How to Claim Research Payroll Credits
Rob Swenson, CPA, MST
If a business dedicates resources to creating or improving products, processes or software, it may be eligible for substantial federal tax credits for “increasing research activities.” There’s just one catch: To enjoy the benefits, the company must have sufficient federal tax liability against which to offset the credit. Historically, that meant income tax liability, but qualifying small businesses may now elect to apply some or all of their research credit against up to $250,000 in payroll taxes. This article details how to claim a research payroll tax credit. A sidebar explains how a business can claim the credit on their 2016 return.
If your business dedicates resources to creating or improving products, processes or software, it may be eligible for substantial federal tax credits for “increasing research activities.” There’s just one catch: To enjoy the benefits, you must have sufficient federal tax liability against which to offset the credit. Historically, that meant income tax liability, but qualifying small businesses may now elect to apply some or all of their research credit against up to $250,000 in payroll taxes.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 not only made the research credit permanent but created the payroll tax election for the research credit (often referred to as the “research and development,” “R&D” or “research and experimentation” credit). IRS Notice 2017-23 provides interim guidance on claiming research credits against payroll taxes. In addition to clarifying the eligibility requirements and outlining the procedures for making the election, the IRS allows companies that failed to make the payroll tax credit election on their 2016 return to take advantage of the credit by filing an amended return on or before December 31, 2017. (See “Not too late for 2016.”)
Is Your Business Eligible
Research payroll tax credits are intended to provide relief to smaller businesses, particularly start-ups, which often invest heavily in research and development but have little or no income tax liability. Although unused credits may be carried forward up to 20 years, payroll tax credits allow these businesses to enjoy the benefits of research credits when they need them most, rather than wait until they begin to generate taxable income.
The PATH Act makes payroll tax credits available to “qualified small businesses,” defined as those with 1) less than $5 million in gross receipts in the current taxable year, and 2) no gross receipts for any taxable year preceding the five-taxableyear period ending with the current taxable year. (For example, a business making the payroll tax credit election for 2017 must not have had any gross receipts before 2013.)
Notice 2017-23 clarifies that, for purposes of determining whether a corporation (including an S corporation) or partnership (including a limited liability company taxed as a partnership) is a qualified small business, gross receipts include:
- Total sales, net of returns and allowances;
- All amounts received for services;
- Income from investments and other incidental or outside sources.
For businesses other than corporations and partnerships, gross receipts include all of a person’s aggregate gross receipts from all trades or businesses. The IRS doesn’t, as many had hoped, establish a “de minimis” test for gross receipts. So, unless the IRS provides additional guidance, a business with minimal gross receipts prior to the five-year period — even a small amount of bank interest — is ineligible. The IRS also requires members of a controlled group, or a group of businesses under common control, to aggregate their gross receipts for purposes of the $5 million threshold.
How to Claim Payroll Tax Credits
To take advantage of payroll tax credits, you must make the election by filing Form 6765, “Credit for Increasing Research Activities,” with your timely filed business income tax return. You may elect to apply some or all of your research credit against the employer portion of Social Security taxes. After you make the election, you may use your research credit to offset payroll taxes on a quarterly basis, starting with the first calendar quarter that begins after you file your federal income tax return. To claim the credit, you must file Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities,” with your Form 941, “Employer’s Quarterly Federal Tax Return,” for that quarter. The maximum payroll tax credit is $250,000 per year (with special rules for allocating that amount among members of a controlled group). In addition, you may not make a payroll tax credit election in more than five tax years. To the extent that your credit exceeds your Social Security tax liability in a given calendar quarter, you may carry the excess forward and use it as a credit against Social Security tax in the succeeding calendar quarter (subject to the annual five-tax-year limits).
The payroll tax credit is a valuable tax break for businesses that wouldn’t otherwise benefit currently from the research credit. The IRS may provide additional guidance that affects your eligibility for the credit, so be sure to monitor future guidance on the subject.
