IRS R&D Tax Credit Payroll Offset: A Flawed Rule?
The IRS R&D Tax Credit Payroll Offset: An Unintended Barrier for Startups?
The Research & Development (R&D) Tax Credit is one of the most powerful tools available to innovative businesses in the United States. Specifically, the payroll tax offset was introduced to help Qualified Small Businesses (QSBs) benefit from the credit even if they are not yet profitable. However, a critical inconsistency in the IRS rules means that startups can lose eligibility due to even a small amount of interest income in a prior year—contradicting the very intent of the provision.
Understanding the QSB Definition
To qualify as a Qualified Small Business (QSB) for the R&D tax credit payroll offset, a company must meet two primary criteria under IRC Section 41(h)(3):
Gross Receipts Requirement – The company must have less than $5 million in gross receipts in the credit year.
No Gross Receipts Before a 5-Year Lookback Period – The company must not have had any gross receipts more than five years prior to the tax year in which it is claiming the credit.
The Issue: No De Minimis Rule for Interest Income
A significant flaw in the rules is that “gross receipts” include all types of income, including even trivial amounts of passive interest income. This means that if a startup earned even a few dollars of bank interest income more than five years ago, it automatically fails the QSB test and loses access to the payroll offset benefit.
Notice 2017-23, Section 3.04 clarifies how "gross receipts" are determined for the purposes of the QSB test:
"The term 'gross receipts' in section 3 of this notice means gross receipts as determined under § 448(c)(3) (without regard to § 448(c)(3)(A)) and § 1.448-1T(f)(2)(iii) and (iv) of the Income Tax Regulations. The definition of gross receipts under § 41(c)(7) and § 1.41-3(c) does not apply for purposes of § 41(h)."
This definition means that even nominal amounts of passive interest income in an otherwise pre-revenue business can be classified as "gross receipts" and disqualify a company from utilizing the payroll tax offset.
Why This Matters
The payroll offset was introduced to allow pre-revenue and early-stage companies to immediately benefit from the R&D tax credit by applying it against payroll taxes rather than carrying forward credits indefinitely. The intent was clear: to support startups in their critical early years. However, the overly broad definition of gross receipts creates an unintended roadblock, penalizing companies for an insignificant amount of historical interest income.
A Call for Common-Sense Reform
A reasonable de minimis exception for passive income would align with the spirit of the legislation while still preventing abuse. Other tax provisions, such as those governing small business accounting methods, already include thresholds for minor interest income—so why not here?
The lack of a de minimis rule hurts the very companies the provision was designed to help, discouraging innovation and growth. Addressing this inconsistency would ensure that trivial amounts of interest income don’t disqualify legitimate startups from benefiting from the payroll offset.
Final Thoughts
The R&D tax credit payroll offset is an invaluable tool for startups, but this technical flaw in the QSB definition creates unnecessary barriers. A simple fix—excluding de minimis interest income from disqualifying a company—would go a long way in ensuring the credit serves its intended purpose.
Do you think this rule needs to be reformed? Let us know your thoughts!
