How To File Your Form 8974

Small businesses should be aware and take advantage of any credits they may qualify for, such as the Research & Development (R&D) Tax Credit. One of the many benefits of the R&D Tax Credit is the ability to offset certain payroll taxes. Qualified Small Businesses (QSBs) utilize Form 8974 to compute the amount of the tax credit they can claim on their employment tax return.

What is Form 8974?

Form 8974 is essential to computing and claiming the R&D Tax Credit for payroll taxes incurred as a result of the increase in research activities. Once a business has received approval from the IRS to claim the R&D Tax Credit, Form 8974 must be filed. For QSBs, Form 8974 must be attached to Form 941.

What is a Qualified Small Business?

To make the payroll credit election, a business must first satisfy the requirements to be a QSB. A QSB is a corporation, partnership, or other business that:

1. Has gross receipts of less than $5 million for the tax year, and; 
2. Does not have gross receipts for any tax year before the five-year tax period ending with the tax year. 

Gross receipts include receipts of the tax year in which they are properly recognized for federal income tax purposes. Gross receipts include total sales – net of returns and allowances – and all amounts received for services. They can also include any income from investments, and from incidental or outside sources.

Calculating gross receipts for tax purposes is also important. The aggregation rule modifies how gross receipts are calculated for businesses with common ownership. For purposes of gross receipt rules, all members of a controlled group are treated as a single taxpayer and the gross receipts of all members are aggregated. Thus, the aggregate of gross receipts must not exceed 5 million dollars. A controlled group includes a group of corporations or of trades and business under common control. While most small businesses may not encounter this issue, it is important to be aware as the aggregation rule may apply to future tax years.

How Do I Qualify for the R&D Tax Credit?

While many businesses can satisfy the requirements for the R&D Tax Credit generally, only QSBs are able to apply for the credit to be administered against payroll taxes. Although they cannot offset payroll taxes, non-QSBs can utilize the R&D Tax Credit to offset their tax liability if the activity and expense requirements are satisfied.

As a reminder, to claim the R&D Tax Credit, the business must satisfy both the Four Part Test and the Qualified Research Expense Test. A general overview of each test is provided below, but a more in depth discussion of how to qualify for the R&D Tax Credit can be found here. 

The Four Part Test requires the activity for which the credit is sought to meet all of the following requirements:

1. Permitted Purpose – The activity must relate to a new or improved business function, performance, reliability, or quality;
2. Technological In Nature – The activity should rely on principles of hard science;
3. Technological Uncertainty – The activity must be intended to discover information that eliminates uncertainty about the capability or method for developing or improving a process or product design;
4. Process of Experimentation – The activity must involve experimentation involving simulation, evaluation of alternatives, confirmation of hypothesis through trial and error, modeling, testing, or refining.

In addition, the expenses pertaining to such activities must be Qualified Research Expenses. To qualify, an expense must be either an In-House Research Expense or a  Contract Research Expense. In general, an In-House Expense is incurred by the company or its employees while a Contract Research Expense is incurred by someone outside the company. The distinction between the two types of expenses is important because Contract Research Expenses are generally limited to 65% of the expenses incurred, In-House expenses are not. 

If a business satisfies all the requirements, they can file Form 6575 along with their income tax return to claim the R&D Tax Credit. Once approval is received from the IRS, the business must file Form 8974. QSBs will attach Form 8974 to Form 941 which is the quarterly tax return for employers. 

When Can A Business Apply For The R&D Tax Credit?

Applying for the R&D Tax Credit generally provides more flexibility in terms of when a business can apply for the credit. The lack of a gross receipts requirement for the application of the credit to tax liability permits businesses with qualifying research activities and expenditures to claim the R&D Tax Credit every year. In addition, businesses may apply for the R&D Tax Credit retroactively by filing an amended return for the previous tax year. However, an amended return may only be filed during an open tax year, which is generally three years after the original return is filed.

For QSBs who are applying to offset payroll taxes, there are more limitations on when they can file. To utilize the R&D Tax Credit to offset payroll tax liability, a business must satisfy the gross receipts requirements to be considered a QSB. Because a QSB is defined as any company with no more than 5 years of gross receipts and less than $5 million of gross receipts in the current year, this payroll tax credit is limited to start-up businesses. Similar to non-qualified businesses, QSBs may file amended returns, provided it is for an open tax year. In addition, the previous tax year that the business wishes to amend must be the first year in which the business has gross receipts and such receipts don’t exceed $5 million.

All businesses may apply for the R&D Tax Credit retroactively, although the determination of whether previous tax years are open and whether the business qualifies for the payroll tax credit serve as limitations to such retroactive application.

How Do You File Form 8974?

Form 8974 is filed in the first quarter following the tax year in which Form 6575 was filed. Form 6575 claims the R&D Tax Credit and is filed alongside the business’ income tax return for the tax year. Section D of Form 6575 is where the business will indicate if they are a QSB and how much payroll tax credit they are applying for. The amount from Section D is then transferred to Line 5 of Form 8974 where the credit amount is determined for the quarter in which Form 941 is filed. Form 941 is an employer’s quarterly tax return and line 11a is where the payroll tax credit is located. Form 8974 is filed as an attachment to Form 941 and the R&D Tax Credit will be applied for that quarter.

Moving Forward

The ability to offset payroll tax liability is an immense benefit that the R&D Tax Credit provides and businesses, especially start-ups, should seek to offset such liability immediately. Due to the extensive list of activities and expenses that qualify for the R&D Tax Credit, businesses are missing out on a great opportunity if they are not claiming the credit to offset their research and development efforts. Regardless of whether your business is a start-up or is well-established, the R&D Tax Credit is a great tax saving opportunity.