R&D Tax Credits for Startups – What You Need to Know
As an entrepreneur, you have a lot on your plate – from go-to-market strategies to finding new clients; the list can be ad infinitum. Losing a chunk of your capital on taxes should be your least worry. Several federal and state incentives help you achieve just that, and the Research and Development (R&D) tax credit for startups is one of them.
Since 2016, this credit has benefited eligible small businesses, allowing them to offset up to $500,000 of their payroll taxes annually – a huge advantage for companies not yet generating taxable income.
You may not believe it, but many startups don’t claim these credits. Why, you ask? Simply by assuming they’re ineligible! It could be due to their size, revenue, or other reasons. With a thorough understanding of how R&D tax credits for startups work, you could be saving a lot of money year after year.
In this article, we’ll explore:
- The concrete benefits of the R&D tax credit aimed mainly at startups
- Qualification criteria and common misconceptions
- How to integrate this credit into your financial strategy
With the insights you might gain from this article, you could significantly reduce your startup’s overall tax burden and improve cash flow. Let’s explore how this often-overlooked credit can become a valuable asset in your financial toolkit.
What Are R&D Tax Credits for Startups?
The R&D tax credit is an incentive the government offers to encourage companies to conduct research and development in the United States. Established in 1981, this tax credit has undergone various changes to ensure it remains beneficial to businesses.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 made this credit permanent, widening its scope, which resulted in a steep increase in the number of startups qualifying for this type of tax credit.
Key Benefits and Changes
In its original form, the R&D tax credit was just another income tax credit. This posed a challenge for startups, as they often needed income tax liabilities to offset. They had to carry the credit to future years when they became profitable.
The PATH Act modified this by permitting startups to use the R&D tax credit to offset the employer component of Social Security taxation. This means even unprofitable startups can benefit from the credit annually.
In addition to the federal government, many states offer this tax credit to boost innovation. While the credit for offsetting income tax liability is unlimited, it is cap-capped for payroll tax offsets.
Initially, payroll tax liabilities were set at $250,000. Still, this limit was increased to $500,000 under the Inflation Reduction Act. This increase can significantly boost a startup’s cash flow, providing approximately up to 10% of annual R&D costs as a federal credit, with additional benefits from state credits.
The R&D tax credit is primarily applied against income taxes. However, startups that haven’t broken even can benefit if they meet other eligibility criteria. Before 2015, these companies had to carry the credit forward until they had an income tax liability.
To qualify, a startup must have less than $5 million in annual gross receipts and no gross receipts before the five years ending with the current tax year. Since profitability often takes several years, most startups are eligible for the credit.
Eligibility Criteria for R&D Tax Credits for Startups
The eligibility criteria are designed to ensure that only genuinely innovative businesses can claim the credit, making it essential for startups to understand and comply with these requirements.
Qualified Small businesses (QSB) must meet two primary criteria to be eligible for R&D tax credits:
- Gross Receipts Less Than $5 Million in the Credit Year: Startups must have gross receipts under $5 million during the credit year. This ensures that the tax credit targets smaller, innovative businesses rather than established companies.
- No Gross Receipts for up to five Years Before the Current Tax Year: Startups can have had revenue for up to five years before the current tax year. This provision aims to support newly established businesses rather than those that have been operational for a long time.
Four-Part Test for Qualifying Activities
The IRS has established a four-part test to determine if a company’s activities qualify for R&D tax credits. This test ensures that the credits are only available to businesses undertaking significant research and development efforts.
1. Technological in Nature: Research and development must be based on sciences like engineering, biology, physics, or computer science. This mandates the companies to base their R&D activities on proven scientific concepts.
2. Permitted Purpose: The research and development activities must create new or improved business components. This includes introducing new functionalities or enhancing a product or process’s functionality, dependability, performance, or quality.
3. Eliminate Uncertainty: Businesses must face significant technical uncertainty at the project’s start. They should be unsure about the method, capability, or design of the product or process they are developing.
