Offsetting small business payroll tax and AMT with R&D credits

In addition to making the research and development (R&D) tax credit permanent, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), provides two key incentives to eligible small businesses for taxable years beginning on or after Jan. 1, 2016. The following information provides some general guidelines, pending issuance of further guidance from the Treasury Department.

Offset payroll taxes by up to $250,000 per year with R&D credits

Businesses with less than $5 million in gross receipts in the current taxable year (and that have no gross receipts for any taxable year prior to the five-taxable-year period ending with the current taxable year) can offset the employer portion of OASDI (Social Security tax) by up to $250,000 each year.

Some specifics

• If gross receipts are less than $5 million in 2016, the business must have no gross receipts before 2012.
• The definition of ‘qualified small business’ includes corporations (including S corporations), partnerships or individuals, but does not include organizations exempt from tax under section 501.
• Controlled group rules apply. All persons or entities with >50 percent common ownership are treated as a single taxpayer under section 41(f)(1) for purposes of this provision.
• Taxpayers must make an annual election specifying the amount of its research credit (not to exceed $250,000) used as a payroll tax credit, on or before the due date of its originally filed tax return, including extensions. After making the election, companies may begin to offset the employer portion of OASDI in the following calendar quarter. Revoking the election requires permission from the Secretary of the Treasury.
• Social Security tax amounts to 6.2 percent of an employee’s social security taxable wages for the calendar year (the 2016 social security taxable wage limit is $118,500).

R&D tax credits now applicable to alternative minimum tax (AMT)

Businesses with average annual gross receipts less than $50 million may now offset both regular tax and AMT with R&D tax credits. Previously, companies in AMT were unable to utilize R&D tax credits to offset their tax liability.

Some specifics

• Section 38(c)(5)(C) defines an ‘eligible small business’ as a corporation that is not publicly traded, a partnership or a sole proprietorship with average annual gross receipts for the three-taxable-year period preceding the current taxable year not exceeding $50 million.
• Special rules under section 448(c)(3) apply: If the business (including predecessor entity) was not in existence for an entire three-year period, the gross receipts test applies to the period it was in existence, and gross receipts for short taxable years shall be annualized.

Frequently asked questions

1.    When do these provisions take effect?

Starting with tax years beginning on or after Jan. 1, 2016. Unless there’s a short tax year, the election would be made on the 2016 calendar year tax return with a due date in 2017 (e.g., March 15, 2017, for corporate taxpayers). Making the election on the 2016 tax return allows the payroll tax offset to be used the following calendar quarter, i.e., applied to the second quarter Form 941 due by July 31, 2017.

2.    What do companies need to do and when?

Since the election needs to be made on an original tax return, companies should begin to review their eligibility under the new rules now. Starting now allows companies to assess their potential benefit and identify information needed to make the election to offset payroll taxes or AMT.

3.    Is this limited to specific industries?

No, any for-profit company conducting qualified research defined by the four-part test below, could potentially be eligible for R&D credits and these provisions. Companies exempt from tax under section 501(c) are not eligible.

Permitted purpose – The activity relates to a new or improved function, performance, reliability or quality of a business component (e.g., a product, process, computer software, technique, formula or invention).

Technological in nature – The activity performed must fundamentally rely on principles of computer science, physical science, biological science or engineering.

Elimination of uncertainty – The activity must be intended to discover information to eliminate technical uncertainty concerning the capability or method for developing or improving a business component, or the appropriate design of the business component to achieve the desired results.

Process of experimentation – Substantially all of the activities must be elements of a process of experimentation designed to evaluate one or more alternative solutions in an effort to eliminate the technical uncertainty.

4.    How will the payroll tax offset be taken on the tax returns?

Three tax forms will be used to report the offset of payroll tax by the R&D credit:

Form 6765 (Credit for Increasing Research Activities) will be revised so companies can make an annual election to specify the amount of R&D credits that will be applied to the employer-portion of Social Security tax. An annual election to apply R&D credits can be made for up to five years.

Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) is a new form that will be introduced in draft version in January 2017. Companies will use this form to report the amount of R&D credits elected on Form 6765 to offset Social Security tax and the form will be filed with Form 941 each quarter that the credit is applied to the Social Security tax liability.

Form 941 (Employers Federal Quarterly Tax Return) will be revised to include the amount reported on Form 8974 each quarter.

5.    Can carryforward credits from taxable years prior to 2016 be used to offset payroll taxes or AMT?

Based on current legislation, carryforward credits from taxable years beginning before Jan. 1, 2016, cannot be used to offset payroll taxes or AMT.

6.    Can a company carryback credits to offset payroll taxes or AMT in prior years?

No, the current legislation does not provide for carryback of credits to taxable years beginning before Jan. 1, 2016.

7.    Will  company need to bifurcate its R&D credit carryforward if it does not use all of the credits for offset?

A company will need to track its credit carryforwards separately. For example, a company may have pre-2016 credits that cannot be used to offset OASDI or AMT but can still be carried forward for up to 20 years to offset regular income tax liabilities. That same company may also have credit carryforwards from post-2015 years that can be offset against OASDI or AMT in future periods. Additionally, if a company makes an election to claim a certain amount of R&D credits against its employer OASDI liability and does not utilize all of the elected credits in the first eligible quarter, the company may carryforward the elected credits to the next calendar quarter. It is unclear whether the payroll tax offset credit may be carried over to the next calendar year if it is not used in subsequent quarters within the same year. It is hoped that the pending IRS guidance will clarify this issue.

8.    Is the payroll tax offset limited to R&D wages?

No. Each year, up to $250,000 in R&D credits may be used to offset employer OASDI tax liability applicable to the entire workforce. In total, a company may be able to offset up to a maximum of $1.25 million of payroll taxes ($250,000 x 5 years maximum).

9.    What is an example of the payroll tax benefit?