Filed under: Tax Compliance & Planning
Beginning in 2023, the Inflation Reduction Act of 2022 (the 2022 Act) allows small business employers who invest in research activity to elect a new payroll credit of up to $250,000. (This goes beyond the $250,000 currently allowed (see below), for a potential annual total payroll credit of $500,000). When applicable, the new payroll credit offsets the electing employer’s future Medicare tax obligations (i.e., 1.45% of all wages paid, also known as the “Hospital Insurance Tax”).
As noted above, the new credit program augments the existing payroll credit election. Since 2016, qualifying taxpayers who make a timely filed election can use credits generated through investment in research activity as future payroll tax credits up to $250,000. Elections made for years prior to 2023 could/can only offset the electing employer’s “FICA Tax” obligations (i.e., 6.5% of applicable wages, also known as Old Age, Survivors, and Disability Insurance Taxes).
For years beginning after 2022, small businesses who annually generate sufficient research credits can now elect up to a total of $500,000 credits per year. However, it’s important to note that the first $250,000 of elected credits offset only FICA tax. Any amount elected over $250,000 can only offset Medicare tax up to an additional $250,000. The new law also implies the type of credit is established at the time of the election. That means any carryforward of the payroll credits retain their character as either a FICA tax credit or a Medicare tax credit, depending on the total amount of the original year election.
To claim the payroll credits, a taxpayer must meet the definition of a “qualified small business” (see below) and generate sufficient research activity credits. The research must be performed in the United States. The election is available annually when made in a timely filed federal income tax return.
Background on the Payroll Credit Program
The Protecting Americans from Tax Hikes Act of 2015 (“the 2015 Act”) created a new incentive program for small businesses that invest in qualifying research. Beginning in 2016, the 2015 Act allowed taxpayers to elect to treat credits generated from qualifying research activity as “payroll credits.” (The annual limit on the election is $250,000.) The payroll credit election is made in the taxpayer’s income tax return for the year the credit is originally generated. The resulting payroll credit is claimed in the taxpayer’s payroll return as an offset to the employer’s future FICA tax obligation. The taxpayer can begin to claim the payroll credit in the payroll return for the first quarter that begins after the date the taxpayer files its annual income tax return containing the election. If the credit exceeds the actual FICA tax liability for the first eligible quarter, the remaining credit carries forward to future quarters until it is fully utilized.
The new payroll tax program created by the 2015 Act was a welcome addition to the incentives associated with research for small businesses. Prior to this program, pre-revenue companies could only enjoy the cash benefit of the research credit in a future period when the company finally generated sufficient revenue to reach profitability. As a result, many early-stage companies never enjoyed the intended timely cash flow boost the research credit program was designed to provide. Because the payroll credit program generates an almost immediate cash benefit, the 2015 Act program greatly accelerated the timing of the intended research subsidy.
Example 1:
Company X reported a loss in its 2015 tax return and also qualified for a research credit of $25,000. Company X first reports profits in year 2020 and 2021 but completely offsets the profits with its prior-year loss carryforward deduction. In 2022, Company X also reports tax due of $50,000 and no longer has any loss carryforward deduction. Finally, Company X realizes the benefit of the $25,000 credit carryforward (seven years after it made its original credit claim).
Example 1a:
Same facts as Example 1, except the year is 2016. Company X qualifies for the payroll credit election. Company X files its income tax return in March of 2017 and elects to treat $25,000 (all of its research credit) as a payroll credit. In its second quarter payroll return, the company reports a $30,000 FICA liability. Company X claims a $25,000 credit against the liability.
Definition of a Qualified Small Business
A taxpayer is a “qualified small business” for this purpose if its revenue (i.e., includes any type of gross receipts) for the year in question is under $5 million, and the year falls before or within a five consecutive year window that begins with the first year the taxpayer reports gross receipts. Note that the rules provide no allowance for de minimis amounts of gross receipts, such as interest on cash reserves. This means that even pre-revenue companies can trigger the beginning of the five-year window.
Also, note that related taxpayers are tested as a single taxpayer for purposes of the $5 million test. A wealthy individual investor or a large strategic business investor, when grouped with a pre-revenue company under the “single company” test, may disqualify the pre-revenue company from accessing the payroll credit.
How the Credit is Claimed (The Forms)
The IRS has created multiple forms to facilitate claiming the research/payroll credits against payroll tax liabilities.
First, the business includes Form 6765, “Credit for Increasing Research Activities” in its income tax return for the year it engages in research activity. This form calculates the amount of the research credit the business is eligible for the reporting year. Form 6765 also includes a section where the business indicates the amount of the research credit it would like to use as a payroll credit against future payroll liabilities.
