Inflation Reduction Act Expands Valuable R&D Tax Credit to Offset Payroll Tax
When President Joe Biden signed the Inflation Reduction Act into law in August 2024, most headlines covered the law’s climate change and health care provisions. However, the law also enhances an often overlooked federal tax break for qualifying small businesses.
Inflation Reduction Act and R&D Tax Credits
The Inflation Reduction Act doubles the amount a qualified business can potentially claim as an R&D tax credit to offset its payroll tax for tax years starting after 2022—to a maximum of $2.5 million over five years.
The credit allows a qualified business to leverage the substantial R&D tax benefit even if it has little to no income tax liability, potentially freeing up significant cash flow.
Pre-Inflation Reduction Act Credit Background
The Protecting Americans from Tax Hikes (PATH) Act created a permanent incentive for eligible start-up companies to pursue R&D activities within the United States.
The Internal Revenue Code (IRC) Section 41 tax credit for qualifying in-house and contract research activities already existed, but early-stage companies that hadn’t yet incurred income tax liability couldn’t take advantage of it.
The PATH Act revised the IRC Section 41 credit to allow taxpayers to elect to apply up to $250,000 of the credit against their share of the Social Security, or Federal Insurance Contributions Act (FICA), tax for their employees, rather than against income tax. The revision became effective for tax years that began after Dec. 31, 2015.
Who Is Eligible for the Payroll R&D Tax Credit?
The payroll tax election is available to taxpayers with gross receipts of less than $5 million for the tax year, and no gross receipts for any tax year more than five years prior to the end of the current tax year. The latter requirement essentially limits the payroll tax credit to start-up companies.
If the taxpayer had a tax year of less than 12 months, the gross receipts must be annualized for a full year.
Be aware not all research is eligible. To qualify for the credit, the research must be:
- Performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions
- Undertaken to discover information that’s technological in nature
- Intended for use in developing a new or improved business product or process
- Part of a process of experimentation relating to a new or improved function, performance, reliability, or quality
What Are the Qualified Research Expenses?
Qualifying research expenses (QRE) include wages for employees involved with the research, supplies to conduct it, and amounts paid for the use of computers. They also include 65% of the amounts paid or incurred for contractors.
The credit equals either the current year IRC Section 41 credit, an elected amount not exceeding $250,000, or the general business credit carryforward for the tax year before application of the payroll tax credit for the year—whichever is smallest.
Note that the general business credit carryforward limit doesn’t apply to S corps or partnerships.
The Inflation Reduction Act Expansion
Under the PATH Act, qualified small businesses could elect to apply their R&D credit against only the 6.2% Social Security tax. Beginning with the 2023 tax year, eligible businesses can now claim a maximum credit of $500,000, which can be applied against the employer's portion of both the 6.2% Social Security tax and the 1.45% Medicare tax for all employees.
This expansion enables businesses to access a larger credit and use it more quickly to offset their payroll tax liabilities. Additionally, under the PATH Act, businesses can elect to offset payroll taxes for a maximum of five years.
Existing aggregation rules continue to apply, treating related entities as a single taxpayer for determining gross receipts, with credits allocated among the entities. However, each entity must make the election independently.
How to Claim the Payroll R&D Tax Credit
You can make a payroll R&D tax credit election by completing the appropriate portion of Form 6765, Credit for Increasing Research Activities, and submit it with your income tax return. To then claim the credit, complete Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, and attach it to your employment tax return.
You can apply the credit to offset payroll tax no earlier than the first quarter after you file the return reporting the election. The credit can’t exceed the amount of tax imposed for any calendar quarter. Unused amounts can be carried forward.
Claims from Previous Years
What if you were eligible for the R&D credit previously but didn’t claim it because you were unaware of it or for another reason?
An election to offset payroll taxes can only be made on an original return. However, taxpayers can still amend their returns for open tax years to apply the credit against income tax. The IRS recently tightened the requirements to claim a refund of the R&D credit.
To be considered sufficient, a refund claim must:
- Identify all the business products and processes to which the IRC Section 41 research credit claim relates for the relevant year.
- For each business product and process, identify all research activities performed, all individuals who performed each research activity, and all the information each individual sought to discover.
- Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year. This may be done using Form 6765.
These so-called items of information must be submitted when the refund claim is filed, along with a declaration signed under penalty of perjury verifying their accuracy. If your refund claim is deemed deficient, you’ll receive a letter providing 45 days to cure the deficiency.
Looking Forward
The IRS announced a revised draft of Form 6765, Credit for Increasing Research Activities, which will be in effect for the 2024 tax year and introduces more comprehensive reporting requirements that may increase the workload for taxpayers.
While the updates aim to improve the reporting process, they also necessitate detailed documentation of research activities.
In its current form, Section E will require taxpayers to provide information such as:
- Number of business components generating QRE
- Amount of officers’ wages included as QRE
- Details on any acquisitions or dispositions of major portions of a trade or business
- If new categories of expenditures were included as current year QRE
- If any QRE were determined under the Accounting Standards Codification (ASC) 730 Directive
Notably, Section G, which is the most burdensome part of the new form, will be exempt for taxpayers claiming a reduced payroll credit, easing compliance for those businesses.
The IRS is expected to finalize the form and provide detailed instructions by early 2025.
We’re Here to Help
For guidance in understanding how the Inflation Reduction Act could impact R&D tax credits, please contact your Moss Adams professional.