The payroll tax offset and start-ups

1Summary

The federal research credit under Section 41 is a credit against income tax. A company that has no income tax to pay gains nothing from it in the year it is earned. Since tax years beginning after 2015, a qualified small business, broadly a company with gross receipts under $5 million and no gross receipts before the last five years, can elect to apply part of its credit against the employer share of payroll taxes instead.12 The IRS says the election is designed to benefit a start-up with little or no income tax liability.3 The amount that may be elected rose from $250,000 to $500,000 for tax years beginning after 2022.13

The offset changes the economics of the credit for a young company. A credit that would otherwise sit as a carryforward becomes a reduction in the payroll tax the company pays each quarter, beginning soon after it files its return.24 That makes the credit close to cash, and it makes the size of the claim matter immediately.

This paper describes how the offset works, what the Treasury Inspector General for Tax Administration has found about it, and which rules govern how the people who prepare these claims may be paid. It finds that the companies the offset is meant to help are often the ones with the least capacity to assess a claim prepared for them, that the claim form asks less of them than of larger claimants, and that no official data shows how their advisers are paid.

2How the offset works

2.1The election

Section 41(h) of the Internal Revenue Code lets a qualified small business elect, for any taxable year, to have Section 3111(f) apply to a "payroll tax credit portion" of its research credit.1 The portion is the least of three amounts: the amount specified in the election, the research credit for the year, and, for a business other than a partnership or S corporation, the business credit carryforward from the year.1 The portion that is elected is not then treated as an income tax credit, except for the purposes of Section 280C.1

The election is made on Form 6765, Credit for Increasing Research Activities, attached to the company's timely filed income tax return, including extensions.35 The IRS states that the election cannot be made with an amended return.3 For tax years beginning in 2016, interim guidance in Notice 2017-23 allowed a business that had filed on time but missed the election to make it on an amended return filed by 31 December 2017.6 The election may be revoked only with the consent of the IRS.15 For a partnership or S corporation it is made at the entity level.1

2.2Who qualifies

A qualified small business is a corporation or partnership with gross receipts of less than $5,000,000 for the taxable year, and with no gross receipts for any taxable year before the five taxable year period ending with that year.1 Other persons qualify on the same tests applied to the gross receipts of all their trades or businesses.1 Tax-exempt organizations are excluded.1 Gross receipts for this purpose are determined under the rules of Section 448(c)(3), not under the research credit's own gross receipts definition.56 All members of a controlled group are treated as a single taxpayer, so the gross receipts of the whole group count.56

A business may not make the election if it, or any member of its group, has already made it for five or more preceding taxable years.15 The offset is therefore available to a business for a limited number of years early in its life.

2.3The amount

The amount specified in an election may not exceed $250,000.1 For taxable years beginning after 31 December 2022, the Inflation Reduction Act of 2022 increased the limit by a further $250,000, to $500,000.13 Within a controlled group, the limit is allocated among the members.16

2.4How the credit is used

The credit is claimed against payroll tax, not income tax. Section 3111(f) allows it first against the employer's old age, survivors and disability insurance tax, the employer share of social security tax, up to the original $250,000 limit, and then, for the remainder, against the employer's hospital insurance tax, the employer share of Medicare tax.2 The credit is available from the first calendar quarter that begins after the company files the income tax return that contains the election.24

The company claims it by attaching Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, to its employment tax return, usually the quarterly Form 941.34 The IRS gives an example: a calendar year business that files its 2024 income tax return on 17 March 2025 first takes the credit on its Form 941 for the second quarter of 2025.4 In any quarter the credit cannot exceed the relevant employer tax, and any excess is carried to the following quarter.2 The Inspector General notes that unused credits can be carried forward to later quarters indefinitely, until the credit is fully used.7

