New businesses and start-up companies may be eligible to apply R&D tax credits against their payroll taxes for up to five years.
The R&D credit can offer significant financial benefits if your company qualifies to receive it. However, there are a few common pitfalls that can delay receipt of the refund and may require additional effort and payments if your submission isn’t completed correctly the first time.
Here’s a checklist of five steps to complete the process in compliance with IRS standards as well as possible consequences if you get it wrong.
1. Identify the right providers
Claiming the R&D payroll tax credit can be complex and often involves coordination between the following parties:
- The taxpayer. The qualified small business performing eligible research activities.
- R&D tax provider. Typically a third party with experience in R&D tax law who verifies taxpayer eligibility, calculates the credit, and documents the credit on behalf of the taxpayer.
- Tax return preparer. The party who prepares the company’s federal income tax return on behalf of the taxpayer.
- Payroll processor. Usually a payroll service provider (PSP) or professional employer organization (PEO) that processes payroll and remits payroll taxes on the company’s behalf.
- IRS. The IRS verifies the federal tax returns filed on behalf of the taxpayer and remits payment.
Many taxpayers assume their tax return preparer or R&D tax provider will help them navigate the ins and outs of these complexities, managing the process from start to finish. However, that isn’t always the case. It’s important to identify an experienced provider to guide your company through the process to avoid getting stuck with credits on paper that your company might never use.
2. Process the credit and understand processing differences
Once your company has verified its eligibility, the credit should be calculated and documented in accordance with statutory and IRS requirements. To learn more about determining your company’s eligibility or calculating the credit, read our article.
Election, Filing, and Reporting
The credit is elected on the taxpayer’s federal income tax return, filed annually, and then reported on a federal payroll tax return, which is filed quarterly. The credit must be elected on the income tax return before the taxpayer can start to apply the credit against payroll taxes in subsequent quarters.
The credit is based on R&D activities and expenses in the previous year but applied to payroll taxes in the future. At each step in this process, different documentation must be generated, and each documentation may require input from multiple service providers.
Each PSP and PEO may have different processes for handling the credits, and some may not process the credit at all. It’s important to understand the documentation required at each step as well as the information each provider needs based on how they process the credits.
Some common processing approaches include the following:
- Quarterly processing. The credit is reported on a payroll tax return at the end of each quarter, and a refund is applied against overpaid taxes. The taxpayer then typically receives a refund check in the mail. This is currently the most common approach among payroll processors.
- Contemporaneous processing. The credit is processed each time a taxpayer runs payroll—for example, semiweekly or monthly—reducing payroll taxes in real-time.
- No support. Some payroll processors don’t support the payroll credit filings. To claim the credit, a taxpayer may need to amend the return manually after the quarterly payroll return has been filed by their payroll processor.
If your company supplies the wrong information to a given provider, you may experience information delays when receiving the refund. If your payroll processor doesn’t assist with filing the credit, you may be required to explore other options. That means it’s important to provide correct, timely information to each provider at every stage of the process.
3. Know your deadlines
The credit must be elected on the federal income tax return before the taxpayer can start applying the credit against payroll taxes in subsequent quarters. For example, a taxpayer would need to file their income tax return by the end of March, or the first quarter (Q1), to apply the credits against payroll taxes in the second quarter (Q2).
Payroll processors, in turn, may have their own internal deadlines for when documentation must be submitted to process the credit. Some PSPs or PEOs, for example, may require documentation several weeks to several months in advance of IRS-imposed filing deadlines.
After quarterly payroll returns are submitted to the IRS, refunds are typically remitted within six to eight weeks. However, if an amended filing is required, this could extend the timeline by several months. A potential consequence of not getting your information in on time could include missing IRS or payroll-processor deadlines, which might cause significant delays in receiving the credit.
4. File amended payroll returns if required
Taxpayers should connect with their payroll processor up-front to verify whether they support the credit. If not, the taxpayer may need to come up with a plan for amending their payroll returns. In some cases, multiple quarters may be impacted, and you’ll need to figure out how much credit could have been used each quarter. Taxpayers are often left to figure this out on their own and are sometimes surprised to find out that the credit can only be applied against the employer’s portion of social security tax.
Potential consequences of filing an amended payroll return: you may be left to file an amended payroll return on your own or pay additional costs to a service provider that is willing to amend the returns for you. Multiple quarters may be affected. Amended payroll returns can cause significant delays in issuing a refund—they can take up to five times longer to process.
5. Follow through with credits being processed
Even after completing each of the previous steps and receiving a check from the IRS, your application process still isn’t over. Instead, your company may need to perform ongoing maintenance, including:
- Submitting information to your payroll processor each quarter, which may require input from several service providers.
- Following up with providers or the IRS to make sure your filings were processed correctly and applied to the right quarters.
- Keeping track of checks received from the IRS and documenting which quarters they relate to.
If your company doesn’t complete these tasks, the following negative outcomes may occur:
- Credits may not be carried over to subsequent quarters
- Quarterly filings may be incorrect
- IRS refunds may be delayed
- Communication with the IRS may be required
We’re Here to Help
Navigating providers can be tricky, but working with a team of experienced tax professionals can help you complete the process from beginning to end while avoiding common pitfalls.
To learn if you’re eligible for the R&D payroll tax credit or for help getting started, contact your Moss Adams professional.
Special thanks to Danielle Bradley, Tax Senior, R&D Tax Credits, for her contributions to this article.