In Notice 2017-23, 2017-16 IRB 1, released March 30, 2017, the IRS provides interim guidance on a new provision included in the Protecting Americans From Tax Hikes (PATH) Act enacted in December 2015 allowing qualified small businesses under Section 41(h) to claim a payroll tax credit for increasing research activities under Section 3111(f). The provision under the PATH Act and the interim guidance affect "qualified small businesses" that do not have sufficient income tax liability to use the research credit as part of the general business credit.

Background

For tax years beginning after December 31, 2015, the PATH Act added new Sections 41(h) and 3111(f) to the Internal Revenue Code. Section 41(h) allows a qualified small business to elect to apply up to $250,000 of its federal research credit against its payroll tax liability. Specifically, Section 41(h)(1) provides that, at the election of a qualified small business for any tax year, Section 3111(f) applies to the payroll tax credit portion of the research credit for the tax year, and that portion may not be treated (other than for purposes of Section 280C) as a research credit. This, in effect, means that an eligible taxpayer can claim a portion of its research credit against the employer's portion of the old-age, survivors, and disability insurance tax (Social Security tax). Section 3111(f)(1) allows the credit to be claimed against the Social Security tax imposed for the first calendar quarter beginning after the date on which the taxpayer files the return on which the research credit is computed and on which the Section 41(h)(4)(A)(ii) election is made. Under Section 3111(f)(2), the credit cannot exceed the amount of payroll tax imposed for any calendar quarter on the wages paid for the employment of all individuals employed by the employer. Section 3111(f)(3) provides that any excess credit "shall be carried to the succeeding calendar quarter and allowed as a credit … for such quarter."

Section 41(h)(2) provides that the payroll tax credit portion of the research credit claimed by a qualified small business for any tax year is the least of: (A) the amount specified in the payroll tax credit election; (B) the research credit for the tax year (determined before the application of Section 41(h)); or (C) for a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under Section 39 carried from the tax year (determined before the application of Section 41(h) to the tax year).

Under Section 41(h)(3)(A)(i), 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. For purposes of determining whether a taxpayer is a "qualified small business," Section 41(h)(3)(A)(i)(I) requires gross receipts to be determined under Section 448(c)(3), without regard to the special rule provided in 448(c)(3)(A).¹ Similarly, Section 41(h)(3)(A)(ii) provides that a person other than a corporation or partnership meeting the gross receipts requirements may also be a qualified small business, but taking into account the aggregate gross receipts received by such person in carrying on all trades or businesses of that person.

In addition, Section 41(h)(5)(A) treats all persons or entities treated as a single taxpayer under Section 41(f)(1) as a single taxpayer for purposes of Section 41(h). Therefore, gross receipts of all members of the same controlled group of corporations must be aggregated for purposes of the gross receipts test under Section 41(h)(3). If the taxpayer is eligible to claim the payroll tax credit under Section 3111(f), then it is allocated among taxpayers treated as a single taxpayer in proportion to each member's expenses on which the research credit is based, and each member can separately elect the payroll tax credit, but not in excess of its allocated dollar amount.

Notice 2017-23

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. The notice specifically provides guidance regarding the term "qualified small business," including applicable guidance for determining gross receipts for purposes of Section 41(h). The notice also provides interim guidance on the time and manner for making the payroll tax credit election and claiming the credit.

For purposes of Section 41(h), the notice defines the term "gross receipts" as gross receipts as determined under Section 448(c)(3); the definition of gross receipts under Section 41(c)(7) and Treas. Reg. Section 1.41-3(c) does not apply for purposes of Section 41(h). The aggregation and allocation rules for controlled groups provided in Section 41(h) are also clarified in the notice, which treats all members of a controlled group, as defined in Section 1.41-6(a)(3)(ii), for a tax year as a single taxpayer for purposes of determining gross receipts. Therefore, the aggregate gross receipts of all members of a controlled group for a tax year must be taken into account in determining whether the gross receipts test under Section 41(h) is satisfied. In addition, the notice allows each member of a controlled group to separately elect the least of: (1) the electing member's allocable share of the group's research credit, (2) the electing member's allocable share of the $250,000 amount (determined by the electing member's share of the aggregated qualified research expense), or (3) for an electing member other than a partnership or S corporation, the amount of the electing member's business credit carryforward under Section 39 carried from the tax year.

The notice does not provide a de minimis test for gross receipts similar to Section 1.41-3(c)(2)(vi), and does not exclude income from grants from the definition of gross receipts.

