This article was updated March 20, 2023.

New businesses and start-up companies may be eligible to apply the R&D tax credit against their payroll taxes for up to five years.

The R&D credit was permanently extended as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. The bill included enhancements starting in 2016, including offsets to the alternative minimum tax and payroll tax for eligible businesses.

While the credit used to offset payroll taxes is based on eligible R&D expenses, it only applies to costs incurred after the bill was signed into law. The maximum benefit an eligible company can claim against payroll taxes each year under the PATH Act is $250,000 annually until December 31, 2022, after that the Inflation Reduction Act increased the election to $500,000.

The R&D Payroll Tax at a Glance infographic serves as a quick reference to help simplify the process of determining eligibility and applying the credit. To gain some clarity around common misconceptions about the R&D tax credit, please see our article.

Below, get answers to the most common questions about how the R&D tax credit can be applied against payroll taxes:

• When Does the Payroll-Tax Offset Take Effect?
• How Quickly Does a Company Need to Get Started?
• Which Companies Qualify for the Payroll-Tax Offset?
• Which Companies Qualify as Having Gross Receipts for Five Years or Fewer?
• How Is $5 Million in Gross Receipts Defined?
• What Are Some Examples of Qualifying Activities for the R&D Tax Credit?
• What Are Eligible R&D Expenditures?
• What Are Some Potential Benefits of the Payroll-Tax Offset?
• Are There Risks to When Claiming the R&D Credit?
• What Documentation Is Required to Claim the R&D Credit?
• Can Proper Documentation Assist Companies’ Financial Statement Reporting per FASB ASC Subtopic 740-10?

For example, taxpayers need to file their 2022 federal income tax return by June 30, 2023, to apply the payroll-tax offset to the third quarter. As a result, the earliest taxpayers are likely to see a benefit is October 2023 when they file their quarterly payroll tax return for the third quarter.

The IRS issued interim guidance on the definition of gross receipts in March 2017. In the guidance, the IRS confirmed gross receipts include the following:

• Total sales—defined as the net of returns and allowances
• All amounts received for services
• Income from investments, including interest income

Although the gross-receipts limitation helps define a company’s eligibility for the credit, it’s important to note the R&D credit itself isn’t based on gross receipts. The actual credit is based on the company’s eligible R&D expenses.

Additional thresholds may apply if a company develops software for internal use. Additionally, activities must be performed in the United States and can’t be funded by another party.

For more information on company qualifications, please see our guide—Claiming the Federal R&D Tax Credit.

For example, a company with $500,000 of eligible expenses—let’s say engineering costs—could receive a $50,000 credit. On the other hand, a company with over $2.5 million in eligible expenses in 2022 could receive a credit equal to the full $250,000 annual limitation.

If the amount of the credit exceeds a company’s Social Security tax liability—also known as the Old Age, Survivors, and Disability Insurance (OASDI) tax—in any given quarter, the excess can be carried forward to the next calendar quarter.

Social Security Tax

The payroll-tax offset can only be applied to the Social Security portion of payroll taxes. Companies are required to pay Social Security tax of 6.2% on up to $137,700 of each employee’s salary. For example, a company that employs 50 employees with an average salary of $75,000 would pay approximately $232,500 in Social Security payroll taxes.

Accordingly, a company would need to have more than $4 million in annual payroll subject to Social Security tax and $2.5 million in eligible R&D costs to offset the maximum $250,000 in payroll taxes each year under the new law.

Even at the small business level, it’s common for IRS technical specialists to be involved in R&D credit examinations. In general, however, larger credits receive more scrutiny from the IRS and often require more review and documentation.

Although many companies in the technology industry are likely engaged in activities that would otherwise be eligible for R&D credits, the rules surrounding the credit are complex and always changing. New legislation, regulations, court cases, and IRS guidelines have drastically shifted the landscape of R&D tax law and will continue to do so in the future.

Considering these complexities and potential financial penalties, companies can benefit from having their activities analyzed by a CPA, attorney, or enrolled agent familiar with the tax law and accounting rules that govern the R&D credit as well as the IRS examination and appeals process.

