Small Business Advantage Credit

Published: Jul 23, 2024
By: Timothy Rankins; Sarah E. Adkisson
Topics: Tax
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IRC Sec. 41 allows companies who have qualified research and development activities to take a non-refundable tax credit (“R&D credit”). The R&D credit allows a company to reduce their tax liability dollar-for-dollar by the amount of their calculated credit.

Special Payroll Credit Election for Small Businesses

The R&D credit was created to incentivize companies to increase their research and development activities. However, smaller companies without an income tax liability have historically been unable to take advantage of the credit. To encourage small businesses to increase their research and development activities, Congress created a new credit option for qualified small businesses.

Since 2015, taxpayers with less than $5 million in gross receipts have been able to make an election to apply up to $250,000 of their calculated R&D credit against the employer portion of the Social Security tax. To qualify, taxpayers must not have had any gross receipts for any tax year more than five years prior to the year in which they are claiming the credit. This effectively means companies cannot claim the payroll credit more than five years in a row.

Changes to the Payroll Credit

The Inflation Reduction Act (“IRA”) was passed in 2022 and included a provision increasing the amount a company can elect as payroll credit. Beginning in 2023, small businesses can claim double the amount available prior to 2023 – up to $500,000 in tax credits. The credit against the Social Security portion is still limited to $250,000, but taxpayers may now elect to apply up to $250,000 against their portion of the Medicare tax.

Taxpayers cannot choose how to split the credit between the two employment taxes or elect to take both at the same time. They must first reach the $250,000 limit against their portion of Social Security taxes before applying any remaining credit amount against their portion of Medicare taxes.

To illustrate, assume Company A is a qualified small business. In 2022; it had a calculated R&D credit of $350,000, and no income tax liability. Company A can apply $250,000 of the R&D credit against its portion of the Social Security tax. In 2024; Company A has the same R&D credit amount and no income tax liability. It can apply $250,000 against its portion of the Social Security tax; then apply the remaining $100,000 against its portion of the Medicare tax.

What Activities Qualify for the R&D Credit?

To qualify for the R&D credit; companies must be involved in qualified research and development activities. These activities must meet a four-part test, and must:

Be considered expenditures under IRC Sec. 174;
Be done to discover information which is “technological in nature” (i.e., biological or physical science, engineering, or computer science);
Be useful in the development of a business component, either new or improved; and
Constitute experimentation that is intended to eliminate uncertainty in the method, design, or capability.

What Industries Qualify for the R&D Credit

There is a misconception that the industries that qualify for the R&D credit are very limited. Many companies may be missing out because they do not realize that they have qualifying activities. Some industries that often qualify include:

Pharmaceutical Companies
Manufacturing
Food Manufacturing
Breweries/Wineries
Life Sciences
Agriculture
Technology

How to Take the Increased Credit

Companies must affirmatively elect to take the payroll credit. The election is made on Form 6765 and attached to the business’s income tax return. The credit must be elected on an original return – it cannot be elected on an amended return. The company can then claim the credit on its quarterly employment tax returns.

The calculation and qualification process for the R&D credit is very complex. Taxpayers who believe they are eligible for the increased credit should reach out to our professionals below to evaluate their eligibility.