The R&D Payroll Tax Credit: What Startups and Small Businesses Should Know
By Archita Roy, Tax Staff Accountant
Many startups invest heavily in research and development during their early years, often before they begin generating profit. Although these activities may qualify for valuable federal R&D tax credits, a business with little or no income tax liability may not be able to use those credits right away. Unused business credits generally may be carried back 1 year and carried forward up to 20 years, subject to the general business credit rules.
To address this timing problem, Congress created a payroll tax credit election for eligible qualified small businesses. Instead of waiting until the business has enough income tax liability, a qualifying startup or small business may elect to use a portion of its federal R&D credit to reduce certain employer payroll taxes.
Who Can Use the R&D Credit Against Payroll Taxes?
A business must first generate federal credit for increasing research activities. In general, qualified research must relate to domestic research or experimental expenditures, be technological in nature, be intended to develop a new or improved business component and involve a process of experimentation directed toward new or improved function, performance, reliability or quality. Activities focused on style, taste, cosmetic or seasonal design factors do not qualify.
The payroll tax credit election is available only to a qualified small business (QSB). To qualify, a corporation or partnership generally must meet both of the following requirements:
- Gross Receipts Test: Gross receipts for the current taxable year must be less than $5 million.
- Five-Tax-Year Test: The business must not have had gross receipts for any taxable year before the five-taxable-year period ending with the current taxable year. Importantly, this test is based on the business’s gross receipts history, not simply when the entity was formed.
For this purpose, gross receipts generally include total sales net of returns and allowances, amounts received for services, investment income, and incidental or outside-source income such as interest, dividends, rents, royalties and annuities. Gross receipts are not reduced by cost of goods sold or by many other costs, and certain items such as loan principal repayments are excluded.
How the Payroll Tax Credit Election Works
A qualified small business does not have to apply its entire R&D credit against payroll taxes. Instead, it may elect to apply only a portion of the credit as a payroll tax credit and preserve any remaining eligible credit for use under the regular income tax credit rules. The payroll tax credit portion is generally the least of the amount elected, the credit otherwise determined for the year, or, for taxpayers other than partnerships and S corporations, the applicable business credit carryforward from that taxable year.
For taxable years beginning after December 31, 2022, eligible businesses may elect up to $500,000 annually. This consists of the original $250,000 limitation plus an additional $250,000 increase.
The election must be made on a timely filed original federal income tax return, including extensions, using Form 6765, Credit for Increasing Research Activities. Once elected, the credit is claimed through Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, which is attached to the applicable payroll tax return, such as Form 941, Form 943 or Form 944.
Which Payroll Taxes Can Be Offset?
Beginning with the first quarter of 2023, the payroll tax credit first reduces the employer share of Social Security tax, up to $250,000 for the quarter. Any remaining credit then reduces the employer share of Medicare tax. If the credit exceeds those payroll tax liabilities for the quarter, the unused amount carries forward to the next quarter.
The payroll tax credit may not be used against federal income tax withholding, the employee share of Social Security tax or the employee share of Medicare tax. It also may not be carried back to prior quarters.
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