A little known tax benefit for new qualified small businesses is the ability to apply a portion of its research credit, but no more than $250,000, to pay the employer’s share of the employees’ FICA withholding requirement (the 6.2 percent payroll tax). That can be quite a benefit, since in their early years, start-up companies generally do not have any taxable profits for the research credit to offset, and quite often it is the early years when there are expenditures that will qualify for the research credit. This can substantially help the cash flow for these young companies.
Qualified Small Business (QSB) – To be able to utilize the research credit against the payroll taxes a company must be a QSB, other than a tax exempt organization, which is a corporation or partnership that:
- - Does not have gross receipts in any year before the fourth preceding year (Code Sec. 41(h)(3)(A)(i)(II)). 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 be in existence for five years, and
- - The gross receipts of the entity for the year the credit is elected are less than $5 million as determined under Code Sec. 448(c)(3).
Any person (other than a corporation or partnership) is a QSB if the person meets the two requirements above taking into account the person's aggregate gross receipts received in carrying on all the person's trades or businesses. (Notice 2017-23, Section 3.02)
Example - The taxpayer is a calendar year individual with one business that operates as a sole proprietorship. The taxpayer has gross receipts of $4 million in 2016. For years 2012, 2013, 2014 and 2015, the taxpayer had gross receipts of $1 million, $7 million, $4 million, and $3 million and did not have any gross receipts for any taxable year prior to 2012. The taxpayer is a qualified small business for 2016 because he has less than $5,000,000 in gross receipts for 2016 and did not have gross receipts before 2012 (before the 5-taxable-year period ending with 2016). The taxpayer’s gross receipts in years 2012-2015 are not relevant in determining whether he is a qualified small business in taxable year 2016. Because the taxpayer had gross receipts in 2012, the taxpayer is not a qualified small business for 2017, regardless of his gross receipts in 2017.
Payroll Tax Portion of the R&D Credit - The payroll tax portion of the research credit is equal to the smallest of the following:
-- The amount specified by the taxpayer in its election to claim the credit, but not exceeding the $250,000 maximum;
-- The research credit determined for the tax year (determined without regard to the payroll tax election made for the tax year); or
-- In the case of a qualified small business other than a partnership or S corporation, the amount of the general business credit carryforward for the tax year of the election (determined without regard to the payroll tax election made for the tax year).
Example - Taxpayer has a $35,000 general business credit in 2017, which includes a $25,000 research credit computed without regard to the payroll tax credit. The taxpayer’s regular and AMT tax liability in 2017 is $15,000. The taxpayer’s 2016 regular and AMT tax liability was $5,000. After offsetting 2017 and 2016 tax liabilities, the taxpayer has a $15,000 general business credit carryforward to 2018 without regard to the election to claim a payroll tax credit. The maximum payroll tax credit that may be claimed in 2017 is $15,000 since this amount is less than the $250,000 maximum and the $25,000 research credit determined for the year of election without regard to the payroll tax credit. The taxpayer elected to use all of the $15,000 as a 2017 payroll tax credit, and therefore will have only $10,000 of the $25,000 R&D credit to carry forward to 2018.