Step	What happens	Where
1	The company figures its research credit and elects an amount, up to $500,000 for tax years beginning after 2022, as a payroll tax credit	Form 6765, Section D, attached to a timely filed original return5
2	The company files its income tax return	The return for the year, for example Form 1065 for a partnership or Form 1120-S for an S corporation6
3	From the first quarter that begins after filing, the credit reduces the employer share of social security tax, then the employer share of Medicare tax	Form 8974 attached to Form 941, 943 or 94424
4	Any credit not used in a quarter carries to the next quarter	Form 897424

2.5Why the offset matters to a start-up

The IRS describes the election as designed to benefit an eligible start-up that has little or no income tax liability.3 A company in that position cannot use an income tax credit until it becomes profitable. The payroll tax election lets it use the credit against a tax it pays every quarter whenever it has employees. The practical effect is that the credit reduces cash outflows within months of the return being filed, rather than waiting for future profits.

This is the feature that makes the offset valuable to the companies it was designed for. It is also the feature that makes the size of the claim felt immediately. A larger claim produces a larger reduction in payroll tax, sooner.

3What the official record shows

3.1Volume

The Treasury Inspector General for Tax Administration (TIGTA) has examined the offset twice. In its first report, issued on 19 December 2018, it recorded that in Tax Year 2017 over 2,200 research credit claims totaling over $53.2 million were made against payroll taxes.8 In its follow up report, issued on 15 April 2026, it recorded that as of June 2025 the IRS had received 11,416 Forms 941 with $382 million in payroll tax credit for Tax Year 2023, and 12,612 Forms 941 with $381 million for Tax Year 2024.7 These figures count employment tax returns, which are filed quarterly, not companies.7

3.2Eligibility errors

In 2018 TIGTA reported that the IRS did not have processes to identify small businesses that did not meet the eligibility requirements and dollar limits for the offset.8 Its review of 1,467 businesses claiming over $53.2 million on Tax Year 2017 employment tax returns identified 143 businesses that claimed or received about $11.8 million in potentially erroneous credits.8 Of those, 81 businesses with claims totaling almost $2.8 million did not meet one or more of the eligibility requirements, and 55 businesses with claims totaling $586,190 had claimed the credit on a return for a period before the credit became available.8 IRS management agreed with all five of TIGTA's recommendations.8

In 2026 TIGTA found that the IRS had fixed earlier problems with three Form 8974 business rules, the automated checks applied to electronically filed returns, and had worked around a programming error that had limited some Tax Year 2023 claims to $250,000.7 It also found that the IRS "still does not have processes to address ineligible taxpayers" who claim the offset.7 Reviewing nearly 7,300 Tax Year 2023 electronically filed business returns with a Form 6765 election, it identified 40 returns where the business did not meet the gross receipts requirement, and found that the IRS had erroneously allowed those businesses to claim $3.1 million as a payroll tax credit.7 TIGTA stated that most businesses that claim the offset are eligible, and that erroneous credits reduce the funding paid into the Social Security and Medicare systems.7 The IRS agreed to review the 40 cases.7

3.3What the record does not show

The TIGTA reports deal with eligibility: whether a business met the gross receipts tests and claimed within the limits.87 They do not report on whether the underlying research credit was correctly calculated, whether the activities claimed were qualified research, or who prepared the claims. No IRS or TIGTA publication found for this paper reports how the advisers who prepare payroll offset claims are paid, or compares the outcomes of claims prepared under different fee arrangements. Neither Form 6765 nor Form 8974 asks for that information.45 Where the record is silent, this paper says so rather than estimate.

4The information a start-up gives the IRS

4.1Less detail on the form

For tax years beginning after 2025, Form 6765 requires most filers to complete Section G, which reports business component information for at least 80 percent of qualified research expenses, up to 50 business components.5 The instructions exempt two groups. The first is a qualified small business, as defined in Section 41(h)(3), that has checked the box to claim what the instructions call a "reduced payroll tax credit".5 The second is a taxpayer whose qualified research expenses are $1.5 million or less, whose average annual gross receipts for the prior three years are $50 million or less, and which is reporting the credit on an original return.5

A start-up making the payroll tax election will usually fall within one or both exemptions. The practical result is that the claim form for the companies that receive the credit as cash asks for less project level information than the form for larger claimants.