The notice provides that a qualified small business makes a payroll tax credit election by completing the appropriate portion of Form 6765, Credit for Increasing Research Activities, or successor form, 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 tax year to which the election applies. The term "return" means the return required to be filed under Section 6031 for a partnership (for example, the Form 1065 or successor form), the return required to be filed under Section 6037 for an S corporation (for example, the Form 1120-S or successor form), and the return for income tax for the tax year for any other qualified small business. If a qualified small business timely files its return for a tax year beginning after December 31, 2015, but fails to make the payroll tax credit election, the notice allows the qualified small business to make the election by filing an amended return filed on or before December 31, 2017, and provides procedures for filing the amended return.

The notice permits any excess payroll tax credit to be carried forward to succeeding calendar quarter(s) and allowed as a payroll tax credit for the succeeding quarter(s), subject to the Social Security tax limitation applicable to the quarter(s).

If a qualified small business files an annual employment tax return, the notice clarifies that the payroll tax credit is claimed on the annual employment tax return that includes the first quarter beginning after the date on which the business files the return reflecting the Section 41(h) election.

Implications

Notice 2017-23 provides clarity on the definition of gross receipts provided in Section 41(h). The notice provides that the term "gross receipts" means gross receipts as defined under Section 448(c)(3). Section 1.448-1T(f)(2)(iv) defines gross receipts for this purpose to include: 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. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of Section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade of business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in Section 1221 (1), (3), (4) or (5).

The definition of gross receipts under Section 41(c)(7), which excludes from the definition of gross receipts amounts received by a foreign corporation that are not effectively connected with the conduct of a trade or business within the United States or its possessions, does not apply. Similarly, Section 1.41-3(c)(2), which provides a de minimis rule that excludes any gross receipts from years before the first year the taxpayer achieves $25,000 in gross receipts other than investment income, does not apply. The exclusion of a de minimis rule and the inclusion of, for example, interest income in gross receipts mean that, for purposes of Section 41(h), even a small amount of interest income for any tax years preceding the five tax years ending with the current year will disqualify the taxpayer from meeting the eligible small business definition.

In addition, the notice implicitly clarifies that a taxpayer can carryforward any excess payroll tax credit to multiple quarters beyond the first quarter in which the taxpayer is eligible to claim the payroll tax credit. Section 3111(f)(3) provides that, if the amount of payroll tax credit exceeds the amount of the taxpayer's Social Security tax paid during the first succeeding quarter in which the taxpayer is eligible to claim the credit, such excess "shall be carried to the succeeding calendar quarter and allowed as a credit … for such quarter." Notice 2017-23 provides that "the excess determined on Form 8974 is carried over to the succeeding calendar quarter(s) and allowed as a payroll tax credit for the succeeding quarter(s), subject to the [Social Security] tax limitation applicable to the quarter(s)" (emphasis added). The notice does not explicitly indicate that a taxpayer can carryforward its excess payroll tax credit to future quarters, but it references "quarter(s)," in plural, indicating that the credit can in fact be carried forward to more than one quarter. The change from the singular to plural reference in the interim guidance signals that the payroll tax credit elected under Section 41(h) and claimed under Section 3111(f) can be carried forward to subsequent quarters, even if those quarters are in later tax years.

Neither the provisions under the PATH Act nor the interim guidance provided in the notice explicitly clarify whether a change in an entity's status from a qualified small business will affect whether the entity can continue to claim a portion of its initial payroll tax credit that has been carried forward to future years. Section 3111(f)(3) does not, however, appear to prohibit this approach, indicating that "the amount of the credit under paragraph (1) [that] exceeds the limitation of paragraph (2) … shall be carried to the succeeding calendar quarter and allowed as a credit under paragraph (1) for such quarter." Paragraph (1) of Section 3111(f) describes the payroll tax credit that is allowed for a taxpayer that has made an election under Section 41(h) for a tax year and paragraph (2) describes the quarterly wage limitation. As long as a taxpayer has in fact made an election under Section 41(h) for a tax year in which it was a qualified small business, the rules do not appear to prohibit a taxpayer from carrying forward the payroll tax credit despite the fact that the taxpayer may no longer be a qualified small business.

For purposes of the carryforward provision under Section 3111(f)(3), taxpayers should consider the likelihood of whether they will transition to a regular tax position in the near future. Once an election is made under Section 41(h) to claim a payroll tax credit under Section 3111(f), the portion of the credit that was claimed as a payroll tax credit will continue to be characterized as such. Therefore, if the taxpayer does not expect to incur significant payroll tax expense in the near future and expects to transition to a regular tax position, it should consider using only a limited amount of the payroll tax credit available and carrying forward the remaining portion as a research credit that can be applied against the taxpayer's regular income tax in future years.