Sidebar: Not Too Late for 2016
If your business didn’t make a payroll tax credit election on its 2016 return, it’s not too late. But you need to act quickly. IRS Notice 2017-23 offers relief to qualified small businesses that filed their 2016 returns on time but didn’t make the election, provided they make the election on an amended return filed on or before December 31, 2017. (Because December 31 falls on a weekend and January 1 is a federal holiday, an amended return filed on January 2, 2018, will be considered timely.) To qualify for the extension, your business must include Form 6765, “Credit for Increasing Research Activities,” with its amended return and either 1) indicate at the top of the form that it is “FILED PURSUANT TO NOTICE 2017-23,” or 2) attach a statement to Form 6765 that the form is filed according to Notice 2017-23. For Illinois taxpayers, the state R&D credit has been retroactively restored for 2016 with the new Illinois budget passed in July. If you have previously filed your 2016 tax return and did not claim the R&D credit, then you can do so on an amended return.
Restricted Stock: Should You Pay Now or Later
Rob Swenson, CPA, MST
For growing companies, equity-based compensation is a powerful tool for attracting and retaining executives and other key employees. This article explains why a person who receives an award of restricted stock or purchases shares subject to vesting should consider making an election under Internal Revenue Code Section 83(b) to accelerate taxable income associated with the stock
For growing companies, equity-based compensation is a powerful tool for attracting and retaining executives and other key employees. If you receive an award of restricted stock or purchase shares subject to vesting, consider making an election under Internal Revenue Code Section 83(b) to accelerate taxable income associated with the stock.
Two Ways Section 83(b) Reduces Taxes
Accelerating income may seem counter-intuitive, but if the stock’s growth prospects are strong and the risk of forfeiture is low, a Section 83(b) election can generate significant tax savings. Ordinarily, restricted stock isn’t subject to tax until it vests. At that time, however, you’re subject to tax at ordinary-income rates on the stock’s vesting-date value (less the purchase price you paid, if any). This can result in a substantial tax bill if the stock has appreciated significantly in value.
A Section 83(b) election can reduce your taxes in two ways:
- If the stock’s value increases, the election minimizes ordinary-income taxes by allowing you to pay the tax on the grant or purchase date value rather than on the vesting date value. If you purchase the stock at its fair market value, you’ll recognize zero income on the purchase date.
- It accelerates the start of the one-year long-term capital gains holding period to the grant or purchase date rather than the vesting date. Remember, long-term capital gains rates are lower than ordinary-income rates.
Bear in mind that you can’t take too long to decide whether to make the election: You have only 30 days from the award or purchase date.
Section 83(b) Election in Action
Let’s say Heather’s employer grants her 10,000 shares of restricted stock with a fair market value of $1 per share. When the stock vests one year later, its value has grown to $10 per share. Heather sells the stock a year after the vesting date for $25 per share. Assume that Heather is in the 35% tax bracket and that her long-term capital gains tax rate is 15%. (To keep things simple, we’ll ignore state and payroll taxes.) If Heather doesn’t make a Section 83(b) election, no tax will be due when the stock is granted. When the stock vests, however, Heather will recognize $100,000 in ordinary income (10,000 × $10), resulting in a $35,000 tax bill. When Heather sells the stock a year later, she’ll recognize a long-term capital gain on the stock’s additional appreciation of $15 per share, resulting in a $22,500 tax bill (10,000 × $15 × 15%). Heather’s total tax liability is $57,500. Now, let’s assume that Heather files a timely Section 83(b) election when the stock is granted. She’ll pay tax on $10,000 in ordinary income as of the grant date ($3,500), but when she sells the stock two years later, all of its appreciation in value ($24 per share) will be treated as a long-term capital gain, resulting in a $36,000 tax bill (10,000 × $24 × 15%). Her total tax liability is $39,500. By making the election, Heather enjoys $18,000 in tax savings.
Consider the Risks
Be aware that a Section 83(b) election isn’t risk-free. If you forfeit the stock (because, for example, you leave the company before it vests) or the stock declines in value, you’ll have paid tax on income you didn’t receive. You also might end up paying more tax than necessary if tax rates go down. Your tax advisor can help you weigh the pros and cons.