What is the R&D Payroll Tax Credit and How Can You Claim It?
Overview of the R&D Credit Payroll Deduction
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The R&D tax credit rewards companies for doing new research and development. Eligible companies then claim a reduction in their income tax liability.
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New or smaller companies that are less than 5 years old and have less than $5 million in gross receipts for the year in question can, instead of claiming the credit against income tax, claim it against payroll taxes.
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There are specific criteria that determine a company’s eligibility, but on a high level, if your company is creating a new product, process, formula, or software, you likely qualify.
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Eligible companies (referred to by the IRS as “qualified small businesses”) figure out their credits the same way but then are able to apply them to payroll taxes. Qualified small businesses used to only be able to apply $250,000, but as of 2023 can go up to $500,000.
What is the purpose of the payroll deduction?
The R&D tax credit was established back in the 1980’s in order to incentivize companies to do, well, research and development. The federal government, as well as many state governments, offer this credit to companies that are trying to innovate and make new products, formulas, and inventions, including new software.
Historically, this leaned more toward manufacturing or traditional scientific research. These were existing, established companies paying income taxes, so they were offered a reduction in income taxes. But with the rise in computer software and small startups that could be doing important research, many small and new startups didn’t have much income tax liability.
So in 2015, the Protecting Americans from Tax Hikes (PATH) Act changed the options. The PATH Act let qualified small businesses apply their credits to payroll taxes. Specifically, it lets companies reduce the employer paid portion of the social security tax under FICA.
Since 2015, it has enabled qualified small businesses to reduce their payroll liability up to $250,000. As part of the Inflation Reduction Act of 2022, this ceiling was lifted to $500,000 for tax years starting in 2023.
What forms do you fill out and when do you file them?
There are a few forms that are important for the R&D credit - form 6765 and form 8974.
Understanding Form 6765
Form 6765, "Credit for Increasing Research Activities," is the cornerstone of claiming the R&D tax credit. It calculates the total credit amount based on eligible research expenses and determines if you qualify for the payroll deduction option.
Key aspects of Form 6765 for payroll deduction:
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Credit Calculation: The form guides you through calculating your qualified research expenses and determining the research credit base. From this base, it calculates the regular income tax credit and, importantly, the portion eligible for payroll tax offset.
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Election for Payroll Deduction: Section D of Form 6765 includes an election form where you signify your intent to apply a portion of the credit against your payroll taxes.
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Filing: Form 6765 must be attached to your timely filed income tax return.
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File with your income tax return, typically due in March or April for corporations.
Form 8974: Claiming the Payroll Tax Offset
Form 8974, "Qualified Research Expenses for QSBs," acts as your claim form for the payroll tax offset portion of the R&D credit.
Key aspects of Form 8974:
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Information Transfer: It pre-fills with relevant information pulled from Form 6765, including the eligible payroll tax offset amount.
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Filing: Attach Form 8974 to your quarterly Form 941, "Employer's Quarterly Federal Tax Return," for the quarters you wish to apply the offset.
Working with a PEO
If you are a small startup with no internal operations or HR team to handle all of this, it’s likely that you work with a PEO, or professional employer organization like ADP, Rippling, or Paychex. Many QSBs utilize PEOs, who handle payroll and tax administration. If you work with a PEO, understanding their role in claiming the R&D tax credit payroll deduction is crucial.
What does a PEO do for your R&D credit filing?
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The PEO gathers payroll and wage data needed for Form 8974.
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They may handle filing Form 8974 with your Form 941.
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They should collaborate with you on verifying expenses and completing Form 6765.
When working with your PEO on this, we recommend the following pieces of advice:
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Inform them about your intent to claim the R&D tax credit payroll deduction.
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Ensure they have access to all required payroll and expense data.
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Understand their role in completing and filing forms. Because the payroll deduction requires quarterly filing, you have to clarify who is responsible for what beforehand, and check after the fact to see how it was handled.
What happens if your company is acquired?
One interesting aspect of this is that R&D credits can be carried forward. Meaning if you can’t use all your credits that you have earned, it is possible to carry them forward for up to 20 years for the federal credit. Other states, like California, have varying rules on carry forward.
So what happens if you have earned all of these credits but have low income tax liability and haven’t used all of them toward a payroll tax deduction, and your company is acquired?
This can get super complicated depending on the circumstances of the acquisition, and it’s important to consult with a professional here. But if we look at US code section 383, in general these credits may be transferable if it’s a deal that includes the stock of the company, but may not be eligible if it includes the assets. So depending on your circumstances, these credits may actually be valuable to an acquiring company.
If you think your company is eligible for the R&D credit, Open Advisor can connect you with the best R&D tax credit partner for your situation. We work with the top companies in the industry which means you get the best fit at the best rate, at no additional cost. Ask for a comparison today.