4.2No refund claim requirements

The IRS requires specific information with research credit claims for refund made on amended returns, and column 49(f) of Section G applies to amended returns that claim a credit not reported on the original return or an increased one.5 Because the payroll tax election can only be made on a timely filed original return, those refund claim requirements do not apply to the election itself.35 The claim is examined, if at all, after the credit has begun to reduce payroll tax.

4.3Recapture if the credit is later reduced

Section 41(h)(6)(C) directs Treasury to prescribe regulations for recapturing the benefit of payroll tax credits where there is a later adjustment to the payroll tax credit portion, including by requiring amended income tax returns.1 In Notice 2017-23, Treasury and the IRS asked for comments on how the IRS should recapture excessive payroll tax credits if, for example, the IRS later adjusts a business's research credit.6 The IRS continues to describe Notice 2017-23 as interim guidance.3 Whatever the mechanism, the credit the company has already used against its payroll taxes is the company's to repay if its research credit is reduced. Nothing in Sections 41(h) or 3111(f) moves that liability to the person who prepared the claim.12

5Who may prepare the claim, and how they may be paid

5.1The tax return preparer

A tax return preparer is any person who prepares for compensation, or employs others to prepare for compensation, any return of tax or claim for refund under the Internal Revenue Code, including a substantial portion of one.9 The preparer of a start-up's research credit computation and payroll tax election will usually fall within that definition, because the election is part of the income tax return.19

The preparer penalty in Section 6694 applies where any part of an "understatement of liability" on a return or claim prepared by the preparer is due to an unreasonable position the preparer knew or reasonably should have known of.10 An understatement of liability includes an overstatement of the net amount creditable or refundable with respect to any tax imposed by the Code.10 The penalty is the greater of $1,000 or 50 percent of the income the preparer derived from the return or claim, rising to the greater of $5,000 or 75 percent for willful or reckless conduct.10 A preparer is not penalized under Section 6694(a) if there was reasonable cause and the preparer acted in good faith.10

5.2Circular 230 practitioners

Treasury's rules governing practice before the IRS, Circular 230, apply to practitioners: attorneys, certified public accountants, enrolled agents, enrolled actuaries, enrolled retirement plan agents and registered tax return preparers.11 Section 10.27 provides that, except in listed cases, a practitioner may not charge a contingent fee for services rendered in connection with any matter before the IRS.12 A contingent fee includes a fee based on a percentage of the refund reported on a return, a percentage of the taxes saved, or one that otherwise depends on the specific result attained.12 A matter before the IRS includes preparing or filing, or assisting in preparing or filing, returns or claims for refund or credit.12

The listed exceptions cover services in connection with an IRS examination of, or challenge to, an original return; certain amended returns or claims filed within 120 days of a written notice of examination or challenge; claims relating solely to statutory interest or penalties; and judicial proceedings.12 None of them covers preparing an original return. On the text of Section 10.27, therefore, a Circular 230 practitioner may not charge a contingent fee for preparing the original return on which a start-up's credit and payroll tax election are made.12

Section 10.34 adds that a practitioner may not willfully, recklessly or through gross incompetence sign a return, or advise a position on it, that the practitioner knows or reasonably should know lacks a reasonable basis or is an unreasonable position under Section 6694(a)(2).13 It also requires the practitioner to inform the client of penalties reasonably likely to apply to a position the practitioner advised on or a return the practitioner prepared.13

5.3The AICPA Code

The AICPA Code of Professional Conduct provides that a member in public practice shall not prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.14 It treats fees determined by the findings of governmental agencies as not contingent where the member can show a reasonable expectation that an agency will give the matter substantive consideration, and it states that this expectation is not reasonable where the member prepares the client's original tax return.14

