Some startups might be able to save up to $250,000 every year on their payroll taxes, but they may not know they qualify for this program.
The Credit for Increasing Research Activities, commonly referred to as the “R&D Credit,“ has been a widely popular government incentive intended to spur innovation and job growth within the United States. The credit was first enacted in 1981, and since then Congress has extended this income tax benefit over 15 times before it was made permanent through the PATH Act of 2015.
Along with the permanency of the credit, Congress also enacted a provision that allows qualified small businesses — i.e., startups — to effectively get a refund on their Social Security payroll tax liability if certain criteria are met, thereby incentivizing companies that truly need every penny to re-invest in development efforts.
For decades, the R&D Credit has been a favorite among businesses who meet the qualifications and were made aware of its generous benefits. However, many new companies are not able to use the R&D Credit when they are operating at a tax loss. Meanwhile, startup businesses with employees have several payroll tax obligations, of which Social Security and Medicare taxes are fairly well-known.
In 2023, the Social Security tax (also known as OASDI), is still going steady at 6.2 percent of an employee’s earnings. However, the maximum taxable earnings has increased to $147,000.This tax is paid concurrently by the employee and the employer, where the employer pays a matching contribution on a monthly basis. Payroll taxes can add up very quickly when building teams of personnel with technical backgrounds, and can catch many startup founders and CFOs off guard.
The criteria for being considered a qualified small business are two-fold:
- The company must have less than $5 million in gross receipts in the year the credit is claimed; and,
- They must not have any gross receipts five years prior to the year they are claiming a credit.
For startups filing their 2022 income tax returns, this would mean that they had less than $5 million reported as gross receipts while also not having any income reported on a tax return prior to 2017. (For example, even if you had interest income in 2016 or prior, you would be disqualified from the payroll tax offset.)
If a company is an eligible QSB and has qualified research expenses to generate an R&D credit as defined by Internal Revenue Code §41, the opportunity to keep more cash on hand can be hugely beneficial. In practice, many startup businesses claiming R&D credits can be found in the software development, FinTech, or life-science space, but the definition of qualified research in the Tax Code is very broad and can have far-reaching applicability (e.g., engineering, aerospace, and defense, mining, manufacturing, food processing, etc.).
Here’s an example of how a hypothetical startup could put this opportunity to work: Two founders create an idea to introduce a new virtual-reality product to consumers and decide to incorporate their company in 2023. They present their concept to venture capital firms and receive funding. Over the course of a few years, they build out a team of engineers and developers and their headcount grows quickly.
By the end of 2022, the company has 20 employees and less than $5 million in gross receipts. Fifteen of the 20 employees are found to have been spending substantially all of their time in 2018 on qualified research activities with respect to IRC §41, which produces $2 million in QREs. Without any “base limitation,“ the company, a QSB, is eligible to offset as much as $200,000 of their payroll tax liability starting in the quarter after they filed their income tax return. For example, if the company has a calendar year-end and filed their extended tax return before the end of Q2, they would first be able to use the benefit with their Q3 payroll tax return filing. If the company is not able to use all of their R&D Credit against payroll tax in that quarter, the credit can be carried forward to subsequent quarters until fully utilized.
However, if the same company was able to generate $4 million of QRE, the company could be entitled to the maximum payroll tax benefit in that year of $250,000. The credit for startups generated in excess of the $250,000 payroll tax offset maximum would be available to offset income tax liability or can be carried forward up to 20 years on the company’s income tax return. If eligible, the company could take advantage of the payroll offset for up to five years, but each year would have to be evaluated to make sure it still met the QSB eligibility requirements.
There has been guidance provided by the IRS that points to the logistics of claiming the R&D Credit against payroll tax, but to the lay person, this guidance is not very clear. Those seeking to benefit from this “cash refund” opportunity face many nuances and challenges. It is best to navigate the many rules with a tax professional working in concert with payroll providers. However, company leaders who are savvy enough to capitalize on Congress’s intent to spur growth in startups are often able to do just that.
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This article originally appeared March 1, 2019 in Accounting Today.
