Federal Research and Development (R&D) Tax Credit: Have Gusto calculate and apply your credit

We need details such as the first year of R&D activities, the first year of revenue generation, and the tax year-end date.  Additional company information needed includes:

• Company type for LLC: Depending on how your LLC is structured and taxed, you'll need to specify its type. Options include "partnership", "sole proprietorship", "S Corporation", or "C Corporation".
  • LLCs with a single member are taxed as sole proprietorships and file form 1040 with a Schedule C for their Federal tax filing
    • Enter Sole Proprietorship when onboarding
  • LLCs with multiple members are taxed like partnerships
    • Enter S-Corp if your business files form 1120 S
    • Enter General Partnerships if your business files form 1065
  • LLCs have the option of being taxed as a C corporation
    • Enter C-Corp if your business files form 1120 
• Your company’s FEIN: You can locate your company's Federal Employer Identification Number (FEIN) in the top-right corner of your company’s Corporate Federal Tax Return form.
  • If your business has had multiple EINs, inform the team to ensure accurate calculations. Be sure to include any changes to your FEIN in the Onboarding Notes section before submitting your information.
• Parent company and subsidiary: A parent company controls or owns the majority of another company, termed as a subsidiary. Ownership is determined by the percentage of shares held, typically at least 51%. This type of corporate structure is commonly referred to as a Control Group.
• Accounting basis: This refers to how you maintain your books or general ledgers, also specified in your tax return.
  • Note: It’s important that your accounting books / ledgers are fully closed and reconciled before we include these expenses in your calculation so that you receive a complete and accurate tax credit. 
• State of business: The state where your business is physically located.
• Impact of revenue and profitability: Your revenue and profitability status affect how your R&D credits can be used. 
  • Example: Startups with annual gross receipts less than $5 million and less than 5 years with gross receipts may have different options for credit utilization.
  • Tip: During onboard, when asked “Was your company profitable in 2024”, we’re trying to determine if your business expects to pay the IRS a tax liability when filing. Since this will impact how you use your R&D tax credits, it’s best to consult your tax preparer if you are unsure if you will incur a tax liability when filing. 

For Gusto customers, wages and contractor payments made through Gusto can be imported directly via the Gusto API. Our software will recommend percentages based on similar companies to yours in both employee size and industry. However, during onboarding, you'll have the chance to review and adjust the software’s suggested percentages for additional accuracy.

• If you have W-2’s for a portion of the year under review, email [email protected] for a secure link to provide that information. 

Important: For R&D wages and expenses to qualify for this credit, all related R&D activity must be conducted on U.S. soil. This includes U.S. territories such as Puerto Rico and Guam. Additionally, Per the IRS, all contractor expenses are calculated using 65% of the total qualified research expenses. This complaint with IRS regulations outlined in IRC Section 41(b)(3)(A). This does not apply to supply or hosting expenses.

Expenses like contractor fees, hosting expenses, patent-related legal fees, and supply costs releated to R&D are used to calculate your R&D tax credit. Expenses can be imported through our CODAT integration. We accept general ledgers through direct integration with supported bookkeeping platforms (QuickBooks Online, QuickBooks Desktop, Xero, and Freshbooks).

• Hard copies of Form 1099 can also be submitted. However, we cannot accept hard copies of general ledgers. If you'd like to provide hard copies of your 1099 contractor expenses, email [email protected] for a secure link to upload these documents.

Expenses are used to help us increase your total R&D tax credit. Providing expense data allows Gusto’s software to review all potential qualified activity including spend on contractors, software expenses, and supplies that may qualify for R&D credit. The IRS discourages qualifying anything under COGS accounts as it's associated with the sales of goods and does not relate to the R&D activities.

Important: For R&D wages and expenses to qualify for this credit, all related R&D activity must be conducted on U.S. soil. This includes U.S. territories such as Puerto Rico and Guam. If your contractors meet this criteria, but are not qualified, email [email protected] to provide more information regarding their scope of work and time spent on R&D. 

It’s best to provide your company’s four years prior federal tax returns (complete filed copies). This helps determine the average annual gross receipts, crucial for accurate R&D credit calculations.

