Applying Research Tax Credits to Payroll Taxes

Recent changes in the federal tax law now allow companies to offset payroll taxes with federal research tax credits. This situation most likely applies to startup companies that are incurring payroll expenses, but not yet generating taxable income. This change is effective for tax years beginning in calendar year 2016.
The payroll tax election may influence some of you to undertake or increase your research activities. On the other hand, if you are engaged in or are planning to engage in research activities without regard to tax consequences, let the below discussion simply serve as notice that some tax relief could be in your future.Why is the election important?

Many startup businesses may not pay income taxes for the first several years of operations, even if they have some cash flow, or even net positive cash flow and/or a book profit. Thus, general business tax credits, including the research credit, offer no immediate benefit for the startup company. On the other hand, many startup companies have large payrolls during the startup phase and incur payroll tax liabilities. The payroll tax election these startups to get immediate use out of the research tax credits. Because every dollar of credit-eligible expenditure can result in as much as a 10 cent tax credit, that’s a big help in the start-up phase of a business-the time when help is most needed.

What businesses are eligible?

To qualify for the election the business (1) must have gross receipts for the election year of less than $5 million and (2) be no more than five years past the period for which it had no receipts (the start-up period). Also, the election cannot be made for more than six years in a row.

Limits on the election

Research tax credits can only be applied against the employer’s “social security” portion of FICA taxes. So the election can’t be used to lower (1) the employer’s liability for the “Medicare” portion of FICA taxes or (2) any FICA taxes that the employer withholds and remits to the government on behalf of employees.

Companies can elect up to apply up to $250,000 of the research tax credits to payroll taxes annually. In the case of a Schedule C business or a C corporation the election can only be used for those research credits which, in the absence of an election, would have to be carried forward. Therefore, a C corporation can’t make the election for research credits that the taxpayer can use to reduce current or past income tax liabilities.

This is a basic overview of how the research tax credit can be applied to offset payroll taxes. Identifying and substantiating expenses eligible for the research credit itself is a complex area. Please contact us, if you are interested in discussing the research tax credit and how it might benefit your company.

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