Small Business Starts-ups Can Now Use Research Credit to Fund Employer FICA Tax
Corporate & Finance Alert
Until recently, the federal tax credit for increasing research activities under Code Section 41 was of limited use to most start-up companies because they typically did not generate taxable income until several years later. Under new law that went into effect for 2016, certain small start-up businesses, even those without profits, can apply a portion of the research credit against up to $250,000 of the employer’s share of FICA taxes each year, whether filing as C corporations, S corporations, partnerships or sole proprietorships.
New Guidance. On March 30, 2017, the IRS issued guidance in the form of Notice 2017-23 regarding how a qualified small business can elect to apply the research credit against the employer’s portion of social security tax. This election is first available for taxable years beginning in 2016, and so may apply to taxpayers filing returns in 2017.
A qualified small business makes the payroll tax credit election by first completing Section D and any other applicable sections of IRS Form 6765, Credit for Increasing Research Activities, and attaching it to the taxpayer’s timely filed (including extensions) income tax return for the taxable year in which the credit arose. In turn, the taxpayer must then claim the employment tax credit on its employment tax return filed for the quarter that begins after the quarter in which that income tax return was filed by including a completed Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. For example, if a taxpayer that is operating as an LLC files a 2016 partnership return on Form 1065 on April 18, 2017 (the final due date, without an extension, this year), when it files its next quarterly payroll tax return (Form 941) which would be for the third quarter, it would then claim the payroll tax credit on Form 8974 filed with the Form 941.
If a qualified small business timely files its income tax return for 2016 without the Form 6765 election, Notice 2017-23 provides that it can still elect to make the payroll tax credit election on an amended return filed on or before December 31, 2017 with a clear reference to Notice 2017-23.
Definition of Qualified Small Business. A qualified small business means a corporation or partnership if:
- The gross receipts (per code Section 448(c)(3)) of such entity are less than $5,000,000, and
- Such entity did not have any gross receipts for any taxable year preceding the 5-taxable year period ending with such taxable year (i.e., a start-up with no receipts earlier than 5 taxable years ago).
A qualified small business also includes a person such as a sole proprietorship (whether directly or through a single-member LLC) who meets requirements 1 and 2 by taking into account the aggregate gross receipts of all trades or businesses of such person.
Example: Application of Credit. To put the new payroll tax credit in perspective, if a qualified small business generates a research tax credit of $200,000 in 2016, and for example has (i) twenty (25) employees who each earn more than the maximum amount ($127,200 in 2017) on which the 6.2% employer’s portion of FICA tax applies, and (ii) forty-five (45) employees earning on average $75,000 each, the employer’s annual portion of FICA for those employees would be $406,875 ((25 x $127,200 x 6.2%) + (45 x $75,000 x 6.2%)). Therefore, such a business could pay just under two quarters of its 2017 employer FICA tax liability by applying the research tax credits it generated in 2016.
Again, the annual maximum amount of the payroll tax credit election is $250,000. In addition, the payroll tax credit may not exceed the employer portion of the FICA tax imposed for the calendar quarter on the wages paid to employees of that employer (i.e., the credit is not “refundable”). Any such excess elected credit, however, carries over to the succeeding calendar quarter. Notice 2017-23 also provides guidance on certain limitations on the available payroll tax credit with respect to controlled groups. For the avoidance of doubt, the new payroll tax credit is not available against the Medicare portion of employment taxes (either the employer or employee components), or the FICA taxes to be withheld from the pay of employees.
Calculation of Credit. The determination of the research credit under Code Section 41 is a bit complicated, and a taxpayer actually has some choices on how to calculate the credit. Very basically, the Section 41 research credit equals the sum of (i) 20% of a business’s qualified research expenditures over the base amount1 (ii) 20% of all basic research payments made to a university, college, or other tax-exempt research organization in excess of a base amount,2 and (iii) 20% of a business’s payments or amounts incurred for energy research conducted by an energy research consortium. Taxpayers may elect to reduce the Section 41 research credit if they would prefer to maximize the amount of research expenditures deducted or amortized under Code Section 174. In addition, rather than receiving a credit based on the excess of qualified research expenditures over the base amount (paragraph (i) above), taxpayers can elect an alternative simplified credit by completing Section B of Form 6765 which calculates the credit based on 14% of the excess of qualified research expenditures for the taxable year over 50% of the average qualified research expenses for the last three taxable years.
Definition of Qualified Research. Qualified research is defined to mean research undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. Substantially all of the activities of the research must be elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality, and the research expenditures must qualify as Section 174 expenses.
Qualified research is defined to specifically exclude (i) research conducted after commercial production; (ii) mere adaptation of existing business components; (iii) duplication of existing business component; (iv) many types of surveys and studies such as efficiency studies, market research, routine data collection, or ordinary testing or inspection for quality control; (v) computer software research for internal use other than certain qualified research; (vi) foreign research; (vii) research in the social sciences, arts, or humanities; and (viii) research funded by a third party.
Conclusion. Because start-up companies are often strapped for cash and the research credit is generally of little value as an offset against income taxes to a start-up, the ability to offset research credits against the employer’s share of FICA is a considerable cash management tool. This is especially true because of the virtually automatic 10% late payment penalty applicable to the late deposit of payroll taxes by more than 15 days. In addition, most lenders and sophisticated venture capital equity sources require that a start-up stay current with all payroll taxes. Finally, Notice 2017-23 outlines a relatively simple process to make the election to apply the research credit against the employer’s FICA liabilities. Start-ups owe it to themselves to see if they can take advantage of this opportunity.
1 The base amount equals the product of multiplying the taxpayer’s base period gross receipts times the ratio of the taxpayer’s qualified research expenses as a percentage of its gross receipts during a fixed base period (the ratio is often statutorily defined as 3% for start-up companies).
2 This second portion of the credit is not available to S corporations.