R&D Tax Credit for Small Businesses: Eligibility, Benefits, and How to Claim

May 17, 2024
Gideon Ward
Fact Checked

Plenty of businesses, including small businesses, can claim the R&D tax credit and benefit from the extra funding. Under specific conditions, startup taxpayers can offset as much as $500,000 of their FICA federal payroll tax liability for up to five years by using R&D credits. The 2022 Inflation Reduction Act doubled this, bringing the previous limit of $250,000 to the current $500,000.

New businesses with revenue under $5M founded in the last five years may qualify. Research activities don’t need to be groundbreaking or successful to be eligible.

How can small businesses qualify for this tax credit? We’ll discuss further in this article.

R&D Tax Credits for Small Businesses

 

A business meeting with professionals discussing charts and data on a whiteboard, relevant to R&D tax credit assessment for small businesses.

The R&D tax credit is a dollar-for-dollar reduction that permits companies that engage in research and development activities to offset their business’s tax liability. It is meant to encourage companies to innovate, create, and perform valuable research for society.

In the past, startups would only benefit from this tax credit claim once it became profitable. However, Protecting Americans from Tax Hikes (PATH) expanded the law and permanently renewed the number of tax credits for families, individuals, and businesses. This expansion allowed unprofitable startups to use their R&D tax credits against their payroll tax liabilities by up to $250,000 annually.

As a result, small businesses can get up to $1.25 million in Research and Development tax credit to offset their costs. Suppose the company has no gross receipts before the five years ending with the current tax year or less than $5 million of annual gross receipts in the tax credit claim year. In that case, this company is qualified for credits against the payroll tax liability. Most startup businesses aren’t profitable for about five to 10 years.

The R&D tax credit differs from a tax deduction because the latter reduces taxable income. This credit directly minimizes a company’s tax liability.

Qualifying Research Activities for the R&D Tax Credit

Proper filing of R&D tax credit for small business entails distinguishing which activities count as federal income tax liability. Generally, a company can claim two broad categories of activities towards the R&D tax credit: QRAs — sometimes called qualified research expenses (QREs) — and basic research payments. Most small businesses can claim expenses under the QRE category.

Here are some examples of qualifying research and development activities that small businesses can declare for this tax credit:

  • Design or development of new or improved products
  • Enhancements to existing processes or products
  • Development or improvement of existing prototypes and software
  • Streamlining manufacturing processes to increase automation or to reduce cost or waste
  • Refining techniques that are already in place
  • Advancing software to bridge or interface between outside entities

While it’s vital to identify which activities count as research activities, companies should also take note of activities that shouldn’t be declared for this tax credit. Here are some examples to take note of:

  • Duplication of a product or process that already exists
  • Studies or surveys conducted, like market research
  • Research conducted once commercial production has begun
  • Research in the humanities or social science
  • Research to adapt an existing product or process to an individual customer
  • Research related to software intended for internal use
  • The fixed costs for maintaining research facilities

Qualifying Four-Part Test

For a small business to be able to declare activities and expenses related to research, these need to pass a standard four-part test. This test applies to companies of all sizes, including small businesses.

Permitted Purposes

The activity must relate to a new or improved business component’s function, performance, reliability, quality, or composition. It should intend to develop a new or improved product, process, or software. Moreover, it ensures that the research is not conducted for non-commercial purposes, such as social science or arts-related endeavors.

Technological in Nature

To qualify for research credits, the activity should fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering and scientific methods. This requires the use of technology or engineering in a field of science.

Moreover, it aims to develop or improve a product, process, or software’s functionality, performance, reliability, or quality. Examples include developing new materials, improving manufacturing processes, or enhancing software functionality.

Elimination of Uncertainty

The activity must be intended to discover information to eliminate uncertainty concerning a particular method or capability for developing or improving a product or process. Uncertainty exists if the capability, method, or design of the product, process, or software is uncertain or not readily known.

Process of Experimentation

The activity must constitute the process of experimentation involving simulation, evaluation of alternatives, confirmation of hypotheses through trial and error, testing and modeling, or refining or discarding of hypotheses. It should involve a systematic process designed to evaluate one or more alternatives and include testing hypotheses, modeling, prototyping, and iterative analysis. It also needs to identify uncertainties and test potential solutions to resolve them.

Qualifying Research Expenditures for Small Businesses

 

Professionals analyzing financial charts and using a calculator, indicative of evaluating qualifying research expenditures for small businesses.

