Each year the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes, under the US Research & Experimentation Tax Credit (R&D Tax Credit) program.
The R&D Tax Credit is a general business tax credit under Internal Revenue Code section 41 for businesses that incur research and development (R&D) costs in the United States. The US R&D tax credit has been around since 1981.
Previously, the program would periodically expire and be renewed by Congress. Businesses wishing to include this in their long-term budgeting plans couldn’t count on the credit being around for certain. In 2015, the Congress made the R&D tax credit permanent as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015 and also made key changes so that more businesses could benefit from the credit.
Historically, startups that were not paying federal income taxes could claim R&D Tax Credits, but would need to carry them forward on their corporate and/or shareholder returns until they could offset their income tax liabilities. This made it difficult for startups or businesses that weren’t profitable to benefit from the credits.
With the new changes, startups can apply the R&D tax credit against the employer portion of Social Security taxes up to $250,000 for each fiscal year. The new Social Security tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability.
What is a qualified small business?
1. A business that has gross receipts of $5 million or less for the tax year.
2. Has gross receipts for five years or less. The business must not have gross receipts for any tax year before the 5-tax-year period ending with the tax year they’re applying for. For example, businesses that have generated gross receipts prior to 2012 are not eligible to claim for the 2016 tax year.
However, businesses that existed prior to 2012 but didn’t receive gross receipts could still qualify. Although the law is intended to benefit small businesses, larger businesses could also benefit from the rules as they’re written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives U.S. Food and Drug Administration approval.
3. Is not a tax-exempt organization under section 501.
What work qualifies for the R&D tax credit?
Qualified research is work intended to achieve innovation within a scientific or technological field. The R&D efforts must pass a 4-part test in order to be eligible:
- Permitted Purpose: develop new (or improve existing) functionality, performance, reliability, or quality of a business component i.e. any product, process, technique, invention, formula, or computer software that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer’s trade or business.
- Elimination of Uncertainty: discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if publicly available information and knowledge cannot be applied to achieve the desired result i.e. capability of development or improvement, method of development or improvement, or the appropriateness of the business component’s design. Some questions to ask yourself are:
– What uncertainties did you attempt to overcome that could not be removed using standard practice?
– What work did you perform in the tax year to overcome the uncertainties described above?
– What advancements did you achieve as a result of the work described?
- Process of Experimentation: utilize a systematic process to identify the uncertainty as well as identify one or more alternatives to eliminate that uncertainty through, for example, modeling, simulation, or a systematic trial and error methodology.
- Technological in nature: within physical or biological sciences, engineering, or computer science.
How do I use the R&D tax credits to offset payroll taxes?
The payroll tax credit election is an annual election made by a qualified small business specifying the amount of research credit, not to exceed $250,000 per year, that may be used against the employer portion of Social Security liability. It is available for qualified expenses incurred in the 2016 tax year and after. If a business receives more than $250,000 in R&D tax credits, the remainder can be carried forward to offset Social Security taxes or reduce taxes owed in future years.
Businesses are required to pay Social Security tax of 6.2% on up to $128,400 of each employee’s salary. This means a business that employs 40 employees with an average annual salary of $100,000 per person would pay approximately $248,000 in Social Security payroll taxes in 2016.
You can first claim the qualified small business payroll tax credit for increasing research activities on Form 941 for the calendar quarter that begins after you file your income tax return. Form 941 is a quarterly statement used to report any withheld taxes from an employee’s paychecks and/or to report payment of the employer’s portion of Social Security or Medicare tax.
For example, if you file your 2016 income tax return based on a calendar year (January 1 – December 31) on March 15, 2017, the 2017 second quarter (April 1, 2017– June 30, 2017) Form 941, which is filed by July 31, 2017, is the first quarter that you can take advantage of the credits.
What are the deadlines to claim?
To offset Social Security taxes owing, the R&D tax credits must be specified and elected by a qualified small business with its timely filed (including extensions) income tax return for the taxable year to which the election applies. You can then begin offsetting your social security taxes for the calendar quarter that begins after you file your income tax return with the payroll tax credit election.
The IRS provides interim relief for qualified small businesses that timely filed returns for taxable year 2016, but failed to make the payroll tax credit election. In this case, the business may make the election on an amended return filed on or before December 31, 2017.
C Corps with a December fiscal year end should claim on or before April 15. C Corps with fiscal year ends other than December should claim on or before 4.5 months following the end of the tax year.
S Corps with a December fiscal year should claim on or before March 15. S Corps with fiscal year ends other than December should claim on or before the 15th day of the 3rd month following the end of the tax year.
To offset income taxes owing, businesses have the flexibility to go back and amend all open tax years (usually last 3 years).
How much of my R&D costs can I recover?
Let’s look at a business operating in California as an example.
Federal portion – ~10% of eligible expenditures.
State portion – 7.5% of eligible expenditures.
Startups could potentially use the credits towards Social Security taxes for up to five years, with a maximum of $1.25 million in total credits claimed on their quarterly payroll tax returns.
For example, a startup with $500,000 of eligible software engineering expenses, could credit $50,000 or more, while a company with over $2.5 million in eligible expenses in 2016 could have a credit subject to the full $250,000 annual limitation. If the credit amount exceeds a company’s Social Security tax liability in any given quarter, the excess will be carried forward to the next calendar quarter.
While the Social Security tax offset may be available to new businesses and startup companies for up to five years, any unused Federal R&D credits that are not elected to offset Social Security taxes may be carried forward for up to 20 years and used when the business becomes profitable.
California state R&D credits can only be applied against income taxes and may be carried forward indefinitely.
How do I know if the work I’m doing qualifies for R&D tax credits?
Here are a few questions that you can use to determine whether the work you’re doing qualifies:
-Are you involved in engineering, design, data collection, testing or other developmental work?
-Have you designed or developed new software?
-Have you changed a process to reduce costs?
-Have you created a new product, made improvements or added new features to an existing product, or built a prototype?
-Have you incurred costs related to a process, project or prototype that is incomplete because of unresolved technical problems?
If you’ve never claimed the US R&D tax credit previously either because you didn’t think you qualified or you couldn’t use the credits, it’s a great time to reconsider.
If you have any further questions, contact us for a complimentary no-obligation assessment. We will go through your project(s) in more detail, tell you what qualifies and what doesn’t, and provide an estimate of your potential return.