While certain issues regarding the definition of a qualified small business and the mechanics of claiming the credit were clarified in the notice, uncertainty still exists regarding various issues.

For example, there is still uncertainty regarding whether taxpayers that utilize "professional employer organizations" (PEOs) to pay their payroll tax can claim a credit under Sections 41(h) and 3111(f). Generally, when a taxpayer (i.e., the customer) uses a PEO, it is outsourcing its payroll functions, including its payroll tax payments to the PEO for a fee. Thus, under this arrangement any payroll taxes owed by the customer are to be paid to the IRS by the PEO under the name and EIN of the PEO. These arrangements are common among entities that may qualify as qualified small businesses under Section 41(h).

The election under Section 41(h)(4) to use a portion of the research credit against the employer's share of social security tax under Section 3111(f) is made on the Form 6765, Credit for Increasing Research Activities, filed by the customer. The customer does not file a quarterly Form 941, Employer's Quarterly Federal Tax Return, on which it can claim the Section 3111(f) credit against it Social Security tax obligation.

The Tax Increase Prevention Act of 2014, enacted December 19, 2014, added new Sections 3511 and 7705 to the Code relating to the federal employment tax obligations and certification requirements of a "certified professional employer organization" (CPEO), and requires the IRS to establish a voluntary certification program for CPEOs. For purposes of federal employment taxes and other obligations under the federal employment tax rules, a CPEO is generally treated as the employer of any individual performing services for a customer of the CPEO and for remuneration remitted to the individual by the CPEO.

The amount of credit applied under Section 3111(f) is computed on Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. The amount computed on the Form 8974 is the amount of the Section 3111(f) credit that can be used in the current period (i.e., quarter). The amount from the Form 8974, line 12, is reported on Form 941 Line 11. If a taxpayer is claiming the research payroll tax credit on its Form 941, it must attach a Form 8974 to that Form 941. As of April 2, 2017, the Form 8974 and its instructions have only been issued in draft form.

The IRS has issued an updated version of Form 941, Schedule R, Allocation Schedule for Aggregate Form 941 Filers, indicating that it must be filed by CPEOs and that filers of the schedule must provide information on the schedule if they use a portion of their research credit as a payroll tax credit. The CPEO must file Form 941, Schedule R, in addition to Forms 8974 and 941. Thus, it appears that the IRS will permit either a CPEO or a Section 3504 agent to claim a Section 3111(f) credit on behalf of its customers. Presumably, the customer and the CPEO will contractually arrange to have the tax savings to the CPEO passed through to the customer, e.g., through reduced fees. It is unclear whether a PEO that is not a CPEO (and is not a designated Section 3504 agent) will similarly be able to claim the Section 3111(f) credit on the Forms 941 filed on behalf of its customers. Further guidance may be provided to clarify this point.

While Section 41(h)(4)(A)(iii) allows for the Section 41(h) election to be revoked with the consent of the Commissioner, the notice does not provide any insight as to how the revocation may be applied for or under what circumstances it may be granted.

Section 41(h)(6)(A) grants Treasury the authority to provide rules to prevent the avoidance of the purposes of the limitations and aggregation rules under Section 41(h) through the use of successor companies or other means. Section 41(h)(6)(C) grants Treasury the authority to provide rules for recapturing the benefit of payroll tax credits when there is a subsequent adjustment to the payroll tax credit portion of the research credit, including requiring amended income tax returns when there is such an adjustment. The Treasury Department and the IRS invite comments on how the IRS should recapture excessive payroll tax credits if there is a subsequent adjustment to the payroll tax credit portion of the research credit. For example, if: (A) the payroll tax credit portion of the research credit is reduced because the IRS subsequently adjusts a business's research credit or the amount of the business credit carryforward under Section 39 carried from the tax year; (B) a business makes an invalid election because, for example, the business is not a qualified small business; or (C) an error in determining or claiming the payroll tax credit is made on the employment tax return. Section 41(h)(4)(B)(ii) provides that a person may not make a payroll tax credit election if such person (or any other person treated as a single taxpayer under Section 41(h)(5)(A) with such person) has made a payroll tax credit election for five or more preceding taxable years.

Treasury and the IRS have requested written comments on these issues, and others relating to Sections 41(h) and 3111(f) and the interim guidance provided in Notice 2017-23, including whether guidance is necessary to address how the Section 41(h) election rules apply to members of a consolidated group.

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ENDNOTES

¹ Section 448(c)(3)(A) provides a rule for the $5,000,000 gross receipts test applicable to determining whether certain corporations and partnerships may use the cash method of accounting, but because that rule relates to prior-year gross receipts it is not applicable to Section 41(h).