If you're using Gusto for the first time to claim R&D tax credits, but you’ve claimed them in prior years, our team will need these prior filings when calculating your credits for the current tax year. 

While Gusto aims to simplify the R&D tax credit application process, there are still complexities that may impact an accurate calculation like Entity Conversions, Fiscal Year Ends, and Control Groups. When submitting your application, it’s important to provide accurate details around these complexities. 

Entity Conversions

An entity conversion involves changing the legal structure or type of a business entity, which may include updates to the incorporation date, business name, or FEIN. When claiming R&D tax credits, it’s important to provide the initial incorporation date and note any subsequent changes, as these can affect credit calculations.

• Example: If an S-Corp incorporated on January 1, 2020, converts to a C-Corp on October 1, 2021, tax filings would reflect three periods: 
  • January 1, 2020–December 31, 2020 (Filed on Form 1120-S)
  • January 1, 2021–September 30, 2021 (Filed on Form 1120-S)
  • October 1, 2021–December 31, 2021 (Filed on Form 1120)

In this case, use the initial incorporation date (January 1, 2020) during onboarding and document any changes, including dates before and after the conversion, in the Onboarding Notes section. For instance, you might note:

• "My business changed from an S-Corp to a C-Corp in 2021. The original incorporation date was January 1, 2020, and the final Form 1120S was filed for the period ending September 30, 2021. The C-Corp conversion began on October 1, 2021, with a year-end of December 31, 2021."

Fiscal Year Ends

A Fiscal Year End (FYE) is the final day of a company’s 12-month accounting period, used for financial reporting and tax purposes. It represents the point when the company closes its books, prepares financial statements, and assesses its annual performance. If a company’s fiscal year-end aligns with the calendar year-end, it falls on December 31.

If the company has had more than one FYE in the life of the business, our team will need to be notified of any prior year-end dates that were previously applicable. We recommend notifying our team in the Onboarding Notes section before submitting your application. 

• Example: "My business changed from a calendar year ending December 31st to a fiscal year end of September 30th in 2021."

Control Groups

A control group, in the context of the R&D tax credit, refers to a collection of related businesses that are treated as a single entity for tax purposes due to shared ownership or control. This affects how the R&D tax credit is calculated and applied, as activities and expenses across all businesses in the control group must be considered. Control groups can be structured in a Parent/Child format or a Brother/Sister grouping. Be prepared to provide additional information regarding the other businesses, such as tax returns, wages and expenses (should a separate study be required by the IRS).

 If you believe your business may be part of a controlled group, you should indicate a ‘Yes’ answer during onboarding when asked if your business has a ‘Parent or Subsidiary’. 

• Example 1: “My business is owned by a holding company. The holding company is U.S. based, does not perform any R&D activity and does not incur additional expenses."
• Example 2: “My business is owned by another entity (Parent). The Parent company also owns other entities but none of them / some of them perform R&D activity."

Qualified wages are calculated based on your employee's contribution to R&D efforts—depending on how much time is devoted to R&D activities will help determine what percentage each employee’s salary can qualify for the R&D tax credit. 

Other qualified expenses are used to help us increase your total R&D tax credit. They’ll provide us with insight to your contractors and supplies that qualify for R&D credit.

Calculation methods

There are a few methods of calculating the credit: 

• Regular method
  • Under the regular method, the base amount is determined by averaging annual gross receipts over the four years preceding the calculation year and multiplying it by a fixed base percentage. The credit is then calculated based on the difference between total qualified research expenses (QRE) and the base amount, using the lower of the two figures, which is then multiplied by 20%. 
  • Last 4 years of filed tax returns (or gross receipt numbers) and current year QREs (wages/expenses) are needed.
    • Example: If the current calendar year is 2025, Gusto would require tax returns from 2020-2023 and wages and expenses from 2024 to calculate a credit. 
• Alternative Simplified Credit (ASC) method
  • The ASC method uses QRE from the past three years to establish the base. The credit is calculated by halving the average QRE from the three prior years, subtracting it from the current year's QRE, and multiplying the result by 14%. If there are less than three years of QRE, the credit is simply 6% of the qualified research expenditures for the current year.
  • To use this method, we need 3 years of prior wages and expenses, and the current year’s wages and expenses
    • Example: If the current calendar year is 2025, Gusto would require wages and expenses from 2021-2024 to calculate a credit using the “ASC” method.
• 280C Election
  • To avoid "double-dipping," where R&D expenses are both credited and deducted, companies are required to reduce the amount of their capital account by the amount their R&D tax credits exceed their allowable R&D expense deduction. To avoid this, companies can make a 280C Election on a timely filed tax return. This reduces the R&D tax credit by the corporate tax rate, avoiding the adjustment mentioned above from being needed.  

