How to Offset Payroll Taxes With R&D Credits

8 minute read

Is your business eligible to apply the R&D tax credit against your payroll taxes? If you’re a new business, you might be able to do this for up to five years. Companies with gross receipts prior to 2016 are ineligible, but there are more qualifications to be aware of.

Have Less Than $5M in Gross Receipts?

A business must have less than $5M in annual gross receipts to be eligible. The IRS defines gross receipts as total sales; all amounts received for services; and income from investments, including interest income. This gross-receipts limitation makes it easy for businesses to determine eligibility for the credit, but it’s important to keep in mind that the R&D credit is not based on gross receipts. Rather, the credit is based on a business’s eligible R&D expenses.

Which R&D Expenses Are Eligible?

A business could have several costs that can be eligible for R&D. Supplies used in research are a common one, but not all supplies are created equal. Supplies that are considered capital items or general administrative supplies are off limits. 

Another common expense is wages. W-2 taxable wages for employees offering direct support and research supervision can be eligible or R&D. In addition, contract research using subcontractor expenses can qualify when performed by an employee. 

Finally, computer rental or lease costs, such as payments to cloud service providers for the cost of renting server space, can be eligible. Consider examples like payments for hosting software under development.

Is the Payroll-Tax Offset Worth Pursuing?

While every business is different, it’s hard to find a scenario in which a company would not benefit from claiming R&D credit. New businesses can potentially claim up to five years with a maximum of $1.25M in total credits. This is because each year, it’s possible to claim up to $250K. 

Here’s an example of how this works: A company with $500K of eligible R&D costs could receive a $50K credit. A company with $2.5M in R&D could take the full $250K. This is because businesses with over $300K in R&D get 10% to offset. Taking into account businesses with under $300K in R&D, they can see anywhere between a 6% and 14% credit for their eligible R&D costs.

It should be noted that the payroll-tax offset can only be applied to the social security portion of payroll taxes. Businesses pay 6.2% on up to $137,700 of each employee’s salary in 2020. As an example, a company that has 50 employees with an average of $75K in salary would pay $232,500 in social security payroll taxes. With more than $4M in annual payroll subject to social security tax, they could offset those taxes with $2.5M in eligible R&D costs. The maximum benefit each year is $250K.

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Proper Documentation for the Payroll-Tax Offset

In order to properly claim the credit, a company should have good documentation, and this documentation varies based on the size and scope of the amount of credit claimed. Generally, it’s a greater time commitment for a company to set up the R&D credit for the first year than it is to use it in year two and beyond. 

There are two major items to keep in mind:

  1.  Prove Nexus: Taxpayers must provide a nexus between their R&D expenses and research. This can involve project-accounting and time-tracking systems that provide insight into a company’s activities.
  2. Pass the 4-Part Test: Documentation should demonstrate how activities meet the four-part test explained below.

Four-Part Test for R&D Credit

Before a business can even begin to offset any payroll taxes, they must first be able to pass a four-part test to determine if their company’s activities qualify for R&D credit.

  1. Permitted Purposes: 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 science.
  3. No 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.

Requirements for Claiming the R&D Credit

After doing the necessary R&D, a company must file Form 6765 with their return in order to actually receive the credit. It’s not likely the IRS will audit just because a company claimed the credit, but it’s always possible. While the details of which specific activities qualify for the credit may seem confusing to many business owners, the rules are pretty straightforward in most cases.

If a business always properly documents its activities and follows the rules, they should have no problem claiming the credit. Offsetting payroll taxes will help free up cash for other uses, and the innovations a company’s R&D brings could help them become more competitive in the marketplace. 

State R&D Credits. In addition to the federal R&D credit, 35 states offer their own R&D credits. While delving into each of these would be beyond the scope of this article, suffice it to say that each company that wants to participate in their state’s R&D credit should look to identify the following:

  • Which entities are eligible for their state
  • Deadline for filing in their state
  • What the tax credit percentage is along with any carryforward credits
  • What the requirements are to qualify for the credit

States that do not have a R&D credit include Alabama, West Virginia, Mississippi, Tennessee, Montana, South Dakota, Michigan, North Carolina, Washington, Missouri, Oregon, Wyoming, Nevada, Oklahoma and DC.

Start Offsetting Payroll Taxes as Soon as Possible

All in all, the R&D tax credit is an extremely valuable tax savings opportunity that encourages businesses to innovate and improve processes, products, software, methods and techniques. The range of activities and businesses that can qualify is extensive, and many businesses are missing the opportunity to claim it.

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