R&D Tax Credit for Small Businesses: Eligibility, Benefits, and How to Claim
Many companies, 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
The R&D tax credit is a dollar-for-dollar reduction that allows companies that engage in research and development activities to offset their business’s tax liability. Its goal is encouraging companies to innovate, create, and perform valuable research for society.
Before, startups could only apply for this tax claim once they became profitable. However, the PATH, or Protecting Americans from Tax Hikes, expanded the legislation and permanently renewed the number of tax credits for businesses, individuals, and families. The expansion permitted unprofitable startups to use their tax credits against their payroll tax liabilities by up to $250,000 annually.
Consequently, a small business can obtain up to $1.25 million in Research and Development tax credits to offset expenses. Let’s say a company doesn’t have 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 this instance, this company is qualified for tax credits against the payroll tax liability. Most startup companies aren’t profitable until after five to ten 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 credits for small businesses entails distinguishing which activities count as federal income tax liability. Generally, a taxpayer 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
A small business must pass a standard four-part test to be able to declare activities and expenses related to research. 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 the research credit, the activity should rely on principles of computer science, engineering, physical sciences, biological sciences, and scientific methods. This requires using technology or engineering in a science field.
In addition, its goal is to improve or develop software, processes, or products’ performance, quality, reliability, or functionality.
Elimination of Uncertainty
The activity must aim to discover information to eliminate uncertainty about a specific capability or method for improving or developing a process or product. There is uncertainty if the software, product, or process’s design method or capability isn’t readily known.
Process of Experimentation
The activity must involve the experimentation process involving alternative evaluation, simulation, hypothesis confirmation via trial and error, refining or discarding hypotheses, or testing and modeling. A systematic process evaluating at least one alternative should be involved, including modeling, prototyping, hypothesis testing, and iterative analysis. It also requires determining uncertainties and testing possible solutions.
Qualifying Research Expenditures for Small Businesses
Companies should note expenditures they can declare for this tax claim in addition to which activities qualify for this tax credit. The credit covers two types of qualified research expenses: in-house and contract. In-house research expenses comprise salaries paid to staff for any qualified activities performed, supplies bought for the qualified research, and contract research expenses paid for the research.
Only salaries, including taxable wages reported on a staff member’s W-2 form, can be considered qualifying research expenses. Only employees involved in qualified research activities or directly supporting these activities count.
Any tangible property purchased to conduct qualified research is considered a supply for the tax credits. Contract research expenses are when a third-party business performs qualified research on behalf of the taxpayer.
How to Claim R&D Tax Credits for Small Businesses
Qualified companies must file IRS Form 6765, Credit for Increasing Research Activities, for this tax benefit. This process includes determining qualifying research activities and providing documentation proving these costs meet the Internal Revenue Code Section 41 requirements. Companies may use business and financial records, oral testimonies, and technical documents.
Before you complete this form, you should carefully read 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:
- Calculate qualified research expenses for the preceding three years.
- Average these amounts.
- Multiply that average by 50%. This number is your credit base.
- Subtract the amount of your credit base from your total R&D expenses for the year.
- 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.