You may be eligible for a research tax credit that can now be used to offset your federal payroll tax bill —if your small business engages in qualified research activities.

The IRS recently issued guidance that explains how to take advantage of this election. This relatively new privilege allows research credits to benefit small businesses that may not generate enough taxable income to use the credits to offset their federal income tax bills. Here are some details.

Who is Eligible?

A qualified small business (QSB) can elect to use up to $250,000 of its research credits to reduce the Social Security tax portion of its federal payroll tax bills, under the PATH Act of 2015. Previously, QSBs could use the credit to offset only their federal income tax bills under the old rules. However, many small businesses owe little or no federal income tax, especially small start-ups that tend to incur significant research expenses.

A QSB is generally defined as a business with:

• Gross receipts of less than $5 million for the current tax year, and
• No gross receipts for at least one tax year in the five-year period preceding the current tax year.

So the payroll tax reduction election is available to only newer small businesses that may still be in the unprofitable start-up phase.

Which Research Activities Qualify?

A business must have engaged in “qualified” research activities to be eligible for the research credit. To be considered “qualified,” activities must meet the following four-factor test:

1. The purpose must be to create new (or improve existing) functionality, performance, reliability or quality of a product, process, technique, invention, formula or computer software that will be sold or used in your trade or business.
2. There must be an intention to eliminate uncertainty.
3. There must be a process of experimentation. In other words, there must be a trial-and-error process.
4. The process of experimentation must fundamentally rely on principles of physical or biological science, engineering or computer science.

Expenses that qualify for the credit include wages for supervising or performing qualified research, time spent engaging in supporting, supplies consumed in the process of experimentation, and 65% of any contracted outside research expenses.

The Timing Issues

The payroll tax reduction election must be made on or before the due date (including extensions) of the QSB’s federal income tax return for the tax year for which the election is to apply. The research credit for that tax year can then be used to reduce the QSB’s federal payroll tax bills, starting with the bill for the first calendar quarter that begins after the date that the QSB files its federal income tax return for the tax year for which the election is to apply.

For example, if your business is a calendar-year C corporation that filed its 2016 federal income tax return on April 18, 2017, then the company can use its 2016 research credit to reduce its federal payroll tax bills, starting with the third quarter of 2017.

The allowable payroll tax reduction credit can’t exceed the employer’s portion of the Social Security tax liability imposed for any calendar quarter. Any excess credit can be carried forward to the next calendar quarter, subject to the Social Security tax limitation for that quarter.

For QSBs that file only an annual federal payroll tax return (for example, certain agricultural employers), IRS guidance specifies that the payroll tax reduction credit is claimed on the annual payroll tax return that includes the first quarter beginning after the date on which the business files its federal income tax return with which the payroll tax reduction credit election is made.

Tax Return Filing Requirements

To elect the payroll tax reduction credit for a tax year for which the election is to apply, QSBs must file specific forms. There are separate forms to attach to your federal income tax return and payroll tax return. In addition, members of a controlled group of corporations must attach a statement showing how each member’s share of the research credit was determined and providing the names and employer ID numbers (EINs) of the other group members.

Many QSBs have already filed their 2016 federal income tax returns without making the payroll tax reduction election. IRS guidance suggests that you file any amended 2016 returns by no later than December 31, 2017.

Need Assistance?

Filler and Associates of Portland, Maine, or your tax advisor can help you make the election for your business (or amend your business’s 2016 federal income tax return, if necessary) and help you file payroll tax returns that take advantage of the new privilege. Your advisor can also answer any additional questions you may have about claiming the research credit.

The new payroll tax reduction credit deal is a welcome change for eligible small businesses that generate research credits.