First-Time Compliance with the R&D Payroll Credit

The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) made permanent the federal Credit for Increasing Research Activities (Research Credit). It also expanded benefits to allow qualified small businesses to elect to designate up to $250,000 of the Research Credit as an offset to the employer’s contribution to social security tax (Payroll Credit)

This election can be made each year for up to five years. The statute instructs taxpayers to make the election for the Payroll Credit on an originally filed income tax return, and provides that the credit shall be applied against the social security component of FICA payroll tax beginning with the first full quarter after the income tax return is filed. The Payroll Credit is then claimed on Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, which must be filed quarterly with Form 941, Employer’s Quarterly Federal Tax Return, for each quarter in which the Payroll Credit reduces the amount of payroll tax due.

What Were the Challenges of Claiming the Payroll Credit in the Second Quarter of 2017?

The 2016 calendar year was the first tax year for which the Payroll Credit election could be made. If a qualified small business filed its 2016 income tax return with the election in the first quarter of 2017, it was eligible for benefits in the second quarter. However, questions regarding the mechanics of the credit and a widespread inability of payroll tax service providers to process Form 8974 meant that many taxpayers eligible for benefits did not receive them. In this first year, as they had typically done in the past, claimants generally made full deposits towards the employer’s contribution to social security. If a claimant’s payroll tax provider was capable of filing Form 8974 for the second quarter, the initial form filed with Form 941 for the period ended June 30th functioned as a refund claim instead of a credit against a payment obligation, thereby creating a lag in the credit’s timing.

Has IRS Issued Guidance to Address these Problems?

On March 30, 2017, IRS published Notice 2017-23 which announced limited relief from the original return requirement for the Payroll Credit election. The Notice allows taxpayers to make the Payroll Credit election on an amended income tax return, if the amended return is filed no later than December 31, 2017. The temporary extension to make the Payroll Credit election provided welcomed relief to taxpayers intent upon filing 2016 income tax returns by the original due dates in the second quarter, and to payroll tax providers that could not implement e-filing capabilities around Form 8974 in time to process second and third quarter claims.

Additionally, on July 31, 2017, IRS published Memorandum AM 2017-003 in which the mechanics of the Payroll Credit were finally confirmed to be a reduction to the deposits an employer would otherwise make towards its quarterly FICA payroll tax liability on a per pay period basis. The Memo also advised taxpayers that Payroll Credit elections made on amended income tax returns pursuant to Notice 2017-23 will be applied prospectively to future quarterly payroll tax liabilities, and not against payroll taxes paid in quarters that predate the Payroll Credit election.

What if my Payroll Tax Service Couldn’t Process My Payroll Credit Claim in the Second Quarter?

Eligible taxpayers with payroll tax services that could not process second quarter claims should complete Form 941-X to show an overpayment of FICA payroll tax equal to the amount of the employer’s contribution to social security that was allowed to be offset by the Payroll Credit in the second quarter. Taxpayers should then attach Form 8974 to Form 941-X and check box two on that form to have their claim processed as a refund. The standard three-year statute of limitations applies to these refund claims. Third quarter claimants who did not begin reducing payroll tax deposits with the first pay cycle of the third quarter should consult their payroll tax service provider to determine whether they can begin reducing deposits immediately, or if they should follow the above refund procedures for third quarter claims.

What Actions are Required to Claim Payroll Credit Benefits for the Remainder of 2017?

Procedures around the Payroll Credit remain challenging because the benefit can only be obtained through the coordinated efforts of multiple service providers. The income tax advisor is likely to prepare the Research Credit claim and make the Payroll Credit election on the income tax return. However, the payroll tax advisor has to file the claim and calculate the reduction that should be applied to the deposits remitted for each pay period in the subsequent quarter. Often, neither advisor can complete Form 8974 on its own because the form incorporates data from both the income tax return and the payroll tax return for the relevant quarter.

As a practical matter, payroll tax service providers have no way of knowing which of their clients conduct qualified research and development and may file a Payroll Credit claim. To solve this problem, payroll services are implementing their own procedures for clients to inform them of a pending Payroll Credit claim. This information has to be provided prior to the first pay period of the quarter in which deposits should be reduced, or the credit will not be applied to the earliest deposits due. As part of their processes, many payroll tax services are setting internal deadlines for clients to submit their Payroll Credit data, adding a second layer of administrative deadlines to the tax return due dates.

The following table describes the key dates and action items that must be completed to process Payroll Credit claims for the remainder of 2017.

Despite IRS guidance, important questions about the Payroll Credit remain unanswered. It is therefore critical that taxpayers confirm specific procedures, deadlines and required documentation with their payroll services as soon as possible. That said, as taxpayers enter the second and third round of quarterly compliance with this important new tax incentive, the lessons learned from first-time compliance efforts will benefit taxpayers and tax providers alike.