Doubling of R&D Tax Credit Can Mean More Cash for Technology Companies and Startups

This is one of two articles about how companies may benefit from the R&D tax credit.

Qualified new businesses and startups, including technology companies, may be eligible to elect to apply the R&D tax credit against their payroll taxes for up to five years, saving them up to $2,500,000 in payroll taxes. The Inflation Reduction Act, signed into law on August 16, 2022, doubled the R&D tax credit available to offset payroll taxes from $250,000 to $500,000, making it an even more valuable credit for tax years beginning after December 31, 2022.

This tax credit can serve as an immediate source of cash, as well as a way to offset future federal and state tax liabilities. Because R&D is such a key aspect of the technology industry, tech companies should be actively evaluating this tax savings opportunity.

Activities that qualify for this offset are expansive—more so than many small business owners realize. And the tax savings can free up cash for other operating costs. Tech companies looking for ways to boost their cash flow can use the savings from the payroll tax offset to fund operations, including payroll and equipment costs, as well as future developments.

Which activities qualify for the R&D tax credit?

Companies, regardless of industry, can potentially qualify for the R&D credit if their activity meets the following four-part test:

• Developmental uncertainty exists. Uncertainty exists if at the onset of the project, the taxpayer is uncertain about (1) if it can develop the product, process, or design it wants to develop, (2) how to develop the product, process, or design it wants to develop, or (3) the appropriate design of the product, process, or design it wants to develop.
• Process of experimentation. The taxpayer must engage in a process of evaluating and testing alternate designs to eliminate uncertainty about the appropriate design of the product, process, or design.
• Technological in nature. The process of experimentation used in the research must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science.
• New or improved functionality. The development activities must relate to a new or improved function of a product, process, or design, or its performance, reliability, or quality. Development relating to style, taste, cosmetic or seasonal design factors do not satisfy this requirement.

Some examples of daily activities in the tech sector that potentially qualify for the R&D tax credit include:

• Software architecture or algorithms aimed at improving efficiency
• New technology to streamline the manufacturing process
• Design of database management systems or document management systems
• Enhanced customer interface software
• Cloud migration solutions
• Software development for planned scaling challenges
• Improving functionality and capabilities of existing applications
• Innovative designs to customer specifications

How does a tech company or other small business with no taxable income benefit immediately from the R&D tax credit?

Once qualified entities identify their qualified R&D activities and calculate the R&D Tax Credit, they can make an election to use up to $500,000 of the credit per year to offset payroll tax cost beginning after December 31, 2022, an election that was previously capped at $250,000. 

Under prior law through December 31, 2022, qualified business were permitted to use their R&D tax credit to offset the 6.2% employer portion of Social Security payroll tax liability up to $250,000. The Inflation Reduction Act expanded this payroll tax offset limit to $500,000, allowing for an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare Payroll tax liability. 

The R&D Tax Credit claim is filed with your federal income tax return and the payroll tax offset is then reported on your quarterly payroll report, Form 941. It is available on a quarterly basis, beginning the first calendar quarter after the taxpayer filed a federal income tax return. 

For example, for an income tax return claiming the R&D tax credit on March 31^st, the taxpayer will be eligible to utilize the credit for the payroll tax offset on the second quarter Form 941 payroll tax return. Unused credits elected to offset payroll tax will carryforward to future quarters.

If a taxpayer cannot use the credit to offset payroll taxes for the current quarter or can only use a portion of the credit, the unused portion can be carried to subsequent quarters. Credit amounts of more than $500,000 can be applied to regular federal income tax and unused credit can be carried forward for 20 years to offset future federal income tax liability.   

To qualify for the payroll tax offset, a startup or business must meet the following three tests:

Gross Receipts of less than $5 million in the tax credit year. This includes all amounts received for services, income from investments, and from incidental or outside sources. As currently defined by the IRS, unearned income (i.e. interest income) would need to be evaluated in determining eligibility for the gross receipts test.

No gross receipts for any taxable year preceding the 5-taxable-year period ending with the tax credit year. However, companies could still be eligible for the R&D tax credit if they have existed more than five years but have spent a significant amount on developing or improving a component if they meet the $0 gross receipts test. The gross receipts limitation includes limits on unearned income. 

Claimed the R&D Tax Credit on a currently filed tax return. The payroll tax offset cannot be taken by claiming the credit on an amended return. Also, the taxpayer cannot use prior year R&D tax credit carryforwards before the initial payroll offset claim.

Here are two examples of how qualified companies can benefit from the credit:

• A company founded in 2020 has generated $300,000 in gross receipts each year to date. In 2023, the taxpayer incurs $8,000,000 in qualified R&D costs related to developing its new product line, while taxpayers employer social security taxes are $240,000 and employer Medicare taxes are $56,000 per quarter. Taxpayer claims an R&D tax credit of $600,000 on a currently filed return and elects to utilize $500,000 for payroll tax offset. Because Taxpayer meets the three criteria of the qualified startup test, the company can offset its employer Social Security/Medicare payroll tax on its quarterly Form 941 filings until the full $500,000 is exhausted. The remaining $100,000 in credits will offset regular income tax or carryforward for 20 years to offset future regular income tax liability.
• The taxpayer incurs $200,000 in qualified R&D costs in development of software client interface, generating an R&D tax credit of $20,000 on a currently filed return. Although the company was founded in 2014, it has generated no gross receipts to date. Therefore, it meets the three criteria of the qualified startup test. The company can offset $20,000 of its employer Social Security/Medicare payroll taxes on its quarterly Form 941 filings until the full elected payroll tax offset of $20,000 is exhausted. 

Weaver can help you identify and calculate your potential R&D tax credit and work with you to build the documentation to support your credit claim. Contact us. We are here to help.

Authored by Angela Joseph, CPA, and Nancy Imholte, CPA.

©2022