IRS Issues Interim Guidance for Taxpayers Applying the Research Credit against Payroll Taxes


  Posted May 09, 2017 at 11:00 AM

       Qualified small businesses can apply elect to apply up to $250,000 of Research and Experimentation Credits (Research Credit) against their payroll tax obligations.  Previously, the credit was only available to offset income taxes and certain taxes on net gains.  This provision is applicable to tax years starting on or after January 1, 2016 and should be of particular interest to companies conducting research and development activities during the start-up and early-growth stages.  Businesses developing new products and software can realize a return on their sunk costs earlier than in previous years.

The ability to apply research credits to payroll taxes is due to the addition of Internal Revenue Code (IRC) sections 41(h) and 3111(f).  These sections were enacted by section 13(c) of the Protecting Americans from Tax Hikes Act of 2015, (Pub. L. No 114-113, Div. Q ,129 Stat. 2242).  IRS Notice 2017-23 provides interim guidance on several issues related to the credit as well as clarification as to the time and manner of making the payroll tax credit election and claiming the credit. 

Qualified Small Business

For these purposes, a qualified small business is a corporation (including an S-Corporation), or partnership (Including LLC’s/LLP’s taxed as partnerships) if the corporation or partnership:

1.      Has gross receipts of less than $5 million for the taxable year, and

2.      Did not have gross receipts for any taxable year before the 5-taxable-year period ending with the taxable year. 

Any other taxpayer, for example an individual taxpayer, is a qualified small business if the person meets the qualifications enumerated above considering the person’s gross receipts in carrying on all the person’s trade or businesses.   The latter provision affects mainly taxpayers filing business activities on Schedule C as flow-through entities apply the credit to payroll at the entity level. 

Gross receipts are defined by IRC section 448(c)(3) (without regard to section 448(c)(3)(A)) and Treas. Reg. section 1.448-1T(f)(2)(iii) and (iv).  So, all gross sales, receipts for services, interest, dividends, rents, royalties, proceeds from the sale of property and annuities are included in the definition of gross receipts.  Businesses had hoped that the Service would include a de minimus provision to exempt small amounts of items of income often found during early start-up stages such as interest income from bank accounts, cash grants and equity investments.  Unfortunately, for the time being, any receipt of income by the start-up small business starts the clock running on the 5-taxable-year period mentioned above.

The Interim Guidance offers the following illustrative.  Company A has the following Gross receipts 

                             Tax Year                                        Gross Receipts

                                2016                                                      $1M

                                2015                                                        7M

                                2014                                                        4M

                                2013                                                        3M

                                2012                                                       4M

                                2011…                                                    $0

Company A had no gross receipts in 2011 or any prior taxable year.  Company A is a qualified small business for taxable year 2016 because it had less than $5M for taxable year 2016 and did not have gross receipts before taxable year 2012 (prior to the five-year-period).  Note that the amount of gross receipts during the five-year-period are irrelevant in determining whether Company A is a qualified small business.  In 2017, Company A will not be a qualified small business because it has gross receipts in 2012. 

Companies that are members of a controlled group, as defined in Treas. Reg. section 1.41-6(a)(3)(ii) are treated as a single taxpayer in determining gross receipts for these purposes.  So, the aggregate gross receipts of all members of a controlled group must be considered in determining whether the requirements mentioned above are satisfied. 

 

Electing the Payroll Tax Credit

Electing to make a payroll tax credit election is a fairly simple process.  The taxpayer completes the appropriate section of Form 6765 and attaches the form to the businesses’ timely or extended return for the taxable year to which the election applies.  Taxpayers who may have already filed their tax returns for a taxable year starting on or after January 1, 2016 may make the election on an amended return filed on or before December 31, 2017.  Taxpayers making the election in this manner must either:

1.      Indicate on the top of its Form 6765 by including a statement such as, “FILED PURSUANT TO NOTICE 2017-23”, OR

2.      Attach a statement to its Form 6765 reflecting that the form is filed electing the payroll tax credit pursuant to Notice 2017-23. 

 Taxpayers then claim the payroll tax credit on the appropriate employment tax return.  Taxpayers filing quarterly employment tax returns claim the credit on its employment tax return for the first quarter that begins after it files the return reflecting the credit.  Taxpayers that file annual employment tax returns claim the payroll tax credit on its annual employment tax return that includes the first quarter beginning after the date on which the business files the return reflecting the election.  

 Taxpayers must also file Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities.  Taxpayers employing a Professional Employment Organization (PEO) can still benefit from this provision.  In this case, the PEO will file a Form 8974 along with their Form 941 and indicate the taxpayer’s EIN and election amount on the Form 8974. 

Limitations on the Credit

The amount of payroll tax credit elected may not exceed $250,000 nor the employer portion of the social security tax.  In addition, the election to apply research credits to payroll tax liabilities cannot be made for more than 5 taxable years.  Members of controlled groups are also subject to special rules considering and allocating these limitations.  Any payroll tax credit that exceeds these limitations are carried over to the succeeding periods and allowed as a payroll tax credit for the succeeding periods subject to the social security tax limitation and General Business Carryforward rules of IRC section 39.  There are no provisions to make the election on amended returns following December 31, 2017. 

Conclusion

Small early-stage businesses developing new products and software programs typically pass on the federal Research Credit since the cash benefit is not realized until the business generates significant taxable income.  Now companies planning to engage in or already engaged in the type of risky developmental activities the Research Credit is intended to incent will utilize the intended benefits sooner.  The new guidance broadens the reach of a proven Federal benefit program to small entrepreneurial, development businesses and encourages and rewards  technological advancement in the United States.