Understanding how the R&D tax credit can offset payroll taxes

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 key incentives to eligible small businesses for taxable years beginning on or after Jan. 1, 2016. One such incentive provides that 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 with the R&D tax credit (referred to as the payroll tax credit).  The payroll tax credit is enabled by the interaction of new IRC sections 41(h) and 3111(f).

On March 30, 2017, the Internal Revenue Service (IRS) issued interim guidance in the form of Notice 2017-23 that describes how eligible small businesses can apply all or part of their research credit against their payroll tax liability. This guidance focuses on the definition of gross receipts, aggregation rules, and the time and manner of making the election to claim the payroll tax credit.

Missing from the interim guidance are several items that many tax professionals had hoped to see addressed, including: (1) a de minimis test in regards to gross receipts, (2) an exclusion for grants, and (3) leniency with regards to the test for controlled groups and/or trades or businesses under common control.

The following addresses some frequently asked questions in relation to the R&D payroll tax credit:

What is the definition of gross receipts for purposes of applying the five-year and $5M gross receipts limitations?

• When determining eligibility for the payroll tax credit, gross receipts must be no more than $5M in the current tax year, and the taxpayer must not have had any gross receipts prior to the five-year period ending with the current tax year (e.g. for tax year 2016, there must be no gross receipts prior to 2012). For purposes of this measurement, gross receipts are defined under section 448(c)(3) (without regard to Sec. 448(c)(3)(A)) and are also defined in sections 1.448-1T(f)(2)(iii) and (iv). Accordingly, gross receipts include total sales (net of returns and allowances) and all receipts received for services, as well as income from investments, including interest, dividends, rents, royalties and annuities. Gross receipts also includes proceeds from the sale of property (described in section 1221(2)) used in a trade or business, reduced by the adjusted basis in the property. Notice 2017-23 clarifies that the definition of gross receipts under section 41(c)(7) and section 1.41-3(c) does not apply for purposes of section 41(h).
• Notice 2017-23 does not provide a de minimis test in regards to gross receipts.  As it is written, a company receiving minimal gross receipts in the form of bank interest or a dividend in any year prior to the five year period referenced above would be ineligible to elect the payroll tax credit.

Is aggregation required when determining whether the gross receipts requirements are satisfied?

• All members of a controlled group or a group of trades or businesses under common control, as defined in section 1.41-6(a)(3)(ii), are treated as a single taxpayer. Thus, the aggregate gross receipts of all members of a controlled group for the taxable year must be considered when determining whether the requirements of the Notice are satisfied.  For example, this would require each taxpayer to consider all related parties (foreign and domestic) that fit the ownership requirements for purposes of applying the gross receipts measurement. This could potentially limit the applicability of the payroll tax credit election for some taxpayers.

How is the $250,000 limitation applied?

• A taxpayer may elect the payroll tax credit in an amount not to exceed $250,000 per year, for a maximum of five years.

Can a tax return be amended to claim the payroll tax credit if the election was not made on an original return as filed?

• The PATH Act of 2015 provides that any election to utilize the payroll tax credit must specify the amount of the credit to which the election applies and must be made on or before the due date of the tax return, including extensions. Notice 2017-23 clarifies that if a qualified small business files its return for a taxable year beginning after Dec. 31, 2015, but fails to make the payroll tax credit election, it may make the election on an amended return filed on or before December 31, 2017. To qualify for this extension, the taxpayer must either (1) indicate on the top of its Form 6765 (Credit for Increasing Research Activities) that the form is filed pursuant to Notice 2017-23 or (2) attach a statement to its Form 6765 reflecting the payroll tax credit election that the form is filed pursuant to Notice 2017-23.

In which quarter can the payroll tax credit first be utilized?

• The payroll tax credit can be utilized in the first quarter that begins after the date on which the taxpayer filed its tax return electing the R&D payroll tax credit.  For example, if a 2016 tax return is filed on April 15, 2017, the credit can first be used in the quarter beginning on July 1 and ending on Sept. 30, 2017.

Can the payroll tax credit be used to offset the OASDI taxes relating to all employees or only that portion which relates to R&D employees?

• The payroll tax credit is not limited to R&D employees but rather can be used to offset the employer’s share of OASDI taxes for all employees.

If a taxpayer makes an election in section D of Form 6765 to claim the payroll tax credit but is unable to use the full credit amount to offset their payroll tax in the first subsequent quarter, what happens to the excess credit not utilized?

• Form 6765 permits the taxpayer to elect the amount they wish to be designated as the payroll tax credit. Any amount not included in this election would be eligible for the standard R&D credit carryback period of one year carryback and carryforward period of 20 years. If the taxpayer elects the payroll tax credit in an amount greater than their payroll tax liability for the following calendar quarter, the remaining credit shall be carried forward to the subsequent quarter(s) to be used against payroll taxes.  Any payroll tax credit election made is irrevocable without consent of the Secretary.

If a taxpayer uses a Professional Employment Organization (PEO), can the taxpayer still take advantage of the payroll tax credit?

• Provided the PEO is certified, the taxpayer will be eligible for the payroll tax credit. The taxpayer should coordinate with the PEO to claim the payroll tax credit. As the PEO is responsible for filing Form 941 (Employer’s Quarterly Federal Tax Return) on behalf of the taxpayer, it will also be responsible for filing Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities). The PEO will designate the amount of payroll tax credit elected by the taxpayer in Sec. D of the taxpayer’s Form 6765 by including the taxpayer’s EIN and election amount on the Form 8974 as filed. The instructions for Form 8974 states that a certified PEO is responsible for completing with Form 941, a Schedule R (Allocation Schedule for Aggregate Form 941 Filers), which shows a list of all of the PEO’s clients. The instructions further state that the PEO is responsible for attaching a Form 8974 for each client that elects the qualified small business payroll tax credit.

What is the expected timing of finalizing Forms 941 and 8974, and when can additional guidance be expected?

• Form 941 and Form 8974 have recently been finalized and are available via the IRS website.
• Within Notice 2017-23, the Treasury Department and the IRS have requested written comments relating to section 41(h) and section 3111(f), as well as the interim guidance provided within the Notice. All comments are requested by July 17, 2017, and as such, we do not expect to receive additional guidance until after the conclusion of the comment period.

The new provisions of the R&D credit that provide for the small business payroll tax credit are complex, and taxpayers should consult their tax advisors to ensure that the small business payroll tax credit applies to their facts.