The Inflation Reduction Act (H.R. 5376), which President Biden signed into law on August 16, 2022, doubles the federal research and development (R&D) credit payroll tax offset for qualified small businesses.
Under prior law, small business startups were permitted to use their qualified R&D credits to offset the 6.2% employer portion of Social Security payroll tax liability, up to $250,000. H.R. 5376 doubles this payroll tax offset limit to $500,000, providing an additional $250,000 that can be used to offset the 1.45% employer portion of Medicare payroll tax liability. This payroll tax election may especially benefit eligible startup businesses that have little or no income tax liability by allowing them to receive a more immediate cash tax benefit from their R&D credit.
Changes to Take Effect in 2023
H.R. 5376 enacts the change to the R&D credit for taxable years beginning after December 31, 2022, which will have the effect of increasing the amount of payroll tax offset available on 2023 federal returns and onwards.
Eligibility Requirements for the R&D Payroll Credit
The R&D credit offset of payroll tax liability is often overlooked by small businesses that have little or no income tax liability. However, it is a significant opportunity for taxpayers that meet the definition of a “qualified small business” (QSB). Specifically, a QSB is defined under Internal Revenue Code Section 41(h)(3) as a trade or business that: (1) is no more than five years past the period for which it had no gross receipts; and (2) and has gross receipts for the election year of less than $5 million.
A QSB’s payroll tax offset can apply against a QSB’s liability for the employer portion of social security tax (up to $250,000) and Medicare tax (up to $250,000), as imposed by Section 3111(a) and (b). However, QSBs may not use the payroll tax offset against any other employment tax liability, and the offset may not be refunded in the absence of liability.
R&D credits may offset a company’s payroll taxes no earlier than the first quarter after the company files its tax return reporting its R&D credit. The chart below illustrates this with an example of a QSB that has $500,000 in payroll expenses per quarter. The potential credit benefit increase for the years before and after the enactment of H.R. 5376 is shown:
| TY 2022 | TY 2023 | |
| R&D Credit Social Security Payroll Tax Offset: | $124,000 | $124,000 |
| R&D Credit Medicare Payroll Tax Offset: | $0 | $29,000 |
| Total R&D Credit Utilization: | $124,000 | $153,000 |
As the chart shows, the expanded R&D credit payroll tax offset will provide startup businesses with increased cash savings by maximizing total R&D credit utilization prior to sustaining sufficient taxable income.
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