R&D Credit Payroll Tax Offset

People working at a startup software development company

New businesses and startups have the opportunity to utilize the R&D tax credit to reduce their payroll taxes for a period of up to five years.

This tax credit was made permanent through the PATH Act of 2015. This act introduced several improvements, including provisions allowing eligible businesses to offset their alternative minimum and payroll taxes.

This credit applies only to qualifying R&D expenses incurred after the bill was signed into law. Under the PATH Act, eligible companies can claim a maximum benefit of $250,000 annually against their payroll taxes until December 31, 2022. However, following the Inflation Reduction Act, this election was increased to $500,000.

This provision offers substantial financial advantages to qualifying companies, enabling them to reduce their tax burden and invest more in their growth and development. It’s a valuable opportunity for businesses to maximize their resources while fostering innovation and research.

Related: Small Business Tax Planning Guide

How Can Startups Benefit From the R&D Credit Payroll Tax Offset?

The payroll tax credit election allows eligible small businesses to reduce their tax liability by a specific amount, up to $500,000 annually. This credit can be applied against their portion of Social Security and Medicare payroll taxes.

Typically, businesses must pay a 6.2% Social Security tax on employees’ earnings up to $147,000 and a 1.45% Medicare tax (with no wage limit). For example, a business with 40 employees earning $100,000 each would pay around $248,000 in Social Security taxes and $58,000 in Medicare taxes. By offsetting these taxes, startups can channel more funds into their business operations.

The full $500,000 credit cannot be applied to a single tax liability. Instead, businesses can allocate $250,000 each toward Social Security and Medicare taxes.

To benefit from this credit, small businesses must:

  1. Complete Form 6765 and specify the payroll tax credit amount. Submit this form with your business income tax return.
  1. Claim the tax credit by filling out Form 8974 and submitting it along with Form 941.

By navigating these steps, businesses can significantly lower their payroll tax burden, allowing them to reinvest in their growth and development initiatives.

Your startup could be leaving thousands on the table — Get your maximum R&D credit refund without the hassle of manual filing.

When Should New Businesses Claim the Credit?

The chance to reduce payroll taxes relies on the expenses incurred during the previous tax year — businesses must plan and act promptly to assess their eligibility under the new regulations. Acting swiftly enables companies to determine the information they must gather by the year-end.

Businesses need to specify and elect this credit in their original tax return to take advantage of the R&D tax credit and use it to lower payroll taxes. Ensuring that the credit is correctly identified and filed in the initial tax filing process is essential to using this opportunity.

Related: Accounting for Startups

How Can Startups Qualify for the R&D Credit?

A small startup company excited to get an R&D tax credit refund

The payroll-tax offset is a valuable opportunity for companies engaged in research activities, even if they aren’t yet profitable. Companies that had revenue before 2016 generally don’t qualify. However, if your business existed before 2016 but didn’t generate any revenue, you might still be eligible.

To qualify for this credit, your company must meet these requirements:

  1. Your business must have gross receipts for five years or less. Interest income, total sales, and money received for services are included in gross receipts.
  1. Your total gross receipts in the year you claim the credit must be less than $5 million.
  1. You must engage in qualifying research activities and related expenses.
  1. You have to confirm that your business has payroll-tax liability.

While designed for small businesses, this law can also benefit larger companies. For instance, many life sciences companies don’t have substantial revenue for years as they await FDA approval for their products. 

This opportunity can significantly boost your business finances, providing a benefit for your research efforts. It’s a valuable incentive that extends beyond just small startups, potentially helping businesses of various sizes.

What Do Businesses Need to Do to Claim the R&D Credit?

Documenting your R&D activities is crucial, but there’s no one-size-fits-all approach. The level of documentation needed depends on your company’s size and the scale of the claimed credits.

At a minimum, your documentation should demonstrate how your activities align with the four-part test for R&D eligibility. The type of documentation needed varies by industry. Companies can leverage records from their day-to-day operations and may need to review contracts with customers, partners, or vendors.

In addition, you must ensure the activities you claim are eligible for the credit — these include:

  • Taxable wages for employees who support or supervise R&D
  • Supplies used in research
  • Contractor expenses for performing research (with some conditions outlined by the IRS in the link above)
  • Computer rental costs, like renting server space that relates to software development

Related: R&D vs. R&E: Differences Explained

Should My Business Offset Its Payroll Taxes With the R&D Credit?

Startup employees having a casual meeting

The benefits of offsetting payroll taxes with the R&D credit are enormous for startups, allowing them to invest more in their business activities, even if they aren’t currently profitable.

The R&D credit is a valuable financial tool that can help your business pursue innovation, reduce its tax liability, and support its overall sustainability and growth.

However, once you start using R&D credits, expect closer scrutiny from the IRS. They assemble specialized teams, even for small businesses, to review these claims. Larger credits face more intense examination, demanding detailed review and documentation.

In addition, claiming credits without proper review and documentation can lead to significant IRS penalties. Incorrect payroll tax payments may result in recovery penalties, making accurate documentation and compliance essential.

Given the intricacies and potential penalties, we don’t recommend filing by yourself, especially if it’s the first year you plan to claim the R&D credit, to ensure compliance and protect your business from financial risks.

Filing your R&D credit claim has never been easier. See how we help startups benefit from their research and development activities.

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