One of the modifications to the research credit that was made as part of the Protecting Americans Against Tax Hikes Act of 2015 was to allow certain qualified small businesses to elect to claim the credit against employer social security, rather than income taxes. In Legal Advice Issued by IRS Chief Counsel AM 2017-003 the IRS outlined issues related to when the elected credit would be used to offset employer social security tax deposit liabilities and the extent of the offset.

A “qualified small business” that may make this election is defined at IRC §41(h)(3). Such a business is generally defined as:

A corporation or partnership, if—
- The gross receipts of such entity (and related entities) for the taxable year is less than $5,000,000, and
- Such entity did not have gross receipts (as so determined) for any taxable year prece ding the 5-taxable-year period ending with such taxable year, and
Any person (other than a corporation or partnership) who meets the requirements of subclauses (I) and (II) of clause (i), determined—
- By substituting “person” for “entity” each place it appears, and
- By only taking into account the aggregate gross receipts received by such person in carrying on all trades or businesses of such person.[1]

However, entities exempt from tax under IRC §501 (such as charities) are not eligible for this credit.[2] The amount of credit elected to be applied against payroll taxes cannot exceed $250,000[3] and can only be made for five taxable years.[4]

The election is made in Section D of Form 6765, Credit for Increasing Research Activities.

The memorandum gives guidance on the mechanics of applying this credit to payroll tax reporting when making use of the credit. The law requires deposits in specific amounts to be made by specific dates or the employer is hit with a penalty—so it’s not enough just to know what the total amount due on a Form 941 or 943 is, but also which required deposits are reduced by the credit and in what amount.

The memorandum first deals with the following issue:

(1) With respect to a calendar quarter in which the payroll tax credit under section 3111(f) is taken, when should an employer take into account the payroll tax credit for purposes of determining its daily tax liability and its deposit liability? Specifically, on which days on Form 941, Schedule B, Report of Tax Liability for Semiweekly Schedule Depositors, should an employer that is a semi-weekly schedule depositor take into account the payroll tax credit, and for which month or months in the quarter should an employer that is a monthly schedule depositor take into account the payroll tax credit?

The memorandum notes that, because the credit is available only for payrolls for first quarter after the Form is filed, the taxpayer will know the available credit when the first payroll for a credit is paid. The analysis goes on to say:

However, the amount of the payroll tax credit that is allowed for the quarter is limited to the employer social security tax on wages paid to the employer’s employees during the quarter. Thus, as the employer makes payments of wages from the beginning of the quarter for which the payroll tax credit is taken, the employer can take the payroll tax credit into account for purposes of the Schedule B and for purposes of deposit liability on the Form 941 or other employment tax return, provided the employer later files Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, with the Form 941 or other employment tax return for the quarter.1

With respect to the timing of the payroll tax credit for purposes of calculating deposit liabilities, the credit should be taken against deposit liabilities and reflected on Schedule B as the employer incurs liability for employer social security tax on wages paid in the quarter to which it applies, beginning with the first payment of wages in the quarter. It would be counter to the purpose of the payroll tax credit to allow it as a credit only when the employer files its Form 941 for the quarter claiming the credit and not as the employer is paying wages during the quarter subject to employer social security tax.2 An employer cannot take the payroll tax credit against employee social security tax or income tax withholding. See § 3111(f)(1). Note that there should be no negative entries on the Schedule B.

The memorandum provides the following detailed steps for a taxpayer to use in computing and making deposits during a quarter when credit is available for that quarter.

Step 1 — Calculate the employer’s share of social security tax included in the liability to be reported on either the Form 941, line 16 (monthly depositors), or Schedule B (semi-weekly depositors) for the first date wages are paid for the quarter.

Step 2 — Compare that amount of employer social security tax on the wages paid for the first pay date to the amount of the payroll tax credit available for the quarter.

If the credit is greater than or equal to the total amount of the employer’s share of the social security tax on wages paid for that pay date, the employer’s share of the social security tax is not reflected on Form 941, line 16, or Schedule B(as applicable) related to that first pay date liability and is not required to be deposited.
If the available credit is less than the employer’s share of the social security tax for that period, the employer’s share of the social security tax is reduced by the amount of the credit and the balance of the employer’s share of social security tax must be included on Form 941, line 16 or Schedule B (as applicable) and in the deposit related to that pay date.
Note that the amounts of income tax withholding, Medicare tax, and employee social security tax on the wages required to be reported on Form 941, line 16 or Schedule B (as applicable), for that pay date (and other pay dates) are unaffected by the payroll tax credit.

Step 3 — Timely deposit the amount of the reported liability for (a) the amount of employer social security tax that cannot be offset by the payroll tax credit, (b) the amount of employee social security tax, (c) the amount of employer Medicare tax, (d) the amount of employee Medicare tax, and (e) the amount of income tax withholding.

Step 4 — If the employer’s share of social security tax for the first pay date is less than the amount of the payroll tax credit allowed to be deducted for the quarter (or year if filing an annual employment tax return), the remaining payroll tax credit can be carried forward to offset the employer share of social security tax in subsequent pay dates in the return period applying these 4 steps until it is used up. If the remaining payroll tax credit cannot be used in the quarter (or the remainder of the year in the case of annual employment tax return filers), the remaining payroll tax credit can be carried forward to the next period to be used to offset employer social security tax liability with respect to wages paid to employees of the employer. A Form 8974 will also be required for each quarter (or year, if filing an annual employment tax return) for which the payroll tax credit offsets the employer social security tax liability on the employment tax return.

