Small businesses don’t have it easy. They must exist and operate in an unforgiving business landscape with giant competitors. Plus, success—often marked by profitability—can be elusive. Small businesses have to be agile, resilient, and lucky to survive.
One other attribute that small businesses need is resourcefulness. In other words, the ability to find ways of doing things given scarce tools, people, and money. One of the best ways for businesses to be resourceful is by using tax credits. And one of the valuable tax credits out there is the Research and Development tax credit.
This post provides an overview of and explains how startups can take advantage of this indispensable resource.
What is the R&D tax credit?
The federal government–and many states–gives innovative businesses a Research & Development (R&D) tax credit. There is no limit if the company uses the credit to offset their income tax liability and a limit of $250,000 for payroll offset (which is set to increase to $500,000 under the Inflation Reduction Act). It’s a thoughtful way to award companies that conduct research and development, in some cases, saving them hundreds of thousands of dollars. This can help companies by providing them with a source of extra cash—up to 10% of annual R&D costs for federal purposes and much more when state credits are factored into the tax return.
Companies that develop new or improved business components, including products, processes, computer software, techniques, and/or formulas of inventions that result in new or improved functionality, performance, reliability or quality may be eligible. Some costs that qualify for the tax credits include the wages of employees performing R&D, the costs of subcontractors performing R&D, raw materials and supplies and web hosts and some software.
The R&D tax credit is typically applied against income taxes. But what if your business is new and not yet profitable? Startups can still benefit from the R&D tax credit too.
How startups may benefit
Before 2015, startups that weren’t making a profit would only benefit from the R&D tax benefit once they became profitable in future years. Companies with losses have no income tax liability, so the unused credits could only be carried back one year, or forward for up to 20 years until they were used or expired. But the Protecting Americans from Tax Hikes (PATH) Act of 2015 changed that. The law expanded and renewed the number of tax credits for families, individuals, and businesses, permanently. This included giving unprofitable startups the opportunity to use their R&D tax credits against their payroll tax liabilities by up to $250,000 a year. R&D tax credits generated by nonprofitable startups can be used to offset the employer’s Federal Insurance Contributions Act (FICA) payroll taxes for up to five years.
That’s potentially $1.25 million in R&D tax credits to offset the costs of your startup. If your business has no gross receipts prior to the five-year period ending with the current tax year or has less than $5 million of annual gross receipts in the tax credit claim year, it’s qualified for credits against the payroll tax liability. Generally speaking, most startups are not profitable for about five to 10 years.
Does your startup qualify for the R&D credit?
Startups should think about the tax credits before tax time and in the earliest days of the new business. The IRS has created a four-point qualification test to find out if your company qualifies for R&D tax credits:
- Purpose – The purpose of your research and development activity must create a new or improved function, performance, reliability, or quality for a business component.
- Eliminate uncertainty – Businesses that qualify for the R&D tax credit must encounter a problem with a high degree of technical uncertainty and try to solve it using their own procedures.
- Technology – The research must be technical in nature—and to be considered technical in nature, an activity must heavily rely on a hard science.
- Experimentation – According to the IRS, the process of experimentation must include simulation, evaluation of alternatives, systematic trial and error, testing, modeling, and refining.
Take for example a startup makeup company that focuses on creating multi-functional beauty products and sustainable packaging.
- By stacking a blush, bronzer and highlighter into one small product, the company is creating a new and improved function, meeting the purpose (qualification #1) of the four-part test.
- A four-in-one makeup pen with eye-liner, lip-liner, brow pencil and highlighter required versatile formulas and experimentation (qualification #4) to find the perfect way to package four different products in one efficient pen.
- Not only do the multi-purpose products reduce packaging, but each piece is also made with recyclable materials and sustainable sourcing, eliminating uncertainty (qualification #2) through experimentation and using chemistry and technology (qualification #3) to reduce packaging and make what they do use sustainable.
Their innovative products allowed them to save money on their payroll taxes, thereby saving money to invest back into their company while building a profitable business.
Keep documentation of R&D expenses
Your business’s bookkeeping is key to identifying research activities that qualify your startup for R&D tax credits in case the IRS asks for justification of R&D expenses. Costs that should be noted include:
- wages for employees who perform, support or supervise R&D activities,
- third-party contractors working in the U.S. that perform R&D activities and
- supplies and materials used in the development process, including payments to cloud service providers.
Complete IRS Form 6765, to establish your R&D tax credits. Depending on your business structure and research expenditures, you may need to fill out other IRS forms such as IRS Form 8932 (wage payments) and IRS Form 3800 (general business credit).
Small businesses must also file Form 8975, the Qualified Small Business Payroll Tax Credit for Increasing Research Activities; but this won’t be filled until the IRS approves your credit.
The R&D tax credit is complex to analyze and document then calculate. If you are looking for help calculating your R&D credits or filling out the IRS form 6765 consult an accountant who is knowledgeable about the credit. .
If your business innovates by creating new products or improving existing ones, there’s a chance that you’ll qualify for the R&D tax credit. It could be an essential piece of the puzzle of keeping your startup moving forward.
