How changes to the research credit help small businesses

Burton S. Speer, BridgeTower Media Newswires

ROCHESTER, NY — The “Protecting Americans from Tax Hikes Act of 2015” (the 2015 PATH Act) included an unexpected taxpayer-friendly bonus: Beginning in 2016, eligible small businesses may claim the research credit against the alternative minimum tax (AMT) liability. Even more important to certain “start-up” businesses is the ability to use the credit to offset the employer’s Social Security portion of the employer’s payroll tax (i.e., FICA) liability. If you don’t yet pay federal income taxes, the current value of a research credit is minor. The ability to offset payroll taxes can be huge, given that many early-stage enterprises do not yet pay income taxes due to their significant start-up expenditures.

The PATH Act has greatly expanded these companies’ potential R&D benefit, enabling them to offset, annually, up to $250,000 of their payroll taxes by using R&D credits. There is a $1.25 million limit on this benefit, over a five-year period. First, a review of the research credit rules. Overall, the research credit can be used by any company and is based on a percentage of the following qualified expenditures:

• Taxable wages for employees for research activities, and wages paid for their direct supervision.

• Supplies used in research, but not capital items.

• 65% of contract research payments made to others for the conduct of qualified research.

• Rental or lease costs of computers used in qualified activities, such as to cloud service providers.

In general, activities that qualify for the credit must meet each part of the following 4 part test:

• Technological In Nature. Activities must fundamentally rely on the principles of engineering, physics, chemistry, mathematics, biology, computer science, or similar natural or “hard” science. Therefore research regarding literary, historical, psychology, arts, humanities or other social sciences do not qualify.

• Permitted Purpose. Goal of the activities must be to develop or improve the form, fit, function, performance, reliability, cost, or quality of a new or existing product, process, technique, invention, software or formula. (Faster, better, stronger, greener, less expensive.)

• Technological uncertainty. The activities have an associated level of uncertainty related to the development or improvement of a product. Uncertainty exists if information available to the taxpayer does not establish a method for determining the ultimate design, and can relate to the capabilities of the product, methods used to make the product, or the correct design of the product.

• Process of experimentation. To eliminate the uncertainty, the activities must constitute elements of a process of theoretical and physical evaluation designed to evaluate one or more design alternatives; including developing hypotheses, and evaluating alternatives through modeling, simulation, systematic trial and error, or other methods.

Additionally, in order to qualify for the credit, the research must be performed in the U.S., and there must be an element of risk to the taxpayer. Research that is “funded” by another person, regardless of results, does not qualify, nor does reverse engineering. Many companies do not believe that they do anything that would qualify for the credit, but they are often wrong. The credit isn’t only for scientists working in white lab coats. If your company does work to improve a manufacturing process, make it quicker, less expensive, or more environmentally friendly, you may qualify for the credit.

And you don’t need to be a large company to get the credit. In fact, IRS records show that nearly $2.5 billion dollars in credits were claimed by companies with less than $25,000 in gross receipts over the past 10 years.
The credit can be used to offset the regular federal income tax, and may be carried back one year and carried forward 20 years. However, as mentioned above, many companies do not currently have a federal tax liability to offset.  Now the provisions included in the PATH Act change that situation for the better.

Certain small businesses may now use current year R&D credits against up to $250,000 of their payroll taxes each year. To be eligible, the company must have less than $5 million of gross receipts in the current year, and not have gross receipts for any tax year before the five tax years ending with the taxable year. So if you had any gross receipts six or more years ago, you are not eligible for this benefit.

A business does not actually need to be a “start-up” to qualify for this favorable payroll tax offset, it just needs to meet the above test. Companies with long development times are particularly fond of this provision.

The payroll tax benefit is available as an offset to your quarterly payroll tax filings, starting with the first calendar quarter that begins after you file your federal income tax return. For example, if you filed your 2016 federal income tax returns timely by March 15, 2017, you can apply the payroll tax offset to the second quarter of 2017. If you extended your tax return, you’ll be able to take advantage of the offset in the quarter after you file your federal return: So if you file your extended 2016 tax return by June 30, 2017, you will begin taking your offset on the Oct. 31, 2017, Form 941 filing, but if you waited one more day until July 1, the earliest you can take the offset would be on the Jan. 31 Form 941 filing.

In computing the $5 million of gross receipts test, businesses related or under common control must aggregate their gross receipts. Gross receipts are total sales (net of any returns and allowances) plus all amounts received for services. Investment income, such as interest, dividends or rental income, is also included.

If you can’t use all of the research credit to reduce your current payroll taxes this quarter, you are able to use the credit in future quarters, subject to the annual $250,000 cap. Any credits greater than the $250,000 annual limit can be used to reduce income tax liabilities for the next 20 years.


Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at Bspeer@ or (585)423-1860.