How this works with Gusto

1. We’ll determine the calculation method based on various factors, such as qualified research expenses, gross receipts, and the duration of your company's qualified R&D activities.
   •  If you provide tax returns, we’ll use the regular method; otherwise, we’ll use the alternative simplified method. 
   • If you provide adequate data for both methods, our team assesses which one yields a higher credit.
2. Our software looks at job titles and suggests percentages based on similar companies to yours in both employee size, and industry. 
   • These are initial estimates that might require adjustments.
3. You’ll review the estimated percentages, and adjust them as needed.
   • If you’re unable to make adjustments, click Book a Call in your R&D dashboard to speak with a member of our team.

• Wages: Salaries, wages, bonuses, and other compensation paid to employees directly involved in conducting, supervising, or supporting qualified R&D activities. All qualified research activity must be related to the development of the product or service provided. Any admin related work would not fit the criteria. 
  
  • Substantially All Rule: This applies when we assign an 80% qualification to an employee’s wages. The IRS allows the remaining 20% to qualify that employee at 100%. This typically applies to high technical roles such as engineers or scientists.
  • There are three categories of activities: 
    • Direct Conduct/Research: Generally technical personnel (engineers, software developers, scientists, chemists, etc.) deeply involved in the development effort.
    • Direct Supervision: Generally the first line of supervisors or managers directing or supervising the Direct Conduct development effort.
      • Example of Qualified Direct Supervision: Direct Supervision also includes the activities of executive personnel in directing the research. 
    • Direct Support: Generally administrative assistants typing lab reports or clerks who clean lab equipment or any employee that assists first line technical personnel in conducting direct research activities. General admin, human resources, or finance do not qualify as Direct Support.
      • Examples of Qualified Direct Support:
        • Gathering technical information from customers and disseminating this back to the design team to facilitate the development,
        • Activities that maintain or "clean" the area where research is being done - such as the cleaning of lab equipment used in the research process, or IT activities used to maintain a computer network used by software engineers to create software code (note - normal janitorial tasks or IT troubleshooting/answering tickets from people about why their email isn't working do not qualify as direct support),
        • Activities that involve gathering, categorizing or otherwise recording test results from any test used in qualified research,
        • Building any physical model that will be used in qualified research.
• Supplies: Costs associated with purchasing materials, supplies, and equipment used and consumed (no longer viable after use) in the R&D development and experiments (raw materials, laboratory materials (beakers, test tubes, etc.), or testing materials).
• Contract Research: Payments made to third-party contractors or research organizations for conducting qualified research (universities, consulting services, research studies, prototype development, and independent contractors).  
  • The research performed must meet the following IRS' criteria for qualified research:
    • Contractors must perform qualified research activities within U.S. territories. 
    • R&D tax credit rules require a 35% reduction ("haircut") on contract research costs mandated to accommodate for overhead expenses. 
    • Unlike wages, the "Substantially All" rule doesn't apply to contract research. Therefore, contractors are typically deemed more involved in the research process. For instance, if an employee, such as a software developer, is usually qualified at 80%, when the same role is filled by a contractor, they should ideally be considered 100% involved in the research process.
• Leasing of Computers: Payments made to an outside company that leases computers for use in qualified research. There are three requirements for these payments to be eligible for the R&D tax credit:
  • 1: The computers are not located on the taxpayer’s site
  • 2: The computers are owned by someone besides the taxpayer claiming the credit
  • 3: The taxpayer is not the computer’s primary user
  • Hosting expenses may also qualify as lease of computers. Qualified hosting expenses can include, but are not limited to: Amazon Web Services, Github, Atlassian. However, cloud-based email, marketing, and communication platforms do not qualify.