4. Experimentation: Experimentation involves systematic trial and error, simulation, testing, and refining new or improved products. This iterative process helps businesses address technical uncertainties and develop innovative solutions.
Calculating the R&D Tax Credit for Startups
Determining your startup’s R&D tax credit involves calculating your qualified research expenses (QREs) using one of two primary methods. Here’s how you can approach this process:
Traditional Method
1. Calculate Qualified Research Expenses (QREs): Identify your total qualified research expenses for the current year. Qualified expenses may include wages for R&D staff, costs of materials, and specific subcontractor fees.
2. Determine the Fixed Base Percentage: The Fixed Base Percentage is 16%. This percentage calculates the base amount from which you’ll measure excess QREs.
3. Calculate the Base Amount: Apply the Fixed Base Percentage to the average of your gross receipts from the prior four years. This gives you the base amount.
4. Calculate the Gross Credit Amount: Multiply 20% by the lesser of the surplus QREs over the base value or 50% of the QREs from the current year. This will provide your credit amount for the first quarter of this year.
Alternative Simplified Credit (ASC) Method
1. Calculate Qualified Research Expenses (QREs): Identify your current year’s qualified research expenses.
2. Determine the Average Qualified Expenses: Calculate 50% of the average qualified expenses over the past three years. If you lack QREs for the previous three years, use 6% of your current year’s QREs as the credit.
3. Calculate the Credit Amount: Apply 14% to the QREs that exceed the 50% threshold of the average qualified expenses. If the threshold calculation is impossible due to a lack of prior data, use the 6% credit rate.
Startup Qualifying Research Expenditures
If your startup qualifies for this credit, you can offset your payroll liability income taxes by using expenses aimed at specific research and development expenses. The following expenditures are considered qualifying research expenditures (QREs):
1. Tangible Supplies: Costs for tangible supplies consumed during R&D activities are eligible. These include materials used directly in the research but exclude depreciable capital items, licensing fees, subscription costs, and general office supplies.
2. Leased Equipment: Expenses for leasing equipment necessary for R&D, such as computers and cloud storage services (e.g., AWS, Azure, Google Cloud), qualify for the credit.
3. Consulting Costs: Payments to third-party consultants who perform R&D work on behalf of your company can be included. To qualify, the work must be conducted within the United States, and your company must retain rights to the results and bear the economic risk.
4. Employee Wages: Operational costs from salary to personnel engaged in qualified R&D activities in the U.S. are eligible. It’s essential to track the time employees spend on these activities across all departments, allowing you to include the relevant portion of their wages from Box 1 of their W-2 form as QREs.
Payroll Tax Credit Option for Startups
Startups can significantly reduce their tax burden through the payroll tax credit, which offsets the employer portion of Social Security and Medicare taxes. This credit is particularly advantageous for emerging businesses, helping them with overhead costs and allocating more funds toward growth and innovation.
For tax years before 2023, startups can claim up to $250,000 against Social Security and Medicare taxes, totaling a maximum of $500,000 annually. Starting from tax years that begin from January 1st, 2023, this amount increases to $500,000 per type of tax.
This change enhances startup support, providing more significant financial relief for startup businesses.
The payroll tax credit operates within a five-year eligibility period, allowing startups to apply for the credit over several years. However, while the total credit amount can reach up to $500,000 annually, it cannot be used in full for a single type of payroll tax liability.
Instead, the credit must be split, with up to $250,000 allocated to Social Security taxes and up to $250,000 to Medicare taxes.
To utilize this credit, startups must complete Form 6765 (Credit for Increasing Research Activities) and choose the payroll tax credit when filing their business income tax return.
Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) should be submitted with Form 941 (Employer’s Quarterly Federal Tax Return) to claim the credit.
How to Claim the Startup R&D Tax Credits
Claiming the R&D tax credits for startups can be complicated, and it’s essential to approach the process methodically to ensure you capture all potential benefits. Follow these simple steps to claim the credits that you are entitled to:
- Maintain complete records.
Begin by carefully documenting every business expense over the year. Accurate paperwork is crucial to determining which expenses are eligible for the R&D tax credit. This meticulous recordkeeping will help speed up the creation of supporting materials for your application.
