As a startup business owner, taking advantage of every possible tax credit is essential. One thing that startups sometimes overlook is the R&D tax credit, which can offset expenses, including wages, supplies, and software, when you use it in research and development. Before you apply the R&D credit to your next tax return, it’s important to understand the eligibility criteria and the process for calculating the credit.
At CMP, our clients include business owners from all walks of life, including startups, and we’re committed to ensuring they don’t pay more in taxes than they are legally obligated to. In this post, we’ll explain who can take the R&D tax credit for startups, how to determine if you qualify, and how much you can potentially save.
What is the R&D Tax Credit?
The R&D tax credit is designed to give businesses that engage in research and development a tax break. It was first introduced in 1981 and made a permanent part of the tax code in 2015 as part of the Protecting Americans from Tax Hikes (PATH) Act, which was signed into law by President Obama.
There’s a common misconception that the R&D credit applies only to companies engaged in scientific research, but that’s not the case. Any business in the process of improving products or processes can qualify to take the credit. It’s safe to say that the misconception of who qualifies may explain why less than three out of ten businesses who qualify claim the credit.
The R&D tax credit is particularly important for startups because many startups have limited resources and may struggle with cash flow. The credit allows you to spend what you need to spend to improve your processes or products, knowing you’ll be able to use some of that money to offset any taxes owed.
The Key Benefits of R&D Tax Credit for Startups
There are three significant benefits of the R&D tax credit for startups.
1. Boost to Cash Flow and Reinvestment in R&D
Generating sufficient cash flow is a challenge for small businesses, and it’s an especially significant hurdle for companies in the startup stage. The R&D tax credit is useful because it allows startups to pursue excellence with the knowledge that some of the money spent on research will return.
On a related note, the credit makes it easy for companies to reinvest in R&D because they’ll have the cash to do so.
2. Competitive Edge by Promoting Innovation
Startup companies have an uphill battle. They need to keep their financial feet under them while differentiating themselves from their competitors. Innovation is one of the surest ways to make a company’s services or products rise above the fray and grab the public’s attention.
The R&D credit encourages innovation by promising startup owners a break on their taxes if they choose to engage in qualified activities. Companies that qualify for the credit and use it to innovate may have a better chance of success than companies that don’t innovate – or do, and fail to take advantage of the credit.
3. Boosts Startup Growth in Challenging Markets
Starting in 2023, the cap for the R&D tax credit to offset payroll tax increased to $500,000 from its previous maximum of $250,000. You can claim up to that amount every year for a maximum of five years.
Being able to recoup some of your research expenses means you’ll have money to use in other areas to promote the growth of your business and meet your goals. For example, you can spend some of what you save on hiring support staff, renting space in a desirable location, or marketing your products and services.
Who Qualifies for the R&D Tax Credit?
The R&D tax credit is available to both startup and established businesses who qualify. The eligibility criteria for startups are clear. You may claim the credit if your business does any of these things.
- Designs new products
- Makes improvements to existing products/develops second-generation products
- Streamlines manufacturing processes to make them more efficient or less costly
- Develops or improves upon existing prototypes or software
- Refines techniques already in place
- Advances software to bridge or interface between outside entities or internally with multiple systems
- Any of the above activities that you outsource to a third-party
The following four criteria must be met to qualify.
- Section 174 Test. Any claimed expenditures must be related to your trade or business.
- Discovering Technological Information Test. The experimentation process you use must be grounded in physical or biological sciences, engineering, or computer science.
- Business Component Test. Your business must intend to apply the discovered information to develop a new or improved business component; in other words, you must connect the research to a relevant aspect of your startup.
- Experimentation Test. Your research process must assess other methods or designs when the outcome is initially uncertain.
This is not a case where you can qualify with one of the criteria. All four criteria must be met for you to claim the credit.
Some of the industries that may qualify for the R&D tax credit include engineering, architecture, manufacturing, agriculture, healthcare, technology, and an array of service industries where processes may be automated or streamlined.
What Expenses Qualify for the R&D Tax Credit?
With a clear idea of the type of activities that may qualify for the R&D tax credit, it’s time to review which expenses meet the criteria to be claimed as qualified research expenses or QREs. Here are some of the most common.
- Employee salaries, wages, benefits, and travel expenses
- Expenses for materials and equipment used in qualified R&D activities
- Costs related to the design, development, prototyping, testing, and evaluation of qualifying research activities
- Contract research costs (qualified at a reduced percentage)
Even startups who claim the R&D credit may not maximize the credit. They might take obvious tax deductions, such as the cost of materials and equipment, but miss out on employee wages or office software that’s used in research. We recommend working with a qualified tax professional who can help you identify qualified expenses and claim the maximum allowable credit.
How to Calculate Your Startup’s R&D Tax Credit
One of the biggest hurdles to maximizing your startup’s R&D credit is understanding how to calculate it.
