By Ashley Chikes

The federal Inflation Reduction Act (H.R. 5376), signed into law by President Biden on Aug. 16, 2022, contains a wide range of provisions aimed to help strengthen the United States economy. To help combat the ever-present cash flow issues among start-up companies, the Inflation Reduction Act includes a provision that doubles the amount of federal research and development (R&D) credits a qualified start-up company can use to offset its payroll tax.  

Originally introduced in 2015 as part of the Protecting Americans from Tax Hikes Act, qualified start-up companies have the ability to use the R&D credit to offset their Social Security tax, but it was limited to $250,000 per year. This provision provided new companies – which oftentimes were not paying federal income tax and would otherwise not benefit from an R&D credit – with another way to inject cash back into their businesses.   

To qualify for the payroll tax offset, a company must have gross receipts of less than $5 million for the tax year and no gross receipts for any tax year more than five years prior to the end of the current tax year. If a company has fewer than 12 months in a given calendar year, the gross receipts are annualized. These qualifications remain in effect under the Inflation Reduction Act.

Now, however, new companies may offset up to $500,000 of the 6.2% employer portion of the Social Security tax and the 1.45% employer portion of the Medicare payroll tax liability.  

The R&D tax credit is a valuable benefit for which many industries qualify, including architecture, engineering, manufacturing, software, and biotechnology. To be eligible for an R&D credit, a company must meet the “qualified research” requirements set forth in Internal Revenue Code (IRC) Section 41. These are commonly referred to as the “four-part test”:

• The activities must be undertaken to develop a new or improved business component, defined as a product, process, formula, software, invention, or technique.  
• There must be an uncertainty related to the capability, methodology, or appropriate design.
• To overcome the uncertainty, the company must undertake a process of experimentation.
• The process of experimentation must be technological in nature.

If a company meets these requirements, it can examine four different types of expenses to include in its credit calculation, including wages, supplies, computer rental (recently interpreted to include cloud hosting), and contractor expenses. To include these expenses, a detailed analysis is required to comply with IRC Section 41.  

If a company is claiming the R&D credit to offset payroll tax, it can only be elected on an original return. Therefore, it is becoming increasingly important to make sure taxpayers are aware of this provision and are using it as soon as possible. If a company is eligible for the R&D credit but did not claim the R&D credit on its original return, all is not lost – it can still amend its tax return to claim the R&D credit to use against future tax liability since the R&D credit can be carried forward for up to 20 years.

This is an incredibly valuable opportunity for qualified start-ups in the United States. While new companies may not have federal income tax within the first several years, most do have at least some payroll tax that can be offset now.  

Ashley Chikes is director of operations at EPSA USA, which has offices in Philadelphia and Houston. EPSA focuses on helping companies take advantage of the research and development tax credit at both the federal and state level. She can be reached at achikes@epsa.com.

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