Not only did the 2015 PATH Act restore and make permanent the Research and Development (R&D) credit under IRC Sec 41; it added new subsection IRC Sec. 41(h) which allows qualified small businesses to use the credit against payroll taxes. Prior to the PATH Act, the R&D credit could only be used against income tax, which did not make it attractive to most start-up companies that typically incur significant R&D expenses but no income tax.
Starting with tax years beginning in calendar year 2016, the new subsection allows a qualified small business to elect to use the R&D credit against payroll taxes. Under IRC Sec 41(h) a qualified small business is a person, corporation or partnership with gross receipts of less than $5 million in the taxable year of the credit, and such entity did not have gross receipts for any taxable year preceding the five-taxable-years, ending with the taxable year of the credit. There are aggregation rules that apply. The election is made on or before the due date, including extensions, of the tax return for the taxable year and must specify the amount of the credit to which the election applies.
The R&D credit elected to be used against payroll tax is limited to the least of $250,000, the amount of the credit determined without regard to the election, or in the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward from the tax year determined without regard to the election.
The payroll tax credit election can only be used against the employer’s share of the social security portion of FICA taxes. It cannot be used to lower the employer’s portion of the Medicare tax or any FICA taxes the employer withholds and remits to the government on behalf of employees.
While the R&D payroll tax credit is limited, the credit against payroll taxes is not taken into account in determining the amount of income tax deduction allowed for payroll taxes. In other words, the payroll tax deduction is not be reduced by the amount of the R&D credit elected to be used against payroll taxes.
The R&D credit against payroll taxes is allowed for the first calendar quarter after the date the tax return is filed with the election. Any credit not used in the first calendar quarter will be carried over to the next calendar quarter. Many small businesses have payroll tax expenses but no income tax while they are in start-up mode which makes the new election to use R&D credit against payroll taxes an opportunity to get immediate benefit from the R&D credit.
Editor’s note: This article originally ran in the Houston Business Journal.