How the Inflation Reduction Act Impacts the R&D Tax Credit

On Aug. 16, 2022, President Biden signed the Inflation Reduction Act (IRA) into law. While much of the media’s focus has been on revenue-generating provisions such as additional IRS funding, there are also several included taxpayer-friendly provisions. One such provision is an increase to the amount of the research and development (R&D) credit that can be taken as a payroll credit for qualifying small businesses.

What Is the Payroll Tax Credit Election?

Prior to 2015, the R&D credit was only eligible to be used towards income taxes. Congress was concerned that the credit was not helping small startup companies who often drive innovation since they may not be profitable for many years. To help startups monetize the credit, Congress created a provision in the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) that allows qualifying small businesses to elect to use up to $250,000 of the credit towards the employer’s portion of the Social Security (OASDI) payroll tax liability. To qualify to make the election, a company must generally meet all the following requirements:

• The taxpayer’s gross receipts are less than $5 million dollars in the current taxable year.
• The business did not have gross receipts for any taxable year preceding the five-taxable-year period ending with the current taxable year.
• The taxpayer has not already made the election in five preceding tax years.

Learn more about the payroll tax credit.

IRA Changes

For tax years beginning after Dec. 31, 2022, the IRA increased the amount of the election from $250,000 to $500,000. However, it is important to note that the first $250,000 is limited to the employer’s portion of Social Security tax and the second $250,000 is limited to the 1.45% Medicare tax (hospital insurance tax).

The expansion of the election is good news for many taxpayers and will increase monetization of the credit for many startups. However, it is important to note that the additional $250,000 may be harder to monetize because it only offsets Medicare tax (1.45%), which is lower than Social Security tax (6.2%). While unused credits can be carried forward and are not lost, companies will want to monitor wage and profitability expectations to ensure that the credit is used in a timely manner. For example, some companies who rely heavily on contract research may not want to elect the maximum amount because it would create a credit that is carried forward for many years.

If you have questions about your eligibility for R&D tax credits or would like to explore your options, please contact a KSM advisor or complete this form.