Comparing Payroll Tax vs. Income Tax Liability When Claiming Federal R&D Tax Credits

When it comes to the federal research and development (R&D) tax credit, did you know there are two ways to utilize the incentive? Depending on a few factors, businesses may claim their federal R&D tax credits against either their payroll tax liability or their income tax liability. While only one can be claimed at any given time, smaller or newer companies frequently utilize the payroll tax options but may eventually outgrow it and instead prefer the income tax option. With the passage of the PATH Act in 2015, TriNet Clarus R+D was founded to help early-stage companies more efficiently claim R&D credits against their payroll tax liability. Follow along as we review the history of the incentive and explore the differences between each option.
What is the Federal R&D Tax Credit?
The incentive was originally introduced as an income tax credit in 1981 to encourage innovation and economic growth in the US. Since innovation is expensive, the government created this tax credit to offset some of that cost. This was great for companies with an income tax liability; however, due to the way the tax credit was originally structured, it excluded many companies that innovate, namely startups. Because startups tend to spend more money than they bring in, and therefore lack profit to utilize an income tax credit, the federal R&D tax credit in its original form offset a tax they weren’t even paying. The passage of the PATH Act in 2015 made the federal R&D tax credit permanent and introduced a payroll tax offset so startups could finally use the incentive against taxes they actually pay – their employer portion of FICA taxes.
Claiming Federal R&D Tax Credit Using Payroll Tax Option
To utilize the federal R&D tax credit against your payroll tax liability, generally, the taxpayer must be a qualifying small business meeting the “5-5-5 Rule.” This means a company must:
- Have less than $5 million in gross receipts for the current tax year.
- Be within their first five years of receiving any gross receipts.
- Can only claim the payroll tax liability offset up to five times on an original, on-time business return.
For purposes of the first five years requirement of gross receipts to qualify for the payroll tax credit, the IRS definition of gross receipts is actually broader than just the sales that are listed on the tax return. It also includes any interest, rent, or royalties you’ve received. So, some businesses start their five-year clock earlier than they realize.
The maximum federal R&D payroll tax credit had been $250k since 2015; however, the Inflation Reduction Act increased the maximum limit to $500k, starting with tax years that began after December 31, 2022. The law also allowed businesses to use the tax credit against both the Medicare and Social Security portions of their payroll tax liability. Once the payroll tax credit is claimed, there is no expiration or specified carry forward period.
Claiming the Federal R&D Tax Credit Using Income Tax Option
To utilize the federal R&D tax credit against your income tax liability, there are no restrictions to gross receipts or number of years. You can claim federal R&D tax credits on amended returns. There is no limit to how large your claim can be, and you can claim it every year that you are eligible. When claiming the tax credit against your income tax liability, you are simply reducing your business’s income tax liability. When you go to pay your income taxes for that year, they are reduced by the amount of the tax credit. If your tax credit amount is larger than your income tax liability, you can carry it forward for up to 20 years.
If this all seems difficult to navigate, that’s where TriNet Clarus R+D can offer an end-to-end solution. Pairing world-class R&D tax credit software with a team of tax experts and CPAs will help support compliance while simplifying the process. To learn more, schedule a free consultation today.
© 2024 TriNet Group, Inc. All rights reserved. TriNet Clarus R+D does not provide legal, tax or accounting advice. The information herein and the opinions expressed may not apply to your company or scenario, so you should consult with your own advisors on how best to proceed.
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ABOUT CLARUS R+DWith custom software backed by a team of tax experts, Clarus R+D specializes in tax credits for growth businesses. Our technology-driven solution simplifies the process, maximizes benefit, and ensures compliance. We partner with accounting firms, financial advisors, investors, payroll providers, and more.