Offset Payroll Tax or Carry It Forward? A Decision Guide for Security Software Startups

TL;DR

• Heading to ISC East? A qualifying small company with little or no income tax liability may be able to elect to use part of its R&D credit against employer payroll tax instead of waiting for profits.
• The choice is not automatic. It depends on your gross receipts, your payroll, how soon you expect taxable income, and how much cash matters right now.
• The election is made on a timely filed original return, so the time to think it through is before you file, not after.

The problem this solves

Security software companies tend to spend heavily on engineering long before they earn taxable income. The federal R&D credit (Internal Revenue Code Section 41) is generally applied against income tax. For a company with a loss, that can mean a credit with nothing to offset.

Two paths may exist. The unused credit can generally carry forward for a long time under IRC Section 39, to be used when income tax shows up. Or, if you qualify as a small business, you may be able to elect to apply part of the credit against employer payroll tax now. Here are four questions to help you weigh them.

Question 1: Do you meet the small business test?

The IRS instructions for Form 6765 describe the test. For a corporation, S corporation, or partnership, gross receipts for the year generally need to be under $5 million, and the company must not have had gross receipts in any tax year before the five-year period ending with the current year. A company also generally cannot make the election for a year if it has already made it for five or more preceding years.

If you are well past the first few years of revenue, or already above the receipts limit, the payroll path may simply not be open. If you do meet the test, move to Question 2.

Question 2: Do you have enough payroll to offset?

The credit applies against the employer's share of payroll tax, per the same IRS instructions, and the elected amount is capped at $500,000 per year. A company with a handful of salaried engineers has a smaller payroll tax bill than one with a large team. If founders take little or no salary, the pool of payroll tax available to offset may be modest.

In plain terms, the election can only use as much credit as you have payroll tax to absorb. Anything left over generally stays in the credit carryforward.

Question 3: How soon do you expect to owe income tax?

This is the heart of the decision.

Leans toward the payroll offset when: profitability looks like it is some years out, and a credit that could sit unused for a long stretch is worth less to you than payroll tax relief that may be available soon.

Leans toward carrying forward when: you expect to reach taxable income relatively soon, since the credit would then offset income tax. Note that using the payroll election reduces the research credit you carry forward by the amount used, so it is a trade, not a bonus.

Question 4: How much does near-term cash matter?

For many startups, the honest answer is "a lot." Reducing payroll tax outflow can stretch runway. If cash is not a pressing concern, and you expect your tax picture to turn around, the carryforward may be worth preserving. Neither answer is wrong. It is a planning choice that depends on your facts.

Mind the timing

The IRS instructions say the election is made each year on or before the due date of the originally filed income tax return, including extensions. The benefit is generally claimed on the employment tax return for the first quarter that begins after the income tax return reflecting the election is filed. That lag matters for cash planning. It also means a study and a decision should happen before the return goes out.

A note on support

Whichever path you choose, the credit itself still has to rest on qualified research and records that support it. For software teams, that generally means being able to connect engineering effort to specific projects and the technical problems those projects were solving. See Treas. Reg. 1.41-4.

For context, Graphite Connect, a Strata software client, identified $1.1M+ in R&D credits. Individual results vary and depend on the specific activities, documentation, and facts.

Heading to ISC East? A word for you

If you are walking the floor at ISC East at the Javits Center in New York (November 3 to 5), you are likely in a room full of companies building the next generation of video surveillance, access control, smart home, and unmanned security products. Here is how this decision framework may apply to you, depending on where you sit:

• Security software and platform founders: this guide is written for you. If your engineers are building analytics, cloud management, or integration software and you are not yet profitable, the payroll tax election may be worth a look.
• Technology consulting and software integration firms: if you build custom software for security and AV clients, your own development team's wages may be part of a credit. Whether the payroll path fits depends on your receipts and history.
• AV and smart home integrators: most established integrators will be past the small business receipts test, but if you have a newer entity or a software spin-off, ask whether it qualifies on its own.
• Device, robotics, and unmanned systems builders: if your hardware company is young and pre-profit, the same four questions apply to you.

Whatever your vertical, if you have questions about the R&D credit or how this choice may fit your year, bring them to us. Strata specializes in the credit, and a short conversation can tell you where you stand.

Where Strata fits

Strata starts with a $0 initial assessment, so you can see what a credit could look like before you decide anything. A typical study takes about 4 to 8 weeks, and your time commitment is modest. Most of the work sits with us. If you are heading into ISC East or planning your year-end, a short conversation can help you line up the numbers and the decision. Request yours at stratataxgroup.com/contact.

Sources

• Instructions for Form 6765 (IRS)
• 26 U.S. Code Section 41
• 26 U.S. Code Section 39, carryback and carryforward of unused credits
• Treas. Reg. 1.41-4

This post is for informational purposes only and does not constitute tax or legal advice. Consult a qualified tax professional regarding your specific circumstances.