5.4Where the rules stop

Circular 230's limits apply to practitioners as defined in its own rules.11 In 2014 the federal District Court for the District of Columbia, following the reasoning of the D.C. Circuit in Loving v. IRS, held that the IRS lacks statutory authority to regulate the preparation and filing of what the court called "Ordinary Refund Claims", refund claims filed after the original return but before an audit.15 The court described Loving as holding that the IRS's authority to regulate representatives practicing before Treasury did not extend to tax return preparers.15 The AICPA Code binds AICPA members.14

The result is that the rules on contingent fees for the original return containing a start-up's payroll tax election depend on who prepares it. A practitioner covered by Circular 230 is bound by Section 10.27, and an AICPA member by the AICPA Code.1214 A preparer who is neither is subject to the Internal Revenue Code penalties but not to those fee rules.1015 This paper found no official data on how many payroll offset claims are prepared by each group.

6The case for success fees for start-ups

A fair account of contingent fees must start with the reasons start-ups agree to them, because those reasons are strongest for exactly this group of companies.

No money up front. A young company that has not yet earned revenue is short of cash. A fee charged as a share of the credit is paid only when the credit is realized, and so it costs nothing in advance. For a company deciding whether to claim at all, that can be the difference between claiming and not claiming.

Risk transferred to the adviser. If the work produces no credit, the company pays nothing. The adviser bears the cost of an unsuccessful assessment. A fixed fee leaves that risk with the company.

Alignment with the benefit. A fee tied to the credit moves with the value the company receives. A company that receives a small credit pays a small fee. Supporters of contingent fees argue that this is a fairer way to price work whose value is not known in advance.

Access to expertise. A start-up rarely has tax staff of its own. Contingent pricing can let it engage specialists it could not otherwise afford, and the offset was designed precisely so that start-ups could use the credit.3

These are real advantages, and nothing in this paper suggests that advisers who charge contingent fees prepare claims less carefully than others. The argument of this paper is not about the conduct of any adviser. It is about what the fee structure rewards.

7The answer

7.1The incentive is the same, and the consequences arrive sooner

A fee calculated as a percentage of the credit rises with the credit. That is true whoever charges it and however carefully they work. For a company using the payroll offset, the credit becomes a reduction in payroll tax within months of filing, so the effect of a larger claim is felt at once.24 If the credit is later reduced, the company must give back what it has already used.16 Under Sections 41(h) and 3111(f), the company, not its adviser, holds the credit and bears its adjustment.12

7.2The companies have the least capacity to check

The offset is limited to businesses with gross receipts under $5 million and a short history of receipts.1 Those are businesses that are unlikely to have tax staff able to review a research credit computation. They are also likely to be exempt from Section G, so the form itself asks them for less project level detail.5 A company that cannot easily test a claim prepared for it relies more heavily on the person who prepared it.

7.3The answers to the case for success fees

The cash argument is the strongest. It is answered in part by the design of the offset itself: the credit arrives within months of filing, so a fee for the work can be agreed in advance and paid from that benefit without being calculated as a share of it.24 The risk transfer argument assumes that the adviser bears the risk that matters. The risk of a fee arrangement that does not pay out is borne by the adviser; the risk of a claim that does not hold, including recapture of credit already used, remains with the company.16 The alignment argument holds only for the amount claimed. It does not hold for the amount that survives examination, which is the amount the company actually keeps. The access argument is a reason for clear and predictable pricing, which a fixed fee also provides.