- Consult with a Tax Professional
Engage with a tax professional to discuss your research activities, product development, and team structure. Provide them with the necessary documentation to accurately calculate your eligible R&D credits.
- Fill out the required forms.
- Form 6765 (Credit for Increasing Research Activities): This form is required to claim the Research and Development Tax Credit. It has to be filed along with your annual corporation tax return. You are required to submit detailed evidence to support your claim.
- Form 8974 (Qualified Small Business Payroll Tax Credit to Increase Research Activities): If you are entitled to apply the credit against payroll tax bills, please submit this form with your yearly tax returns.
- Form 941 (The Employer’s Quarterly Federal Tax Return): Use this form to submit the payroll tax credit, including any modifications made using Form 8974.
- Follow Filing Deadlines
Adhere to the deadlines for filing income tax returns and payroll tax returns. The timing of your payroll tax credit claim should align with the payroll tax election and the regular payroll tax filing schedule to ensure the proper credit application.
- Include Detailed Instructions and Documentation
When filing, ensure that all forms are completed accurately line by line and that any required documentation is attached. This includes detailed records of the research activities and expenditures.
Claiming R&D tax credits can be challenging. At TaxCredits, we are dedicated to simplifying this process for you. We connect you with trusted CPA firms specializing in maximizing your tax savings potential.
Claim Your Credits with expert help to ensure you receive the full benefits you’re entitled to.
State-Level R&D Credits for Startups
In addition to federal R&D credits, your startup might also qualify for state-specific R&D tax credits based on your location. Here are some states that offer such incentives:
California provides a 15% non-refundable tax credit for R&D activities, allowing startups to reduce their state tax liability.
Arizona offers a tax credit of 24% on the first $2.5 million in qualifying R&D expenses and a 15% credit on expenses exceeding that amount.
New York grants a 6% tax credit on R&D expenses incurred within the state, encouraging local innovation.
Texas provides R&D tax incentives through franchise tax credits and sales tax exemptions, benefiting startups involved in research and development.
Connecticut offers two types of credits for C corporations: Incremental and Non-Incremental. The state provides a credit ranging from 2% to 20%, with a 15-year carryforward period and refunds for small businesses.
Final Words
Claiming R&D tax credits can be a complicated process, especially for startups. However, a quick cost-benefit analysis will prove it will work in your favor.
Detailed recordkeeping, precise form submissions, and expert guidance are crucial. So, actively seek professional support to ensure you maximize your eligible credits.
At TaxCredits, we simplify this process and connect you with top CPA firms to help you claim the credits you deserve. Claim Credits and let our experts guide you.
FAQs
Can an LLC claim R&D credit?
Yes, LLCs can claim R&D tax credits like other business structures, including S Corporations and sole proprietorships. The key to taking advantage of this is to ensure that the R&D activities meet the required criteria set by the IRS.
Can my startup claim R&D tax credits if we’re not profitable yet?
If you still need to reach the break-even point, don’t worry. It’s still possible to benefit from R&D tax credits. Unprofitable startups can receive a cash credit for eligible R&D expenses or carry forward losses to offset future profits.
How much can my startup save with R&D tax credits?
By claiming R&D tax credits, you can deduct an additional 130% of eligible R&D expenses from your taxable profit, reducing your overall tax bill substantially.
How far back can I claim R&D tax credits?
R&D tax credits can be claimed up to two years after the end of your accounting period. To maximize your claim and tax code, make sure to include all qualifying R&D expenditures from within the financial period before the deadline.
What impact does the R&D tax credit have on my startup’s valuation?
R&D tax credits can positively impact your startup’s valuation by improving your financial statements through reduced tax liabilities and increased cash flow, making your company more appealing to prospective investors.
What happens if my startup is acquired? Do we lose the R&D tax credits?
If your startup is acquired, the R&D tax credits typically transfer to the acquiring company, depending on the acquisition agreement and regulatory conditions. Reviewing the terms to understand how the credits will be handled is essential.