Aside from which activities qualify for this tax credit, companies should note expenditures they can declare for this tax claim. The R&D tax credit covers two categories of qualified research expenses: in-house and contract research expenses. In-house research expenses include wages paid to employees for any qualifying activities performed, supplies purchased to conduct qualified research, and contract research expenses paid to conduct qualified research.

To clarify, only wages that include all taxable wages reported on an employee’s W-2 form can be declared as qualifying research expenditures. In addition, it should be highlighted that only employees involved in qualified research activities or directly supporting these initiatives are qualified.

Any tangible property bought to conduct qualified research can be considered a supply for this tax credit. An engineering firm working to improve the quality of a product may declare the materials used for that project as supply expenses.

Contract research expenses are when a business performs qualified research on behalf of the taxpayer. In this case, 65% of the amount paid to the non-employee can be considered a qualified expense.

How to Claim R&D Tax Credits for Small Businesses

Companies must file IRS Form 6765, Credit for Increasing Research Activities, for this tax benefit. This process includes identifying qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business records, financial records, oral testimonies, and technical documents.

Before you complete this form, you should familiarize yourself with the instructions mandated by the IRS. The PDF version of this form can be easily downloaded from the IRS website.

In general, the IRS Form 6765 has four sections:

  • Section A is used to claim the regular credit and contains 11 lines of required information.
  • Section B applies to the Alternative Simplified Credit or ASC.
  • Section C identifies additional forms and schedules that require reporting based on one’s business structure.
  • Section D only applies to qualified small businesses or QSBs making a payroll tax election.

The IRS recommends that companies calculate their credit using both regular and simplified credit methods, and then they fill out the section (A or B) that would result in the greatest tax benefit.

3 Benefits for Claiming R&D Tax Credits

Companies that claim R&D tax credits can enjoy the following benefits:

1. Reduced Tax Liability

Tax liabilities, like payroll taxes, can be very costly for startups. This tax credit empowers companies by directly decreasing their tax obligations. It can even offset payroll taxes.

2. Increased Cash Flow

The R&D tax credit provides immediate cash flow benefits, allowing reinvestment in business growth. The money qualified small businesses to receive from this benefit can be allotted to other vital research-related activities.

3. Growth Opportunities

Increased funding for research activities can lead to new market opportunities and revenue streams for small businesses.

R&D Payroll Tax Offset

The federal R&D payroll tax offset provision of the R&D Tax Credit allows a startup company to claim credit against their payroll taxes. Under IRC Section 41(h), a qualified small business can use its federal R&D credit to offset its employer-paid payroll taxes starting in tax years after December 31, 2015.

To be eligible for this, the business must have less than $5 million in gross receipts in the credit year and has no “gross receipts” for any taxable year preceding the 5-taxable-year period ending with the credit year.

How to Calculate R&D Credits for Small Businesses

Calculating one’s R&D credits entails five crucial steps:

  1. Calculate qualified research expenses for the preceding three years.
  2. Average these amounts.
  3. Multiply that average by 50%. This number is your credit base.
  4. Subtract the amount of your credit base from your total R&D expenses for the year.
  5. Multiply by 14% to find your R&D tax credit.

The credit is calculated as 10% of QREs more than the base period up to $2M and 2.5% for expenses above $2M. The base period is greater than either a) the average annual gross for the four preceding tax years multiplied by a fixed-base percentage or b) 50% of current year QREs.

Other Tax Credits for Small Businesses

Small companies are eligible for other tax credits that can improve their overall business operations in addition to the R&D tax credit.

Work Opportunity Tax Credit 

This is a federal tax credit available to employers who invest in American job seekers who have consistently faced barriers to employment. Employers may meet their business needs and claim a tax credit if they hire an individual in a WOTC-targeted group.

SECURE 2.0 Act

This act contains 92 new provisions to promote savings, boost incentives for businesses, and offer more flexibility to those saving for retirement.

Natural Disaster Tax Relief

This bill sets forth tax relief provisions for individual taxpayers for losses resulting from a major disaster occurring in 2023.

Claim R&D Tax Credits for Small Businesses

Startups can benefit tremendously from the R&D tax credit. However, when dealing with taxes, it’s best to leave things to the professionals. Companies should seek help from experts in payroll tax credit matters and more if they intend to maximize these benefits.

FAQs

Can LLC claim R&D credit?

Yes, an LLC can claim R&D tax credit.

Can a sole proprietor claim an R&D tax credit? 

If your business is a sole proprietorship, you can qualify for the federal R&D tax credit.

How much can you Write Off for R&D?

This depends on the qualified expenses, but companies can generally claim up to $500,000.

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