7.4Professional rules already reflect the concern

The rules that limit contingent fees for original returns, in Circular 230 and the AICPA Code, already apply to many of the people who prepare these claims.1214 They rest on the same concern: that a fee contingent on the amount reported on a return creates an incentive that the client may not be able to see or test. What the rules do not do is reach every preparer, and no rule requires a claim to state how its preparer was paid.4515

Our position

Congress should prohibit contingent fees, commonly called success fees, in federal research and development tax credit engagements under Section 41, so that advisers are paid for the work they perform rather than for the size of the claim they produce. That includes the work of preparing a qualified small business's credit and its payroll tax election. Swanson Reed, which publishes this paper, is a fixed-fee R&D tax adviser. It has a direct commercial interest in the outcome: it does not charge success fees, and a ban would remove a pricing model it competes against.

8What this means for the evidence

Three gaps in the public record limit what anyone can say about payroll offset claims.

First, there is no official data on how claims are prepared or paid for. The forms do not ask, and no IRS or TIGTA report found for this paper addresses it.4587

Second, the published reviews of the offset deal with eligibility, not with the accuracy of the research credit itself.87 TIGTA's findings show that eligibility errors occur and that, as of its 2026 report, the IRS did not have a process to address ineligible claimants after processing.7 They do not show how often the underlying credits are overstated.

Third, the recapture rules remain the subject of interim guidance that asked for comments in 2017.36

These gaps mean that the case made here rests on the structure of the incentive and the profile of the companies concerned, not on measured outcomes. That is stated plainly so that readers, including those who disagree, can weigh it accordingly.

References

Office of the Law Revision Counsel, 26 U.S.C. 41, Credit for increasing research activities, subsection (h) and statutory notes on Pub. L. 114-113 and Pub. L. 117-169, United States Code 2024 edition published by the Government Publishing Office. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleA-chap1-subchapA-partIV-subpartD-sec41.htm (accessed 11 October 2026). Back
Office of the Law Revision Counsel, 26 U.S.C. 3111, Rate of tax, subsections (a), (b) and (f), United States Code 2024 edition published by the Government Publishing Office. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleC-chap21-subchapB-sec3111.htm (accessed 11 October 2026). Back
Internal Revenue Service, Qualified small business payroll tax credit for increasing research activities (page last reviewed or updated 28 June 2026). https://www.irs.gov/businesses/small-businesses-self-employed/qualified-small-business-payroll-tax-credit-for-increasing-research-activities (accessed 11 October 2026). Back
Internal Revenue Service, Instructions for Form 8974 (Rev. December 2024), Reminders, "Who Must File Form 8974?" and "When Must You File?". https://www.irs.gov/instructions/i8974 (accessed 11 October 2026). Back
Internal Revenue Service, Instructions for Form 6765 (Rev. December 2025), "Qualified Small Business (Payroll Tax Credit Election)", "Payroll Tax Credit Election", "Section D", "Requirements To Complete Section G" and "Column 49(f)". https://www.irs.gov/instructions/i6765 (accessed 11 October 2026). Back
Internal Revenue Service, Notice 2017-23, Interim Guidance on Payroll Tax Credit Election, Internal Revenue Bulletin 2017-16, sections 2, 3, 4.02 to 4.06 and 6. https://www.irs.gov/irb/2017-16_IRB (accessed 11 October 2026). Back
Treasury Inspector General for Tax Administration, Controls for the Qualified Small Business Payroll Tax Credit Were Updated, but Ineligible Taxpayers Continue to Receive the Credit, Report Number 2026-408-012 (15 April 2026), Highlights, Background and Results of Review, pages 1 to 4. https://www.tigta.gov/sites/default/files/reports/2026-04/2026408012fr.pdf (accessed 11 October 2026). Back
Treasury Inspector General for Tax Administration, Processes Are Needed to Identify Small Businesses Erroneously Claiming the Research Tax Credit Payroll Tax Offset, Reference Number 2019-40-014 (19 December 2018), Highlights and Background. https://www.tigta.gov/sites/default/files/reports/2022-02/201940014fr.pdf (accessed 11 October 2026). Back
Office of the Law Revision Counsel, 26 U.S.C. 7701, Definitions, subsection (a)(36), United States Code 2024 edition published by the Government Publishing Office. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleF-chap79-sec7701.htm (accessed 11 October 2026). Back
Office of the Law Revision Counsel, 26 U.S.C. 6694, Understatement of taxpayer's liability by tax return preparer, subsections (a), (b) and (e), United States Code 2024 edition published by the Government Publishing Office. https://www.govinfo.gov/content/pkg/USCODE-2024-title26/html/USCODE-2024-title26-subtitleF-chap68-subchapB-partI-sec6694.htm (accessed 11 October 2026). Back
Treasury Department, Regulations Governing Practice before the Internal Revenue Service (Circular 230), 31 CFR 10.2(a)(5) and 10.3. https://www.ecfr.gov/current/title-31/subtitle-A/part-10/subpart-A/section-10.3 (accessed 11 October 2026). Back
Treasury Department, Regulations Governing Practice before the Internal Revenue Service (Circular 230), 31 CFR 10.27, Fees, paragraphs (b) and (c). https://www.ecfr.gov/current/title-31/subtitle-A/part-10/section-10.27 (accessed 11 October 2026). Back
Treasury Department, Regulations Governing Practice before the Internal Revenue Service (Circular 230), 31 CFR 10.34, paragraphs (a) and (c). https://www.ecfr.gov/current/title-31/subtitle-A/part-10/section-10.34 (accessed 11 October 2026). Back
American Institute of Certified Public Accountants, AICPA Code of Professional Conduct (updated for all official releases through September 2026), ET 1.510.001 Contingent Fees Rule, paragraphs .01 and .03, and ET 1.510.010 Tax Matters, paragraph .03. https://pub.aicpa.org/codeofconduct/ethicsresources/et-cod.pdf (accessed 11 October 2026). Back
US District Court for the District of Columbia, Ridgely v. Lew, Civil Action No. 1:12-cv-00565 (CRC), Memorandum Opinion, 16 July 2014, pages 1 to 2 and 8 to 9. https://www.govinfo.gov/content/pkg/USCOURTS-dcd-1_12-cv-00565/pdf/USCOURTS-dcd-1_12-cv-00565-1.pdf (accessed 11 October 2026). Back