Next, when filing its quarterly payroll tax, Form 941, the employer includes Form 8974 “Qualified Small Business Payroll Tax Credit for Increasing Research Activities.” Form 8974 is used to determine the amount of the payroll tax credit that an employer can claim on Form 941 as an offset against its FICA tax for the reported quarter. Since the credit is not refundable, Form 8974 limits the credit to the lessor of:
A) the total amount elected on Form 6765, or
B) the employer’s total FICA tax liability for the quarter.
If B) applies, any excess credit is carried forward and reported successively in future quarters until it is fully utilized.
As mentioned above, beginning in 2023, some employers will be allowed to claim the payroll credit against Medicare taxes. Accordingly, the IRS is expected to revise these forms and/or their instructions to facilitate the additional credit claim opportunity.
Enhancements Added by the Inflation Reduction Act of 2022
The 2022 Act clearly enhances the payroll credit program for some taxpayers for tax years that begin after December 31, 2022. As mentioned above, it allows up to an additional $250,000 payroll credit that can offset the Medicare tax. However, it appears that the Medicare tax offset is not available unless the total amount of the research credit in a given year exceeds the $250,000 FICA tax offset credit. Also, a literal reading of the new law implies that the character of any quarterly credit carryforward is fixed as FICA tax or a Medicare tax credit in the year of the original claim, depending on the total amount of the payroll credit election in that year. That is, if the original credit is less than or equal to $250,000, it is all characterized as a FICA tax credit. If the amount elected exceeds $250,000 then the excess (up to an additional $250,000) is characterized as a Medicare tax credit.
Please note that the above explanation (as illustrated in the examples below) is based on this author’s literal reading of the language of the 2022 Act. Further published guidance by the IRS or Treasury could prescribe a different interpretation. For example, allowing the credits to offset both types of payroll taxes in an applicable quarter, regardless of the election amount, up to $500,000, would be a welcome interpretation.
Example 2:
Company X reports $180,000 of credit in its 2023 return filed on March 18th of 2024, and second quarter 2024, reports a FICA tax liability of $50,000 and a Medicare tax liability $30,000. In the second quarter return, the employer can only offset $50,000 of FICA tax. Even though the total credit exceeds the FICA tax liability, none of the credit can offset the Medicare tax liability for second quarter. The remaining $130,000 would be carried forward as a credit that can only offset FICA tax in third quarter (and beyond if not used).
Example 2a:
Assume the same facts as Example 2, except Company X elects a total payroll credit of $300,000 in its 2023 return. Then in second quarter 2024, all of the FICA tax liability could be offset, leaving a $200,000 credit carrying forward to offset only future FICA tax liabilities, and all of the second quarter Medicare tax liability could also be offset, leaving a $20,000 credit carrying forward only as a Medicare tax offset to third quarter (and future quarters, if applicable).
Note that the new law did not change the definition of a qualified small business for this purpose. Early versions of the bill suggested increasing the revenue limit to $10 million per year, but this was removed in final enacted bill.
Does Claiming the Payroll Credit Reduce the Employer’s Deduction for Payroll Taxes?
No, the rules allowing the payroll credit state that even though the payroll credit reduces the actual amount of payroll taxes due for a given quarter, the payroll credit does not reduce the income tax deduction for the full payroll tax liability (i.e., the amount calculated before application of the credit).
Example 3:
Company A’s Form 1120 for 2022 reports a payroll credit election of $50,000. The return is filed in March of 2023. Company A’s second quarter Form 941 reports a FICA tax payroll liability (before the application of the payroll credit) of $60,000. Company A claims the full 2022 payroll credit of $50,000. Company is allowed an income tax deduction of $60,000 in its 2023 Form 1120, even though its net second quarter FICA tax liability after the credit was only $10,000.
Conclusion:
Beginning in 2023, qualifying small businesses that invest in qualified research activity can enjoy additional payroll credits (raising the annual limit from $250,000 up to $500,000). This is welcome news to early-stage companies. However, note that the newly allowed credits (i.e., credits exceeding $250,000) can only be applied against future Medicare tax liabilities. In some cases, this could delay the full enjoyment of the additional credits. Allowing the additional credits to offset either type of payroll tax would have provided a more helpful incentive to many small businesses seeking to fund additional research.
If you have questions about the federal payroll credit, reach out to a Clark Nuber professional.
Mandy Collins is a valued Clark Nuber alum.
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