers should also consider tax planning opportunities to claim similar credits and incentives at the state level. For example, taxpayers may be eligible to offset Georgia state payroll withholding payments by using a Georgia research credit. While this is like the federal payroll tax offset, taxpayers must carefully follow the required state processes and procedures to make a valid claim.
The enhanced payroll tax offset provides a great opportunity for QSBs that do not have a federal income tax liability to otherwise offset their payroll tax and see near-term tax savings. Given the current economic uncertainties, this opportunity could provide taxpayers with another cash flow fund for its future research efforts and business operations. However, taxpayers should seek advice to evaluate and determine their eligibility and qualification for this incentive due to the inherent complexities of the R&D credit and the payroll tax offset rules.
— Pinky Shodhan, CPA, J.D., LL.M., MBA; Clay Chaberski, CPA; Nick Perry, E.A.; Monica Bambury, J.D., LL.M.; and Kevin Benton, E.A., are with Grant Thornton LLP. To comment on this column, contact Paul Bonner, the JofA’s tax editor.