Necessary Documentation
Part of claiming the R&D credit is documenting your qualified expenses. These include:
- Payroll records for any employees involved in R&D
- Contracts and invoices paid to third-party partners involved in R&D
- Expenses, receipts, and accounts for R&D-related supplies and equipment
- Blueprints, designs, drawings, prototypes, and patents related to your research
- Project and meeting notes related to research
If you have employees who sometimes engage in R&D, you’ll need to track their research time separately.
Calculation Methods
The IRS allows two different calculation methods for companies that claim R&D credit. The first is the regular method, and the second is the alternative simplified method. The IRS recommends that businesses calculate using both methods and choose the option that provides the highest tax benefit.
You may not be able to use the traditional or regular method as a startup, but we’ll walk you through it. You’ll start by calculating the percentage of your gross receipts that you spent on R&D. The maximum allowable percentage is 16%.
Using the traditional method, you’d apply the base amount by applying that percentage to the average of the prior four-year gross receipts. To determine the gross credit amount, you’ll multiply 20% by the smaller excess over the base or 50% of your current year QREs.
The simplified method uses 14% of the current year’s QREs, which exceed 50% of the average qualified expenses for the past three years.
If you don’t have any QREs in the prior three years, you can still claim 6% of the current year’s QREs. In other words, a startup that spent $1,000,000 on R&D could claim a maximum of $60,000 in its first year.
How to Claim the R&D Tax Credit for Your Startup
If you qualify for the R&D tax credit, here are the detailed steps to claim it for your startup business.
Step 1: Track your R&D processes internally, making sure to keep meticulous records. This includes tracking employee hours for R&D work separately and maintaining detailed documentation like invoices, contracts, blueprints, designs, prototypes, patents, meeting notes, and receipts for taxes that may support your claims during tax filings.
Step 2: Use either the traditional or simplified method to calculate the amount you may claim as the R&D tax credit.
Step 3: Complete Form 6765 to include with your business tax return.
Step 4: Complete your business tax return.
Step 5: File your tax return, including Form 6765.
Keep in mind that the IRS is considering rule changes for the R&D tax credit, so it’s possible there may be additional requirements by the time you file your 2024 business tax return.
Need the Help of a Startup Tax Expert?
It’s possible for startup businesses to file a tax return and claim the R&D credit without help from a startup tax expert, but here are some reasons you may want to consider working with a professional.
- You’re not sure whether your business qualifies to take the R&D tax credit
- You have questions or doubts about how you’ve calculated the credit
- You’re worried that you might miss something on your business tax return or form 6765
When you work with a tax expert or use R&D tax credit software, you may be able to avoid some of the most common mistakes people make when calculating the R&D credit. There’s also a chance that your expert (or software) can identify expenses that you might have missed, thus increasing the amount of your credit.
When choosing a professional to work with, look for someone with significant experience preparing and filing business tax returns. This is not the time to count on your accountant or someone who has general tax experience but isn’t an expert in R&D taxes.
Instead, choose someone who has a deep understanding of the R&D tax credit and how it works, such as experienced R&D tax credit consultants who have partnered with businesses in your industry or sector. It’s important to be sure that your tax pro understands both federal and state R&D tax credits. That way, you can be confident your calculation will be done correctly and that you won’t miss out on taking full advantage of the R&D credit.
FAQs About R&D Tax Credit for Startups
Startups often have common questions about the R&D tax credit and its application. Here’s what you need to know:
What happens if I don’t qualify for the R&D tax credit?
If you don’t qualify for the R&D tax credit, you won’t be able to claim it. Some activities may not qualify. If you don’t qualify for the current tax year, it doesn’t mean you can’t in the future.
What happens to unused R&D credits?
If you don’t use your R&D credit, the IRS allows businesses to carry the credit forward for up to 20 years. You can work with your accountant to determine the most advantageous time to claim the R&D credit for startups.
How long does it take to receive R&D tax credit benefits?
The R&D tax credit may be used as soon as you file your business tax return. It’s not a refundable credit, but it does directly reduce the amount of tax you owe. This makes it different from a deduction, which reduces your taxable income. If you owe money to the IRS, the R&D tax credit may reduce or eliminate what you’ll need to pay.
What’s the difference between federal and state R&D tax credits?
The federal R&D tax credit is part of the federal tax code and is overseen by the IRS. Some states provide R&D tax credits as well. For example, the state of Utah has an R&D tax credit that may allow businesses to claim up to 7.5% of their research expenses. Understanding how these credits align with Utah business taxes is essential, as tax laws vary from state to state. Be sure to check your state’s specific tax regulations.
Final Thoughts: Why Startups Shouldn’t Miss Out on R&D Tax Credits
The R&D tax credit for startups is something that can help small businesses offset expenses related to research and improve their cash flow. The credit serves as an incentive for innovation and can make it easier for startups to differentiate themselves from their competitors.
Even companies that haven’t claimed the R&D tax credit in the past may be able to do so going forward. We encourage you to explore your eligibility and take advantage of the maximum allowable credit. Our tax pros are here to help!
