Sound familiar? You’re a young and innovative company doing novel and interesting things. Not necessarily a manufacturer, but you might be.
As a result of your innovations, you have the activities and expenditures to earn a federal research tax credit you can apply against your income tax. (A surprisingly broad range of activities and expenditures qualify for the credit.)
Problem. You don’t actually have an income tax liability, or it’s too small to absorb the entire credit.
There’s a possible solution. You may be able to use your research tax credit to reduce the employer portion of Social Security taxes. Or you could use it to reduce your alternative minimum tax (AMT).
The federal research tax credit encourages investments in U.S.-based research and experimentation by offering businesses a dollar-for-dollar reduction in their federal income tax liabilities. But for many young and innovative companies, the research credit has traditionally provided no tax benefit as they are either not profitable or don’t have sufficient income to actually pay federal income taxes.
To help expand the reach of the credit, Congress enacted a payroll tax offset and a lesser-known offset to the alternative minimum tax (AMT) for certain small businesses. To use either offset, you must first qualify for a federal research tax credit, having incurred expenditures for qualified research during the tax year. Generally, this research is technological in nature and relates to new or improved business components, such as processes, products, software, techniques or formulas.
Qualifying for and Applying a Payroll Tax Offset
Qualifying businesses can use their research credits to offset payroll tax liabilities — specifically, the employer portion of Social Security tax. This dramatically broadens the pool of businesses that can benefit from the research tax credit, although it still eliminates those without employees.
Qualified Small Business
To be eligible for the payroll tax offset you must be a qualified small business, defined as a for-profit C or S corporation, partnership or person that satisfies the following requirements:
Your business has not generated gross receipts for longer than the last five years. If you generated gross receipts that extend back further than the five-year period that ends in the current tax year, you do not qualify.
Your gross receipts in the tax year for which you are claiming the credit are less than $5 million. Generate more and you do not qualify.
Qualified small businesses do not include not-for-profit organizations.
Applying the Payroll Tax Offset
Assuming your business qualifies and pays payroll taxes for employees, the maximum amount of research credit you can apply to offset payroll taxes in any one year is $250,000 — for a maximum of five years. You can, however, carry any excess credit back for one year and forward for 20 years.
To apply the credit against your payroll tax liability, you must actually make an election on your federal income tax return and indicate the amount of the credit you intend to apply.
You can begin applying the payroll offset in the first calendar quarter that falls after the date you file the return electing to use this approach.
Qualifying for and Applying an AMT Offset
Qualifying businesses can choose to use their research tax credits to offset AMT liabilities.
Eligible Small Business for an AMT Offset
To qualify for the AMT offset you must be an eligible small business, defined as a nonpublic C or S corporation or a partnership or sole proprietorship that satisfies the following requirements:
Your business’ average annual gross receipts for the previous three years cannot exceed $50 million.
For partnerships and S corporations, the maximum gross receipts requirement applies to the business and, separately, to each of its partners and shareholders.
Using an Alternative Minimum Tax (AMT) Offset
You can elect to apply any amount of your research credit to offset your AMT — subject to an overall limit on general business tax credits that is calculated, in part, based on your tax liability.
You are not required to make an election to use the AMT offset. Simply apply it on your federal income tax return.
As with the payroll tax offset, you can carry any excess credit back for one year and forward for 20 years.
For more information on the basic rules, including the two methods for calculating the research credit, refer to our previous post Losing Out on the Federal Research Tax Credit? Basic Rules for the Research Credit and Alternative Simplified Credit Method.
Want to discuss research tax credits and offsets?