Section 174 of the Internal Revenue Code (IRC) defines R&D eligible costs. It’s important to understand the difference between being eligible for R&D tax credits and Section 174 deductions. 

Effective 2022, Section 174 was updated to require that companies spread their R&D expenses out over a five-year period—more information can be found here.

The requirement to amortize Section 174 costs may have an impact on accounting and tax reporting requirements. By leveraging the benefits of both R&D tax credits and Section 174 deductions, businesses can manage their tax liabilities and support ongoing innovation and growth initiatives.

• R&D tax credits: Cover qualified expenses such as wages, supplies, contracts, and computer leasing costs directly associated with research activities, but not expenses like rent and utilities.
• Section 174: Includes the typical costs such as wages, supplies, contracts, and computer leasing, however, it also covers expenses like rent and utilities.

Even if your business is not claiming the R&D tax credit, the IRS requires any business performing R&D to amortize (spread out) all R&D expenses over multiple years. We recommend speaking with your tax preparer to assess how this might impact your filing. 

The table below shows what forms are needed.

*Form 3800 and K-1 are not needed for payroll tax offset utilization.

Form 6765 is the form used to claim R&D tax credits and must be filed with your Federal Income Tax Return. 

There's a section at the bottom of Form 6765 to allow QSBs to elect to apply some or all of the credit towards offsetting payroll taxes.  

Important: If using the credit towards payroll tax, be sure Section D/Box 41 is checked. If it's not checked, the credit will be used towards income tax.

For a Qualified Small Business (QSB), the payroll tax credit can be first claimed on the business tax return for the first quarter after filing the income tax return with Form 6765 reflecting the payroll tax election section.

Profitable companies

• If a profitable company files an on-time tax return without marking the payroll election section, the R&D credits are used as a liability tax offset at the time of filing. Any unused credits can be carried forward to offset future income tax liability.
• If the tax return is filed on time without Form 6765, the company must amend the return to include Form 6765 and claim the credits. Starting January 10, 2022, a Declaration Statement is required for any refund claims from the IRS. Gusto's R&D Tax Credit Team can assist with this statement. *At this time, Gusto does not support amendments and cannot provide R&D tax credits for prior years.

Non-profitable companies

• For companies that were not profitable and filed on-time tax returns without the payroll election section, the credits can be carried forward. These credits can be used in future years when the company generates income tax liability. Credits can be carried forward for up to 20 years.
• If the tax return is filed on time without Form 6765, the company has two options to report these carry-forward credits:
  • DO amend the prior year's return to include Form 6765, claim the credit, and report the credit balance as a deferred asset on the balance sheet. Declaration Statements are not required to amend to include credits that are carried forward for future use.
  • DO NOT file an amendment and simply report the credit balance on a carry-forward schedule.

Using the credit to offset payroll taxes must be filed on Form 8974, which is attached to your quarterly payroll tax returns (Form 941). This form should be submitted to your payroll provider to incorporate the credit into your payroll tax return.

The credit will be applied against employer payroll taxes quarterly, beginning the first calendar quarter after filing your federal income tax return. 

To receive your credit quickly, timing is everything. Form 6765 needs to be filed with your tax return, so keep these dates in mind:

• End of quarter deadlines: Payroll offset can begin the quarter after they're filed. So if claiming R&D tax credits to offset your payroll taxes, you’ll want to file before the end of the quarter, on or before your IRS filing deadline.
  • Q1: March 31
  • Q2: June 30
  • Q3: September 30
  • Q4: December 31
• Federal tax filing deadline: By entity types with a calendar year-end of 12/31.
  
  • S-Corp, Partnership
    • March 15: On time
    • Sept 15 : Extended
  • C-Corp, Sole Proprietorship
    • April 15: On time
    • October 15: Extended
  • Any entity with a Fiscal Year end of September 30th
    • Sept 15: On time
    • April 15 (of the following year): Extended
  • Reminder: If the Federal tax deadline falls on a weekend or holiday, the deadline will be pushed to the next business day. 
• IRS turnaround
  • 10–12 weeks (estimate)

Payroll offset is an option for companies meeting the IRS' "startup rules". These companies can leverage R&D credits to offset their payroll taxes, specifically the employer-paid portion of the social security and medicare tax. To qualify as a startup, a company must meet two essential rules:

• Rule 1: The company has less than five years of gross receipts/sales. 
• Rule 2: The company has less than $5 million in gross receipts/sales in the tax year for which the credit is claimed.

