The Inflation Reduction Act that President Biden signed into law back in August, has a lesser-known provision that could benefit many small business startups, allowing them to potentially double the amount of the research and development tax credit they can claim from $250,000 to $500,000 per year against payroll taxes.
This little-known tax benefit for new, qualified small businesses is the ability to apply a portion of their research credit – up to $500,000 after December 31, 2022, to pay the employer’s share of their employees’ FICA withholding requirement (the 6.2% payroll tax). This is double the amount allowed under prior law. This can be quite a benefit, as in their early years, start-up companies generally do not have any taxable profits for the research credit to offset; quite often, it is in these early years when companies make expenditures that qualify for the research credit. This can substantially help these young companies’ cash flow.
Research Credit – The research credit is equal to 20% of qualified research expenditures in excess of the established base amount. If using the simplified method, the research credit is equal to 14% of qualified research expenditures in excess of 50% of the company’s average research expenditures in the prior three years.
Qualified Research – Research expenditures that qualify for the credit generally include spending on research that is undertaken for the purpose of discovering technological information. This information is intended to be useful in the development of a new or improved business component for the taxpayer relating to new or improved functionality, performance, reliability, or quality.
Qualified Small Business (QSB)– To apply the research credit to payroll taxes, a company must be an aQSB and must not be a tax-exempt organization. A QSB for purposes of this credit is a corporation or partnership with these criteria:
- The entity does not have gross receipts in any year before the fourth preceding year. Thus, the payroll credit can only be taken in the first 5 years of the entity’s existence. However, this rule does not require a business to have been in existence for at least 5 years.
- The entity’s gross receipts for the year when the credit is elected must be less than $5 million.
Any person (other than a corporation or partnership) is a QSB if that person meets the two requirements above after taking into account the person’s aggregate gross receipts received for all the person’s trades or businesses.
Example – The taxpayer is a calendar-year individual with one business that operates as a sole proprietorship. The taxpayer had gross receipts of $4 million in 2022. For the years 2018, 2019, 2020, and 2021, the taxpayer had gross receipts of $1 million, $7 million, $4 million, and $3 million, respectively; the taxpayer did not have gross receipts for any taxable year prior to 2018. The taxpayer is a qualified small business for 2022 because he had less than $5 million in gross receipts for 2022 and did not have gross receipts before 2018 (the beginning of the 5-taxable-year period that ends in 2022). The taxpayer’s gross receipts in the years 2018-2021 are not relevant in determining whether he is a qualified small business in the taxable year 2022. Because the taxpayer had gross receipts in 2018, the taxpayer will not be a qualified small business for 2023, regardless of his gross receipts in that year.
The research credit must first be accrued back to the preceding year, where it must be used to offset any tax liability for that year. Then, the excess, up to $500,000 maximum, (up from a maximum of $250,000 in years before January 2023) can be used to offset the 6.2% employer payroll tax. Any amount not used is carried forward to the next year.
This expanded R&D tax credit won’t show up on tax returns until 2024 since it can first be claimed for the tax year 2023.
If you have questions related to the research credit or if your business could benefit from using the credit to offset payroll taxes, please give this office a call.