The IRS has updated two tax forms to reflect recent amendments to the research credit allowing qualified small businesses to claim the credit against their federal Form 941 payroll tax liability for tax years beginning on or after January 1, 2016.

Background

In addition to permanently extending the research credit under Section 41, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) made certain amendments to the credit for eligible small businesses and start-up companies. See Tax Alert 2015-2409{}.

New Sections 41(h) and 3111(f), added by the PATH Act, allow qualified small businesses to elect to apply the research credit against the employer's federal payroll tax liability (of up to $250,000 annually) for tax years beginning after December 31, 2015.

For these purposes, a "qualified small business" is generally defined as a corporation, partnership or sole proprietorship with: (1) gross receipts of less than $5 million for the tax year and (2) no gross receipts for any tax year before the five tax years ending with the election year.

New draft forms

The 2016 draft Form 6765, Credit for Increasing Research Activities, includes a new Section D, "Qualified Small Business Payroll Tax Election and Payroll Tax Credit." Line 41 of Section D includes a checkbox for qualified small businesses to elect the payroll tax credit. In line 42, taxpayers enter the portion of their current year credit (up to $250,000) elected as a payroll tax credit. Additional adjustments are made in new lines 43 and 44.

The draft 2017 Form 941, Employer's Quarterly Federal Tax Return, includes a new line 11 for reporting "Qualified small business payroll tax credit for increasing research activities." The draft form also includes a new line 12 to adjust total taxes by subtracting the credit in line 11.

Both draft forms refer to Form 8974, a new form for the payroll tax credit for research expenses, which the IRS has not yet released.

Implications

The option of applying the research credit to Form 941 payroll tax liabilities is beneficial because it gives employers a more immediate cash benefit. For instance, where an employer's biweekly Form 941 deposit obligation is $500,000, the employer can reduce the deposit by up to the maximum of $250,000. The research credit is then reported on the Form 941 that includes the biweekly payroll period in which the cash benefit was derived.

Before applying the research credit against Form 941 tax deposits, it should be confirmed that there are no outstanding assessments for the respective federal Employer Identification Number. The IRS can first apply outstanding liabilities to be first applied to outstanding obligations, and when that occurs, application of the credit against a Form 941 deposit could result in late deposit penalties.

In certain industries, like the life sciences and technology industries where smaller, start-up companies are common and are not yet profitable, this election will provide a welcome cash benefit. While, as a practical matter, a taxpayer will not get the benefit of this provision until 2017 (the calendar quarter after it files its return computing the 2016 research credit to which the election will apply), it is nevertheless important to take steps now to ensure expenses are properly captured and quantified. As the provision provides an alternative (and more favorable) alternative to existing carryover/carryforward regimes, Section 41(h) can be a powerful tool in a start-up's arsenal from both a tax and overall business/capital raising perspective.

Taxpayers should note that these are draft forms and are not to be used for filings until final versions are issued. Comments on the draft forms may be submitted to the IRS via the link on the first page of the draft forms.

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