Note: After the fifth year, payroll tax offset becomes unavailable. The offset option is limited to a timely filed tax return or a superseding tax return.

How credits are applied

Gusto will apply your R&D tax credits directly to your account. Simply upload a copy of your filed tax return inclusive of Form 6765 provided by Gusto directly in your R&D Dashboard. Ensure the copy of your filed return lists the date it was filed. Gusto will apply the credits to your payroll taxes for you and assist with filing the quarterly forms. 

Payroll offset will begin offsetting payroll taxes the quarter after they're filed and must be claimed on tax returns filed by the original IRS deadline, or under extension.

Claim the credit as a payroll offset in real time 

It’s easy to apply your R&D payroll offset credits with Gusto. Once you’ve filed your return with the form 6765 our team provides, you can upload it directly to your R&D portal. Our team will review your filing and apply the credits for use the quarter after they were filed. 

Only one year’s credit can be claimed at a time until the full amount is used up. 

• In 2023, the IRS updated the guidelines to allow for the R&D tax credit to be applied to employer Medicare once the employer's share of Social Security is exhausted. For now, Gusto will not be applying the real-time credit to Medicare. Gusto will report any Medicare credit amounts on the quarterly filings and the IRS will refund the company. 

Important: The option to claim the credit in real-time only appears in your account if there's a remaining balance to apply credit to. It also depends on when your accountant filed your most recent business income tax return because you're eligible to claim the credit on the first day of the following quarter. For example, if your return was filed in May, then the credit period begins July 1st (the first day of the next quarter) and runs through June 30th of the next year. 

Find your credit utilization to date 

1. Sign in to Gusto.
2. Click Reports. 
3. Select the Federal R&D tax credit option.
4. You'll see the exact breakdown and usage of your credits.

For the real-time redemption, you can look at the tax totals on the payroll history, and compare those numbers to the total taxes debited for in the cash requirements summary, to see that we did not debit the employer paid portion of social security taxes for that amount.

Profitable companies, like C-Corps and Sole Proprietorships, can use R&D credits to offset some or all of the business’ tax liability due when filing.

Profitable pass-through companies, like S-Corps and Partnerships, can apply R&D credits to offset personal income tax liability of their shareholders, partners, or LLC members.

A pass-through entity is defined as a business where their profit flows through to owners or members and are taxed under the individual income tax—these entity types do not pay income taxes at the business level.

If a company does not have taxes to offset in the tax year in review, or is not profitable, both federal and state R&D credits can be carried forward. Carry forward credits remain a deferred asset on your company’s tax return balance sheet until they can be used against future tax liability.

Alternatively, if you have prior year tax liabilities, you can apply your current-year R&D tax credits to the prior year by amending the return. 

Reminders

• Federal credits can be carried forward for up to 20 years.
• Each state has its own rules regarding the expiration of credits. 
• Example: California's state credit can be carried forward indefinitely.
• Businesses can also carry back the R&D tax credit for one year to apply the credit retroactively by amending the prior year return.

When claiming R&D tax credits, keeping comprehensive documentation is required as evidence of eligible R&D activities.

The documentation confirms the activities your company has performed used science and technology to create something new or improve existing products or processes.

Documentation needed to back up claims

Supporting documents are documents that originated during the development year and support your R&D claim by demonstrating the pieces of the 4-part criteria test. We suggest organizing your documents by business components and by the related tax year. 

Examples of supporting documentation for each of the criteria can be found below.

Documentation best practices

• Document the time spent by each employee on qualifying R&D activities.
• Specify the nature of their tasks and the percentage of time dedicated to R&D. 
• Document the experimental process, including any hypotheses, testing methods, and outcomes. 
• Highlight instances where uncertainties were encountered and the steps taken to resolve them.
• Explicitly tie expenses to the R&D project to demonstrate the allocation of resources for qualifying activities.
• If external parties are involved in your R&D activities, maintain detailed documentation of subcontractor agreements and the specific R&D-related tasks they performed. 
• This includes invoices, contracts, and any other relevant documentation.