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Accountants & Financial Advisors

Start-ups: New Bang for R&D—Save More as an S Corporation

Small businesses can use their research and development tax credits to reduce their Social Security taxes under the Protecting Americans from Tax Hikes (PATH) Act of 2015.

This truly benefits start-up companies that are involved with research and development activities.  The government finally understood that it takes time to develop and grow a new business (and for that business to start paying income taxes). If you have employees in your start-up, it’s a good guess that payroll taxes are a big part of your tax bill.

Because of this law, start-up businesses have the opportunity to claim both a tax credit and a tax deduction for the same dollar spent on research and development. This double bite out of your taxes works like this: You get a research credit against payroll taxes. And you still deduct the payroll taxes as business expenses to calculate taxable income. 1

You can use this new payroll tax credit if you operate as an S corporation, C corporation, partnership, or sole proprietor. But you may be able to save even more money if your business becomes an S corporation.

Big Decision to Incorporate

It is a big decision to form an S corporation. For federal tax purposes, not much changes for you because the corporation’s income and deductions pass through to you as a shareholder, and you report them on your personal tax return.2  Like a proprietorship, with an S corporation, you don’t pay corporate tax.

But as an S corporation, you are subject to the state corporate laws, such as holding regularly scheduled director and shareholder meetings and maintaining minutes, bylaws, better records, and separate bank accounts. Also, you now are required to file corporate tax returns, in addition to your personal returns.

S Corporation Can Mean More Money for You

When you look at this new payroll tax credit and compare the S corporation with the sole proprietorship, you will find that the S corporation can save more money. Why? Put simply: your salary in the S corporation increases the payroll, enabling the possibility of more tax credits.

If you form an S corporation and work for the S corporation, you are both the owner-shareholder and an employee. Your S corporation counts the Social Security taxes that it pays on your personal wages to calculate its new payroll tax credit, because it is your employer.3   If your wages are a significant portion of the total payroll, S corporation status increases the amount of this new payroll tax credit and gives you more tax savings.

As a sole proprietor, you pay self-employment taxes. The law does not allow you to apply the research tax credit against your self-employment taxes.   To be clear, sole proprietors also can take this new payroll tax credit. But the earnings of the proprietor do not count when calculating the amount of the credit.

What Is a Qualifying Small Business?

The most important requirement to qualify for the new payroll tax credit is the amount of your gross receipts. A small business qualifies for this credit if its annual gross receipts amount to less than $5 million.4

There is a second rule that uses typically complicated IRS language: your business cannot have any gross receipts in any year beginning before the preceding fifth year.5   What does this mean? For practical purposes, it means that the payroll tax credit is available only for start-ups. And you can claim the new payroll tax credit for up to five years, only.6

Mechanics: The Credit and How It Works

To use the research and development credit against your payroll taxes, you must make an election each year.7   The deadline for the election is the due date of your original return (with extensions).8

You then apply the tax credit to the payroll for the first calendar quarter beginning after the date you file your tax return. With no election, you use the research and development tax credit against your regular income taxes or carry forward the research and development credit until you owe income tax.

The payroll tax credit is limited to $250,000 per year for a maximum of five years.9 You can apply some, all, or none of your research credit to reduce payroll taxes and can apply any difference to reduce income taxes. The choice is yours. You just need to say so in the election.

You use the credit to reduce the employer’s share of Social Security taxes.10 The credit does not apply to the employee’s Social Security taxes (the part that the company had to withhold from employee wages and pay over to the IRS on the employee’s behalf).11

1   IRC Section 3111(f)(4).

2   IRC Section 1366(a)(1)(A).

3   IRC Section 3111(f)(1).

4   IRC Section 41(h).

5   Ibid.

6   Ibid.

7   IRC Section 41(h)(4)(A).

8   Ibid.

9   IRC Section 41(h)(4)(B)(i).

10 IRC Section 3111(f).

11 IRC Section 3101.

12 IRC section 38.