With first quarter 2017 payroll taxes, qualified small businesses will recognize the immediate reduction of the employer portion of social security tax under the Federal Insurance Contributions Act (FICA) by electing to use their Research & Experimentation Tax Credit (R&E) to offset this tax.  The ‘Protecting Americans From Tax Hikes’ (PATH) Act enacted in December 2015 allows qualified small businesses to claim R&E credits earned in 2016 and thereafter to offset FICA when the business does not have sufficient income tax liability to use the research credit to offset income tax. This was a common issue with start-up’s and small businesses who invested heavily in research and development, but were limited in their ability to use the R&E Tax Credit until the business had taxable income. Taxpayers should evaluate how much payroll tax will be incurred when determining how much R&E Tax Credit to apply against payroll vs. expected income tax liabilities in the future. Pass through entities may also plan on the immediate offset of business payroll taxes rather than passing through the R&E credit to owners to use on their personal come tax returns.

The Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released Notice 2017-23 to provide interim guidance for qualified small businesses making the payroll tax credit election. If the amount of the payroll tax credit exceeds the employer portion of social security tax for any calendar quarter, the excess credit is carried to the succeeding calendar quarter and allowed as a payroll tax credit.

A qualified small business makes a payroll tax credit election by completing the appropriate portion of Form 6765, Credit for Increasing Research Activities, relating to the payroll tax credit election, and attaching the completed form to the qualified small business’s timely filed (including extensions) return for the taxable year to which the election applies. If a qualified small business timely files its return for a taxable year beginning after December 31, 2015, but fails to make the payroll tax credit election, it may make the election on an amended return filed on or before December 31, 2017.

Qualified small businesses claim the payroll tax credit on Form 941, Employer’s Quarterly Federal Tax Return, or on its annual employment tax return, and must complete Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities.

A “qualified small business” is defined as a corporation or partnership with:

  1. Gross receipts of less than $5 million for the current tax year, and;
  2. No gross receipts for any tax year preceding the five-tax-year period ending with the year in which the taxpayer makes the election.

A person other than a corporation or partnership meeting the gross receipts requirements may also be a qualified small business, but must take into account the aggregate gross receipts received by such person in carrying on all trades or businesses of that person. All members of a controlled group for a taxable year are treated as a single taxpayer. Thus, the aggregate gross receipts of all members of a controlled group for a taxable year must be taken into account in determining whether the requirements of Notice 2017-23 are met. Organizations exempt from income tax are not qualified small businesses even if they meet the other requirements.

The term “gross receipts” includes total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. Gross receipts are not reduced by cost of goods sold or by the cost of property sold.

Certified professional employer organizations (CPEOs) provide outsourced employee management, such as payroll and benefits, to businesses. CPEOs are treated as the employer of the individuals performing services for a customer of the CPEO, and may be permitted to claim the R&E credit on behalf of its customers (i.e., the CPEO claims the R&E credit of the taxpayer generating the credit, on its behalf). The taxpayer and CPEO must agree on how to pass the CPEO tax savings on to the taxpayer.

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Research Tax Credit Permanently Extended, Offsets AMT, Offsets FICA Taxes of Start-ups

PDF: Interim Guidance and Request for Comments; Election by Qualified Small Business to Claim Payroll Tax Credit for Increasing Research Activities