Qualified Small Business Payroll Election
Beginning for tax years after December 31, 2015, a qualified small business may elect to apply a portion of its research credit, but no more than $250,000 ($500,000 after December 2022 – IR Act 2022 Sec 13902), against the employer’s share of the employees’ FICA withholding requirement (the 6.2 percent payroll tax).
Qualified Small Business
A qualified small business (QSB) for this purpose is a C corporation, S corporation or a partnership provided:
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It does not have gross receipts in any year before the fourth preceding year (Code Sec. 41(h)(3)(A)(i)(II))., However, this rule does not require a taxpayer to be in existence for five years. Thus, the payroll credit can only be taken in the first 5 years of the entity’s existence
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The gross receipts of the entity for the year the credit is elected are less than $5 million as determined under Code Sec. 448(c)(3), and
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It is not a tax-exempt organization.
Any person (other than a corporation or partnership) is a qualified small business if the person meets the requirements of the first 2 bullets above taking into account the person's aggregate gross receipts received in carrying on all the person's trades or businesses. (Notice 2017-23, Section 3.02)
Example - The taxpayer is a calendar year individual with one business that operates as a sole proprietorship. The taxpayer has gross receipts of $4 million in 2023. For years 2019, 2020, 2021 and 2022, the taxpayer had gross receipts of $1 million, $7 million, $4 million, and $3 million and did not have any gross receipts for any taxable year prior to 2019. The taxpayer is a qualified small business for 2023 because he has less than $5,000,000 in gross receipts for 2023 and did not have gross receipts before 2019 (before the 5-taxable-year period ending with 2023). The taxpayer’s gross receipts in years 2019-2022 are not relevant in determining whether he is a qualified small business in taxable year 2023.Because the taxpayer had gross receipts in 2019, the taxpayer is not a qualified small business for 2024, regardless of his gross receipts in 2024.
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Payroll Tax Portion of the R&D Credit
The payroll tax portion of the research credit is equal to the smallest of the following:
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The amount specified by the taxpayer in its election to claim the credit, but not exceeding the $250,000 ($500,000 after December 2022) maximum.
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The research credit determined for the tax year (determined without regard to the payroll tax election made for the tax year); or
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In the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carry forward for the tax year of the election (determined without regard to the payroll tax election made for the tax year).
Note: Determining the amount of the #3 limitation is quite complicated! Since the R&D credit is part of the general business credit, it must first be added to the general business credit for the year and used to offset any regular tax liability and any AMT liability. Then, the general business credit must be carried back one year. Any excess after the carry back is carried forward to the year after the year for which the credit was computed. The payroll credit is limited to the amount of the business credit carryover. See the steps outlined below:
Current Year:
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1. Determine the R&D credit
2. Add the R&D Credit to the General Business Credit (GBC)
3. Offset any current regular or AMT tax with the GBC
4. Carry any excess back to preceding year
Preceding Year:
5. Offset any preceding year taxes
6. Determine credit remaining that could be carried over if payroll credit wasn’t claimed
Current Year:
7. The payroll credit is limited to carryover from the preceding year.
Next Year:
8. Adjust the R & D credit carryforward by the amount of the payroll tax credit claimed
Example – Taxpayer, operating as a Schedule C sole proprietor, has a $35,000 general business credit in 2023, which includes a $25,000 research credit computed without regard to the payroll tax credit. The taxpayer’s regular and AMT tax liability in 2023 is $15,000. The taxpayer’s 2022 regular and AMT tax liability was $5,000. After offsetting 2023 and 2022 tax liabilities, the taxpayer has a $15,000 general business credit carryforward to 2024 without regard to the election to claim a payroll tax credit. The maximum payroll tax credit that may be claimed in 2023 is $15,000 since this amount is less than the $500,000 maximum for 2023 and the $25,000 research credit determined for the year of election without regard to the payroll tax credit. The taxpayer elected to use all of the $15,000 as a 2023 payroll tax credit, and therefore will have only $10,000 of the $25,000 R&D credit to carry forward to 2024.
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Electing the Payroll Tax Credit
Complete Section D of Form 6765 – Credit for Increasing Research Activities to make the election to claim the payroll credit. Then complete Form 8974 - Qualified Small Business Payroll Tax Credit for Increasing Research Activities and attach it to each quarterly payroll tax return (generally Form 941) until the credit is used up. See the Form 8974 instructions for additional guidance.
Caution: The election cannot be made if the taxpayer made an election for five or more preceding years. (Code Sec. 41(h)(4)(B))