R&D Tax Credit Payroll Offset – How Your Firm Can Benefit!

In March, we discussed some great updates to the Research & Development (R&D) tax credit. First introduced in 1981 as a temporary measure (and extended 16 times in the years since), the credit finally became permanent in late 2015 with the passage of the Protecting Americans from Tax Hikes (PATH) Act.

But this permanency wasn’t the only positive change. PATH also stated that small businesses can use the R&D tax credit to offset their payroll taxes for up to five years. Given that 90% of tech startups fail within their first year, this provides a critical and immediate benefit to young companies that are earning little (if any) income but still have employees to pay.

Even better news – this provision goes into effect as of December 31, 2015. So if you’re a small/start-up tech firm, you can start preparing now to take advantage of this benefit on your 2016 tax return! Read on to see whether you qualify and how to get started.

What companies are eligible for the tax credit payroll offset?

The new payroll provision is available only to small businesses, as defined by the following requirements:

  • The company has gross receipts of $5 million or less in 2016.
  • The company has only had gross receipts within the last five years. So if you have any gross receipts from earlier than 2012, you do not qualify. (Note that it’s fine if your company has existed for longer than five years; it just can’t have gross receipts from before that timeframe.)
  • The company participates in qualifying research activities and expenditures.

What can be classified as R&D?

Essentially, R&D encompasses work that results in improved products or processes to the extent that these improvements are new to the market or industry. Experimenting with new technologies and materials, designing new products, research to discover new knowledge are all examples of R&D. You might have noticed a pattern of “new” here; this is because there must be a level of uncertainty related to the product or process development. The work must also have a general business purpose, as opposed to research performed merely out of curiosity.

How do I get started?

You’ll need to gather documentation that demonstrates how your company’s work fills the qualifications of R&D as specified by this provision. Thankfully, 2016 isn’t even halfway through – so there’s plenty of time to start preparing!

The key is to provide documentation proving that the work is actually based in research and development (this proof is often called a “nexus” by tax professionals). This can include minutes from meetings, email exchanges, and other communications that show your intent and a trial-and-error process.

Documenting the hours worked for specific projects will also demonstrate the specific intent of the work. If you use project management or tracking software to monitor your company’s progress (and employee hours), you already have a good start as long as each project’s description is thorough enough to demonstrate that it falls under R&D.

Compiling documentation now and as the year progresses can save you many hours of work during tax season. You can also use this information if you’re writing off R&D expenses beyond payroll tax, such as equipment purchases.

Sounds like a lot of paperwork. How much can it really help me?

The maximum credit is $250,000 each eligible year (for up to five years) against your payroll taxes under this new provision. Any unused portion of your yearly credit can also be rolled over for use the following year. So the benefits can really add up.

For example, a company with $50,000 of eligible R&D expenses could potentially have a credit of $5,000, while a company with over $3 million in eligible R&D expenses in 2016 could have a credit subject to the full $250,000 annual limitation. If the amount of the credit exceeds a company’s social security tax liability in any given quarter, the excess will be carried forward to the next calendar quarter.

As with many tax credits, qualifications for the R&D credit payroll offset are subject to interpretation. Using these credits can also open you up for scrutiny by the IRS. So be sure to ask an accounting professional if you have any questions about how to use of this credit and determine eligible work.

Laying the groundwork to take advantage of the R&D credit might seem daunting at first and will take a bit of time. But the benefits can make a huge difference during the years leading up to profitability – a time when many startups are shuttered before realizing their potential. See what these new developments can do for you!

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