Payroll Tax Credit for R&D: A Strategic Option for Startups

For many businesses, especially startups, the traditional R&D tax credit is a valuable tool for offsetting tax liabilities. However, businesses in their early stages often face a common challenge: they are not yet generating taxable income to utilize the traditional credit.

In response to this, the IRS offers a payroll tax credit option for small businesses, which allows them to leverage the R&D tax credit even before turning a profit. This is particularly useful for startups that have substantial research and development expenses but lack the revenue to immediately benefit from the traditional tax credit.

In this article, we’ll explore the payroll tax credit option, how to elect it on a timely filed return, the differences between the payroll tax credit and the traditional R&D tax credit, and the eligibility requirements for each.

What is the Payroll Tax Credit for R&D?

The payroll tax credit is a part of the R&D tax credit that enables eligible small businesses to use the credit to offset up to $500,000 of their payroll tax liability each year (starting with tax year 2023). This provision is especially useful for startups or early-stage companies that may not have any income tax liability to reduce but still have significant payroll expenses.

The payroll tax credit applies against the employer portion of the Social Security tax (6.2%) on wages paid to employees. This helps startups conserve cash by reducing their payroll tax obligations, effectively putting more capital back into the business to support further research and development efforts.

How to Elect the Payroll Tax Credit Option

To take advantage of the payroll tax credit, eligible businesses must make a timely election on their federal income tax return (Form 6765, “Credit for Increasing Research Activities”). It’s important to ensure the return is timely filed, including extensions, as the IRS does not permit late elections for this credit.

Here’s how to elect the payroll tax credit on your return:

1. File Form 6765: On your federal income tax return, complete Section D of Form 6765 to indicate your election to apply a portion of your R&D credit against payroll taxes.
2. Claim the credit on Form 941: After making the election on your income tax return, you can begin claiming the credit on Form 941, which is your quarterly payroll tax return. You will do this in the calendar quarter after you file the tax return with the election.
3. Offset payroll taxes: Once the election has been made and approved, the business can use the payroll tax credit to offset its Social Security tax obligation for that quarter and subsequent quarters.

Eligibility Requirements for the Payroll Tax Credit

Not all businesses can elect the payroll tax credit. To qualify, a business must meet specific eligibility requirements:

• Gross receipts: The business must have less than $5 million in gross receipts for the current tax year.
• Age of the business: The business cannot have gross receipts for more than five tax years. In other words, the company must be relatively new, and startups in their first five years of generating revenue are the primary target for this credit.
• R&D activities: The business must have qualifying research and development activities that meet the requirements of the traditional R&D tax credit. This means the company must be engaged in activities that meet the four-part test outlined by the IRS, which includes working to eliminate technical uncertainty through a process of experimentation based on hard sciences.

Differences Between the Payroll Tax Credit and the Traditional R&D Tax Credit

While both the payroll tax credit election and the traditional R&D tax credit are designed to incentivize research and development activities, they serve different purposes and are targeted at different types of businesses.

Timing of Benefits

• Traditional R&D tax credit: The traditional credit is applied against a company’s income tax liability. This means it benefits companies that are already generating taxable income. For companies without tax liability, this credit can be carried forward to offset future tax liabilities.
• Payroll tax credit: The payroll tax credit offers immediate benefits to startups or businesses that have little or no taxable income but do have payroll tax obligations. It allows these businesses to take advantage of the credit early in their development cycle, helping them conserve cash by reducing payroll taxes.

Eligible Businesses

• Traditional R&D tax credit: Available to all businesses engaged in qualifying R&D activities, regardless of their size or revenue. This credit can be used to offset income tax liability at both the federal and state levels.
• Payroll tax credit: This option is limited to startups and small businesses with less than $5 million in gross receipts and no more than five years of revenue. It specifically targets early-stage companies that are not yet profitable but still have significant payroll expenses.

Usage of Credit

• Traditional R&D tax credit: Applied to income tax liabilities and can be carried forward up to 20 years if not fully used in the year earned. This allows companies to bank the credits until they have enough income tax liability to utilize them.
• Payroll tax credit: Used to offset the employer portion of Social Security taxes on wages (6.2%). This credit is now capped at $500,000 annually (for tax years beginning in 2023), which can be claimed over multiple quarters if necessary.

Maximizing the Payroll Tax Credit for R&D

For small businesses and startups, the payroll tax credit provides an invaluable opportunity to claim the R&D tax credit even before they become profitable. By reducing payroll tax obligations, companies can direct more capital toward growth and innovation. However, to maximize the benefit, it’s essential that businesses carefully document their R&D activities to ensure they meet the eligibility requirements and properly file the necessary forms.

Understanding whether to elect the payroll tax credit versus carrying forward unused traditional R&D tax credits requires a clear strategy. Startups should evaluate their growth projections, payroll expenses and future profitability to determine the best course of action.

Closing Thoughts: Consult an R&D Tax Credit Expert

Navigating the complexities of the R&D tax credit, including the payroll tax option, requires careful attention to detail. Ensuring that your business qualifies for the credit, properly documenting R&D activities and electing the payroll tax credit on a timely filed return are all critical steps.

At James Moore & Co., our R&D tax credit expert, Lucia Valenzuela, and her specialized team guide businesses through these complex tax matters. We offer tailored advice to help you maximize your R&D tax credit potential, whether through the traditional credit or the payroll tax option. Reach out to James Moore for personalized guidance on claiming and utilizing your R&D tax credits. Let us help you turn your innovation into tax savings today and in the future!

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.