- Find out how the Inflation Reduction Act will impact the research and development tax credit.
- Learn about the research credit payroll tax option.
- Find information about the research credit.
- Learn what qualifies as research.
- What is a qualified small business?
The Inflation Reduction Act President Biden signed into law has a provision that could benefit small business startups. It will allow them to potentially double the amount of the research and development tax credit they can claim. The credit will increase from $250,000 to $500,000 per year against payroll taxes.
This little-known tax benefit for new, qualified small businesses is the ability to apply a portion of their research credit – up to $500,000 after December 31, 2022 – to pay the employer’s share of their employees’ FICA withholding requirement (the 6.2% payroll tax). This amount equals double the amount allowed under prior law. This can be quite a benefit. In their early years, start-up companies generally do not have any taxable profits for the research credit to offset. Often, companies make expenditures that qualify for the research credit in these early years. This can substantially help these young companies’ cash flow.
The research credit is equal to 20% of qualified research expenditures in excess of the established base amount. If using the simplified method, the research credit is equal to 14% of qualified research expenditures in excess of 50% of the company’s average research expenditures in the prior three years.
Qualifying research expenditures generally include spending on research undertaken for the purpose of discovering technological information. This information is intended to be useful in the development of a new or improved business component for the taxpayer relating to new or improved functionality, performance, reliability, or quality.
Qualified Small Business (QSB)
To apply the research credit to payroll taxes, a company must be a QSB and must not be a tax-exempt organization. A QSB for purposes of this credit is a corporation or partnership with these criteria:
- The entity does not have gross receipts in any year before the fourth preceding year. Thus, generally, businesses can only take the payroll credit in the first 5 years of the entity’s existence. However, this rule does not require a business to have been in existence for less than 5 years; for instance, if there were no gross receipts for a business until it opened its doors 6 years after starting to develop a product, it would still potentially qualify.
- The entity’s gross receipts for the year when the credit is elected must be less than $5 million.
Any person (other than a corporation or partnership) is a QSB if that person meets the two requirements above after taking into account the person’s aggregate gross receipts received for all the person’s trades or businesses.
The taxpayer is a calendar-year individual with one business that operates as a sole proprietorship. The taxpayer had gross receipts of $4 million in 2022. For the years 2018, 2019, 2020, and 2021, the taxpayer had gross receipts of $1 million, $7 million, $4 million, and $3 million, respectively. The taxpayer did not have gross receipts for any taxable year prior to 2018.
The taxpayer is a qualified small business for 2022 because he had less than $5 million in gross receipts for 2022. He also did not have gross receipts before 2018 (the beginning of the 5-taxable-year period that ends in 2022). The taxpayer’s gross receipts in the years 2018-2021 are not relevant in determining whether he is a qualified small business in taxable year 2022. Because the taxpayer had gross receipts in 2018, he will not be a qualified small business for 2023 (and thus will not be eligible for the expanded $500,000 maximum but will be limited to $250,000), regardless of his gross receipts in that year.
How you can use the research credit
The research credit must first be accrued back to the preceding year, where it must be used to offset any tax liability for that year. Then the taxpayer can use the excess, up to $500,000 maximum, (up from a maximum of $250,000 in years before January 2023) to offset the 6.2% employer payroll tax. Any amount not used carries forward to the next year.
This expanded R&D tax credit won't show up on tax returns until 2024 since it can first be claimed for tax year 2023.
Have questions related to the research credit? Could your business benefit from using the credit to offset payroll taxes? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.