The IRS provides in the memorandum an example of applying these rules.

Example 1

Facts: On April 6, 2017, Employer X, a semi-weekly schedule depositor, filed an income tax return electing a payroll tax credit under section 41(h) of $5,000. Employer X claims the payroll tax credit under section 3111(f) for the third quarter of 2017, the first quarter that begins after the return electing the payroll tax credit was filed. During 2017, Employer X pays $10,000 of wages subject to social security tax each week to its employees, pays the wages on Friday of each week, and pays no other wages during the week. For purposes of this example the total income tax withholding with respect to the total wages paid each wage payment date is assumed to be $1,000, and it is assumed that no employee is subject to the Additional Medicare tax and that no employee receives remuneration in excess of the social security tax wage base. The employer social security tax (6.2%) on each payment of wages is $620 (6.2% X 10,000), the employee social security tax on the wages is $620, and there are 13 payroll dates during the quarter. The employer would also incur liability for employer Medicare tax (1.45%) on each payment of wages, or $145 (1.45% X 10,000) and employee Medicare tax of $145 would be withheld, for a total of $290 Medicare tax liability on each payment date.

Analysis: In determining its social security tax liability for purposes of Schedule B with respect to the first wage payment date in the 2017 third quarter, Employer X would add the employer social security tax of $620 and the employee social security tax of $620, but then reduce that amount by $620 of the payroll tax credit to determine a social security tax liability of $620, which would be added to income tax withholding of $1,000 and the employer and employee shares of Medicare tax ($290) to determine the amount to enter on Schedule B for that payment date. The second wage payment date through the eighth wage payment date would contain similar calculations of the liability for social security tax for purposes of Schedule B. Thus, $620 multiplied by 8, or $4960 of the $5,000 elected credit will have been used by the eighth payroll date. With respect to the ninth payroll date, the employer will have $40 remaining payroll tax credit that it can use. Therefore, the liability for employer social security tax for that payment will be $620-40 or $580. With respect to the remaining pay dates for the quarter, the amount to be entered on the Schedule B will include liability for the employer social security tax of $620 because the payroll tax credit will have been fully used up before the payments are made, or a total of $1240 social security tax.

Thus, looking at the entries to be made on Schedule B beginning with the wages paid on Friday, July 7, 2017, the employer would enter for month 1, box 7 the amount of $1910 [consisting of employee social security tax of $620, Medicare tax of $290, and income tax withholding of $1000]. The amount of $1910 would also be entered in each of the next 7 pay dates (i.e., month 1 boxes 14, 21, 28 and month 2 boxes 4, 11, 18, and 25). Then in month 3, box 1, the amount of $2490 [consisting of employee social security tax of $620, employer social security tax of $580, Medicare taxes of $290, and income tax withholding of $1000]. In month 3, the amount of $2530 [$620 employee social security tax, $620 employer social security tax, Medicare taxes of $290, and $1000 income tax withholding] will be entered in each of boxes 8, 15, 22, and 29. The employer should make deposits on the dates that are appropriate for the liabilities reflected in the Schedule B.

The second issue dealt with in the memorandum is how the credit should be used if a taxpayer makes the election to apply research credit against payroll taxes on an amended return. Notice 2017-23 provided a limited opportunity for taxpayers to use an amended return to make this election, rather than having to make it on an original return, so long as the amended return is filed before December 31, 2017.[5]

The issue is presented as follows:

(2) If, pursuant to section 4.02 of Notice 2017-23, 2017-16 I.R.B. 1100, a qualified small business that filed a tax return not electing the payroll tax credit files an amended tax return electing the payroll tax credit under section 41(h), for which quarter does the taxpayer claim the payroll tax credit under section 3111(f) on its employment tax return:

(a) the quarter beginning after the date the qualified small business filed the amended return electing the payroll tax credit under section 41(h), (b) the quarter after filing the original tax return not electing the payroll tax credit, or (c) some other quarter?

The memorandum concludes that option “(a)” above is the proper choice—the credit will be allowed for wages paid in the first quarter after the amended return is filed with the IRS.

The memorandum concludes:

Nothing in Notice 2017-23 changes the rule in section 3111(f)(1) that the amount elected under section 41(h) shall be allowed as a payroll tax credit “for the first calendar quarter which begins after the date on which the taxpayer files the return specified in section 41(h)(4)(A)(ii)” making the election. Therefore, if the payroll tax credit is elected on an amended return, the payroll tax credit elected is allowed against employer social security tax for the quarter that begins after the amended return is filed. The payroll tax credit cannot be applied to an earlier quarter.

[1] IRC §41(h)(1)(A)

[2] IRC §41(h)(1)(B)

[3] IRC §41(h)(4)(B)(i)

[4] IRC §41(h)(4)(B)(ii)

[5] Notice 2017-30, 2017-16 IRB 1100, Section 4.02