To deter companies from claiming credits without the proper level of review and documentation, the IRS can impose significant penalties. Failure to pay the proper amount of payroll tax may also result in trust fund recovery penalties, which can include a 100% penalty and personal liability for the amounts due.

What Documentation Is Required to Claim the R&D Credit?

It’s important for companies to have the right documentation in place. It’s also key to know there isn’t a one-size-fits-all approach to documentation.

The adequate level of documentation varies based on the size and scope of the claimed credit amounts.

Companies should expect a greater time commitment in the first year when they’re getting set up to claim an R&D credit. They’ll also need to put appropriate measures in place to completely use the credit going forward.

Depending on the company, it’s possible any historic R&D spending incurred may need to be evaluated.

Proving Nexus

Taxpayers often will need to provide a nexus between their R&D expenses and qualified research activities. This can be challenging—even for companies that have some level of project tracking in place. This is because time- and expense-tracking systems aren’t generally intended to track eligible R&D expense to business components or R&D activities.

The subjectivity and interpretation of R&D rules make it difficult to develop the perfect software tool for tracking eligible expenses and documentation, particularly when considering annual updates to tax law, regulations, and IRS guidance. For this reason, it’s important to note that while project-accounting and time-tracking systems aren’t prerequisites to claiming the R&D credit, implementing them can supply important insight into your company’s activities.

Meeting the Four-Part Test

At minimum, taxpayers’ qualitative documentation should demonstrate how their underlying activities meet the four-part test. Examples of adequate documentation can vary by industry, but it’s possible for companies to leverage documentation they generate in their day-to-day operations. Qualitative documentation may also require review and analysis of any contracts between companies and their customers, partners, or vendors.

Taxpayers that have some level of familiarity with the R&D credit should carefully evaluate their methodology and documentation standards with respect to R&D credits being used under the new rules.

Additional Industry-Specific Guidance

Companies in the software and pharmaceutical industries especially can benefit from reviewing the IRS audit guidelines applicable to their industries. These are available on the IRS website:

• Audit Guidelines on the Application of the Process of Experimentation for All Software
• Pharmaceutical Industry Research Credit Audit Guidelines

We’ve also prepared industry-specific articles about the R&D tax credit:

• Aerospace
• Agribusiness
• Construction
• Food & Beverage
• Forest Products
• Industrial Hemp & CBD
• Oil & Gas
• Software Companies
• Spirits
• Technology Companies
• Vineyards & Wineries

The payroll-tax offset is available to eligible new businesses and start-up companies for up to five years. Any unused R&D credits that aren’t elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable. This length of time makes thorough documentation even more important.

Can Proper Documentation Assist a Company’s Financial Statement Reporting for FASB ASC Subtopic 740-10?

Financial Accounting Standards Board (FASB) accounting standards codification (ASC) Subtopic 740-10 specifies a tax position won’t be recognized in a company’s financial statements unless it’s likely the position will be sustained upon examination.

All public companies and entities adhering to US generally accepted accounting principles are required to analyze and disclose uncertain tax positions on their financial statements. Many corporations are also required to report those positions on their federal income tax return.

For public companies and companies with audited financial statements, the rules surrounding how R&D credits are recognized on their financial statements can be very complex and subjective. These credits often receive a high level of scrutiny from lenders, investors, and financial statement auditors, especially when a company hasn’t performed an R&D study for management to use in their decision-making processes.

Many unprofitable companies claim R&D credits every year with little support and without fully considering the risk of an audit by taxing authorities. With the help of specialists, these companies can generate more certainty around their credits and assist management with R&D-credit decision-making processes.

To learn more, please read our article, 3 Key Attributes to Look for in an R&D Tax Credit Service Provider.

We’re Here to Help

To learn more about the R&D payroll-tax offset, whether your business qualifies, or our other R&D tax services, go to our R&D Tax Credit Spotlight and contact your Moss Adams professional.