Does Your Research Create a Tax Saving Opportunity? The Research Tax Credit May Lower Your Payroll Taxes Too
Has your small business started benefiting from the decreased tax rates enacted under the Tax Cuts and Jobs Act of 2017? If you have, did you know that there is another tax provision that can decrease your payroll-related tax expense? In 2015, Congress enacted a tax provision that allows certain small businesses to use their research tax credit against their payroll tax obligations. Prior to passage of this provision, a company could either amortize the cost of research over a period of time and/or take a business tax credit against their income tax only. However, there are a number of startup companies that do not generate significant income their first couple of years due to the cost of development, lack of sales, and paying employees that weren’t really able to take advantage of such an opportunity. Therefore, the Congress passed this new provision to allow small businesses to who are not generating significant income to still take advantage of the tax saving opportunities by receiving a credit against their payroll-related cost that has been incurred to develop, research, and generate new ideas.
In order to ensure that only small businesses take advantage of this provision, the IRS has placed eligibility restrictions to prevent abuse. Under IRS guidelines, only small businesses defined as either a corporation, partnership, or individuals who have (1) less than $5 million in gross receipts, (2) five years or less of gross receipts, (3) has qualified research expenses, and (4) the research is associated with the trade or business of the company are eligible to use a portion of their research tax credit against their payroll-related expenses.
So only certain research activities qualify as a qualified research expense for purposes of this provision. IRS guidelines provide that a qualified research expense should be used to assist with (1) a technical uncertainty, (2) process of experimentation, (3) be technological in nature, and (4) have a qualified purpose. In simple terms, the research should be incurred in order for you to have the information necessary to better understanding whether a particular product is viable. Once you’ve determined the qualified research expense you have to look at what expenses associated with that activity may be eligible. Generally eligible expenses include (1) wages paid to employees engaged substantially in the research, (2) supplies associated with conducting the research, (3) cost to contract the research out to someone else (certain limitation on contract work), and (4) cost to rent or lease computers used to produce the research. There are some special rules associated with wages paid to an employee and a contractor so be sure to check with a tax professional.
It is important to consider whether the expenses associated with the qualified research are related to you trying to create a new or improved function, increase performance, or increase the quality of an existing product. If your goal is to change the cosmetic look of your product, change the aesthetic appeal, or change the design then the expense may not qualify as a qualified research expense. In addition, it’s important to consider the time of the research, who is the research designed to help (external vs. internal support), and what is the purpose of the research.
How much is the credit?
Unfortunately, small businesses cannot take the full amount of expenses incurred for qualified research as a payroll-related credit. However, the IRS allows small businesses to take a credit of up to $250,000 a year for no more than five-year period. In addition, if you do not “use up” your credit for a particular year then you are allowed to carry-over the credit into the next tax year.
There are rather complex rules associated with taking advantage of this provision so it is very important to consult with a tax professional. The tax professional can assist you with understanding what forms must be provided prior to receiving the deduction, what expenses would qualify as a research and development expense, and what things should be considered. However, if you are a startup company and want to understand whether or not your company either qualifies for this credit opportunity or should taking advantage please reach out to Robinson Legal for additional information. We’d love to have a conversation with you about what opportunities you may qualify for and get things started so you can start saving money.