Each year, the government provides over $12 billion in tax incentives to thousands of businesses all over the nation.
The startup R&D tax credit is one of the most lucrative tax incentives today. For the past forty years, it’s been helping businesses save hundreds of thousands of dollars in tax payments, and it can help yours most likely.
However, you might be thinking your business doesn’t qualify. Or, you might not know what the R&D tax credit even is. That’s what we’re discussing. So, keep reading to learn if your company qualifies for the R&D tax credit.
Related: Small Business Tax Planning Guide
Table of Contents
What Is the Startup R&D Tax Credit?
The startup R&D tax credit is a tax incentive for businesses developing or improving a product, idea, software, technique, formula, etc.
Your startup may be eligible if it:
- Creates new or original products
- Improves existing products
- Expands processes, patents, prototypes, or software
- Employs or contracts designers, engineers, or scientists
The research and development credit is available in 30 states and at the federal level. It applies to small, mid-size, and large businesses.
Treasury regulations state that the development research must be technological and reveal new information. The Discovery Test (more on that later) helps recognize the new information.
Most importantly, the product or service in development does not need to succeed to qualify for this incentive.
As of 2023, startups can get up to $500,000 to use toward their payroll tax liability. The R&D credit applies to more industries than you would think — Start working on getting your refund here.
Who Can Claim the Startup R&D Tax Credit?
If you want to claim the R&D credit against your payroll taxes (and not income taxes) a few other boxes need to be checked to qualify for the R&D credit. Your business must:
- have gross receipts of $5 million or less
- have gross receipts for five years or less
- not be tax-exempt under section 501
If you don’t meet these criteria, you can still take the R&D tax credit against income tax from the business.
Speak to a startup R&D tax professional about whether your company matches these requirements.
What Qualifies as R&D?
If you believe your startup qualifies for the R&D tax credit, let’s define what counts as research and development.
Businesses must pass a four-part test to prove their work qualifies. The parts of the test are:
Part 1: New or Improved Business Component
, or improve existing , functionality, performance, dependability, or quality of a product, process, technique, invention, formula, or software that the company intends to use in business.
Part 2: Elimination of Uncertainty
Abolish any uncertainty of the developing business component element.
Some questions to ask in this part are:
- What uncertainties did you strive to remove using typical methods? Could they not be removed?
- What work did you do to remove the uncertainties?
- What advancements did you achieve?
Part 3: Process of Experimentation
Overcome the uncertainty using a systemized process and identify alternative solutions. Alternatives can be identified using modeling, trial and error, simulation, etc.
Part 4: Technological In Nature
The research must rely upon the principles of the physical or biological sciences, engineering, or computer science.
There you have it. If you still don’t think you qualify, let’s go over why many companies don’t believe they’re eligible for the startup R&D tax credit.
Related: R&D vs. R&E: Differences Explained
What Expenses Qualify For the Startup R&D Tax Credit?
If you qualify for the startup R&D tax credit, you can use the money you spend on specific research and development expenses, reducing your tax bill or offsetting your payroll taxes. Here’s what qualifies as qualified research expenditures (QREs):
- Supplies: You can include the cost of supplies used in R&D, but this excludes capital items subject to depreciation, licensing fees, subscription costs, and general office supplies.
- Computers: Expenses related to leasing computers for R&D, including cloud storage fees for platforms like AWS, Azure, or Google Cloud, are eligible.
- Third-Party Consultants: Payments made to consultants performing R&D work in the United States are qualified if your company retains rights to and bears the economic risk of the research.
- Employee Wages: Wages paid to employees engaged in qualified research activities within the United States count. Keep accurate records of time spent by employees across departments on R&D activities. This allows you to include the relevant portion of their W-2 wage amount as a QRE.
Understanding and maximizing these qualifying expenditures can significantly impact your bottom line. Make the most of this opportunity to drive your business forward while optimizing your financial outcomes.
5 Reasons Companies Think They Don’t Qualify
It’s easy to think your business doesn’t qualify for the startup R&D tax credit if it’s not a major tech company or finding a cure for cancer. But don’t sell your business so short. Here are five reasons companies don’t think they’re eligible:
1. They don’t employ staff with engineering or science degrees
It’s easy to think that companies with engineering or science degrees are the only companies eligible for the R&D credit. But what many people don’t realize is that the government wrote the rules of the tax credit to apply to many different industries.
2. They don’t pay income tax
Startup businesses could be eligible to apply up to $500,000 for up to five years of the federal R&D credit. The reason? It’s to offset the FICA Act portion of their payroll taxes (you must meet the mentioned requirements to qualify).
3. The company isn’t cultivating anything new
Simply put, research and development don’t have to be new. It can be to build on an existing product or service. Plus, the work only has to be new to the company, not necessarily new to the world.
4. The company isn’t focused on development or research
A traditional laboratory doesn’t have to be the end-all to the R&D credit. Indeed, most businesses that qualify don’t have elaborate laboratories dedicated to the latest scientific breakthroughs.
5. AMT is the basis of the company
AMT stands for Alternative Minimum Tax. Most companies haven’t reaped the full benefit from the R&D credit because of AMT. However, after 2016, taxpayers subjected to AMT have been able to offset AMT with the R&D tax credit.
The point is not to sell your business short. If, after reading this, you think your business meets the standards for a successful credit claim, let’s review the required documentation for a claim.
How To Calculate the Startup R&D Tax Credit
You can use one of two methods to calculate your startup R&D tax credit:
- Traditional Method: This method calculates 20% of your current year’s QREs that exceed a base amount. The base is determined by applying a percentage (not exceeding 16%) against the average of your prior four years’ gross receipts. The final credit amount is 20% of the smaller value between the excess over the base or 50% of the current year’s QREs.
- Alternative Simplified Credit (ASC) Method: With this approach, you calculate 14% of the current year’s qualified expenses that exceed 50% of the average QREs from the past three years. If you didn’t have QREs in the past three years, the credit is 6% of your current year’s expenses.
Both methods use Form 8974 to determine the credit amount that can offset your payroll tax liability.
What Documentation Is Needed To Claim the Credit?
It’s important to keep documentation of your research and development because the tax credit is for both current and prior years. Some documentation you’ll need to make a claim is:
- Payroll records
- Employee timesheets
- Project management notes
- Technical meeting minutes
- Emails about technical problem-solving
- Any expense details and invoices
- Form 6765 filled out for tax filings
Combine these records with the fruits of your labor, and you’ll have the foundation of a proper R&D claim.
How To Claim the Startup R&D Tax Credit
First, it’s crucial to maintain detailed records of all business expenses throughout the year. This not only helps you track your performance against the budget but also identifies which expenses qualify for the R&D tax credit. Without clear records, you might waste time clarifying expenses later.
Then, you’ll fill out Form 6765 with your annual tax return and submit the required documents as proof of your R&D activities. Startups also have to file Form 8974 to apply the credit toward their payroll tax liability.
By following these steps and all of the tips listed above, you can maximize your startup R&D tax credit benefits to fuel your growth.
Related: Accounting for Startups
How Could Your Company Benefit From the R&D Tax Credit?
The startup R&D tax credit slashes a company’s tax liability. That means more money in your business wallet. Plus, there are no limits on expenses and credits claimed each year.
If you can’t spend all your credits, don’t fret. Your credits can carry forward twenty years- just be sure to check with your state.
The bottom line is this: many businesses can claim the R&D tax credit but don’t. Why not see if your startup applies? The worst that can happen is the government says no.
But the best that could happen? $500,000 in savings.
Don’t leave money on the table. We simplify the process for startups to get their maximum R&D tax credit — Get started here.