For qualified small businesses (QSB), including technology companies, federal tax credits for research and development (R&D) can be a valuable tool for offsetting payroll tax costs. A tax credit is an immediate source of cash, as well as a way to offset future federal and state tax liabilities. Because R&D is such a key aspect of the technology industry, technology companies should be especially tuned in to this tax savings opportunity.
Activities that qualify for this offset are expansive—more so than many small business owners realize. And the tax savings can free up cash for other operating costs. Technology companies looking for ways to boost their cash flow can use the savings from the payroll tax offset to fund operations, including payroll and equipment costs, as well as future developments.
Once qualified entities identify their qualified R&D activities and calculate the R&D Tax Credit, they can make an election to use up to $250,000 of the credit per year to offset payroll tax cost.
Which Activities Qualify for the R&D Tax Credit?
Companies, regardless of industry, can potentially qualify for the R&D credit if their activity meets the following four-part test:
- Developmental uncertainty exists. Uncertainty exists if at the outset, the taxpayer is uncertain about (1) if it can develop the product, process, or design it wants to develop, (2) how to develop the product, process, or design it wants to develop, or (3) the appropriate design of the product process or design it wants to develop.
- Process of experimentation. The taxpayer must engage in a process of evaluating and testing different alternatives designed to eliminate uncertainty about the development or appropriate design of a product, process, or design.
- Technological in nature. The process of experimentation used in the research must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
- New or improved functionality. The development activities must relate to a new or improved function of a product, process, or design, or its performance, reliability, or quality. Development relating to style, taste, cosmetic or seasonal design factors do not satisfy this requirement.
Some examples of daily activities in the tech sector that potentially qualify for the R&D tax credit include:
- Software architecture or algorithms aimed at improving efficiency
- New technology to streamline the manufacturing process
- Design of database management systems or document management systems
- Enhanced customer interface software
- Cloud migration solutions
- Software development for planned scaling challenges
- Improving functionality and capabilities of existing applications
- Innovative designs to customer specifications
How Does a Technology Company or Other Small Business With No Taxable Income Benefit Immediately From the R&D Tax Credit?
Under current law, qualified small businesses can elect to offset payroll taxes up to $250,000 per year with their R&D tax credit. Pending federal legislation (The FORWARD Act) would increase this amount to $1 million per year.
The payroll tax offset is available for the employer’s Social Security portion (OASDI) of payroll taxes and is reported on the taxpayer’s Form 941. It is available on a quarterly basis, beginning the first calendar quarter after the taxpayer filed a federal income tax return. For example, for an income tax return claiming the R&D tax credit on March 31st, the taxpayer will be eligible to utilize the credit for the payroll tax offset on the second quarter Form 941 payroll tax return.
If a taxpayer can’t use the credit to offset payroll taxes for the current quarter or can only use a portion of the credit, the unused portion can be carried to subsequent quarters. Credit amounts of more than $250,000 can be applied to regular federal income tax and unused credit can be carried forward for 20 years to offset future federal income tax liability.
To qualify for the payroll tax offset, a startup or business must meet the following three tests:
Gross Receipts of less than $5 million in the tax credit year. This includes all amounts received for services, income from investments, and from incidental or outside sources. As currently defined by the IRS, unearned income (i.e. interest income) would need to be evaluated in determining eligibility for the gross receipts test.
No gross receipts for any taxable year preceding the 5-taxable-year period ending with the tax credit year. However, companies could still be eligible for the R&D tax credit if they have existed more than five years but have spent a significant amount on developing or improving a component if they meet the $0 gross receipts test. The gross receipts limitation includes limits on unearned income.
Claimed the R&D Tax Credit on a currently filed tax return. The payroll tax offset cannot be taken by claiming the credit on an amended return. Also, the taxpayer cannot use prior year R&D tax credit carryforwards before the initial payroll offset claim.
Here are two examples of how qualified companies can benefit from the credit:
- The taxpayer incurs $200,000 in qualified R&D costs in development of software client interface, generating an R&D tax credit of $20,000 on a currently filed return. Although the company was founded in 2014, it has generated no gross receipts to date. Therefore, it meets the three criteria of the qualified startup test. The company can offset $20,000 of its FICA payroll taxes on its quarterly Form 941 filings using the R&D tax credit.
- A company founded in 2017 has generated $300,000 in gross receipts each year to date. In 2020, the taxpayer incurred $8,000,000 in qualified R&D costs related to developing its new product line, generating an R&D tax credit of $600,000 on a currently filed return. Because it meets the three criteria of the qualified startup test, the company can offset its FICA payroll tax on its quarterly Form 941 filings using $250,000 of R&D tax credits. The remaining $350,000 in credits will carry forward for 20 years to offset future regular tax liability.
Weaver can help you identify and calculate your potential R&D tax credit and work with you to build the documentation to support your credit claim. Contact us. We are here to help.