Cite this paper

Summary

1Summary

2How the offset works

2.1The election

2.2Who qualifies

2.3The amount

2.4How the credit is used

2.5Why the offset matters to a start-up

3What the official record shows

3.1Volume

3.2Eligibility errors

3.3What the record does not show

4The information a start-up gives the IRS

4.1Less detail on the form

4.2No refund claim requirements

4.3Recapture if the credit is later reduced

5Who may prepare the claim, and how they may be paid

5.1The tax return preparer

5.2Circular 230 practitioners

5.3The AICPA Code

5.4Where the rules stop

6The case for success fees for start-ups

7The answer

7.1The incentive is the same, and the consequences arrive sooner

7.2The companies have the least capacity to check

7.3The answers to the case for success fees

7.4Professional rules already reflect the concern

8What this means for the evidence

References

About this paper

Cite this paper

Summary

1Summary

2How the offset works

2.1The election

2.2Who qualifies

2.3The amount

2.4How the credit is used

2.5Why the offset matters to a start-up

3What the official record shows

3.1Volume

3.2Eligibility errors

3.3What the record does not show

4The information a start-up gives the IRS

4.1Less detail on the form

4.2No refund claim requirements

4.3Recapture if the credit is later reduced

5Who may prepare the claim, and how they may be paid

5.1The tax return preparer

5.2Circular 230 practitioners

5.3The AICPA Code

5.4Where the rules stop

6The case for success fees for start-ups

7The answer

7.1The incentive is the same, and the consequences arrive sooner

7.2The companies have the least capacity to check

7.3The answers to the case for success fees

7.4Professional rules already reflect the concern

8What this means for the evidence

References

About this paper

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