Alt text: R&D Tax Credits For Startups
Businesses of all sizes have a similar desire, no matter what industry they are in – to reduce the taxes they are paying.
For smaller businesses and startups there are a variety of reasons to want a lower tax bill.
- Increase the bottom line (retained earnings)
- Have more reserve cash
- Have money to allocate to a pending project
- Do more marketing
- Hire more talent, etc.
- Increase business valuation
The Research and Development tax credit (“R&D tax credit”) makes that possible.
If you're a small business working on making your products, processes, or software better, faster, cheaper, or greener, you could claim some R&D tax credits. If you are creating new product lines, new products, new processes or extending your current product or service functionality, you likely qualify. And don't worry if your research isn't groundbreaking or mind-blowing – even if it doesn't work out, it could still qualify.
And even if you don't owe any income tax, you could still use these credits to offset a significant chunk of your FICA federal payroll tax liability for up to 5 years and $500K, after the government recently doubled the limit from $250,000 to $500,000 in the 2022 Inflation Reduction Act.
Additionally, any unused credits can be carried forward to offset future federal and state income taxes for up to 20 years, including capital gains tax on the sale of your business. For pass through entities such as LLCs, partnerships and S-Corps, R&D tax credits flow through to the owners to reduce their personal income taxes.
Who Can Claim R&D Tax Credits?
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As a business leader, you may be surprised to learn that your company could be eligible for R&D tax credits, even if you don't fit the regular definition of an R&D-focused organization.
The eligibility criteria for claiming these credits are wider than many people realize, making them accessible to more businesses across various industries. In fact, most small business owners and operators don’t even realize they are conducting R&D, due to a common misperception of the definition of R&D under Section 41 of the US tax code.
First and foremost, it's important to understand that you don't need to employ a team of scientists or engineers to qualify for R&D tax credits.
While having dedicated R&D staff can certainly help, it's not a requirement. In fact, as long as an employee, manager, partner or owner spends time working on qualified research activities, they contribute to your company's eligibility.
Another common misconception is that you can’t claim R&D credits if you aren’t paying income tax yet. This is not the case. You can still benefit from R&D credits by applying them against your payroll tax liability and applying them against future income or a business sale. This is especially valuable for startups and small businesses that may not have significant income tax obligations in their early years or may never earn a profit before exiting.
It's also worth noting that your R&D efforts don't have to result in a groundbreaking new invention to qualify for the credit. You just have to meet the criteria of the four-part test (more on that later).
The IRS defines qualified research activities as any technical work done to develop new or improved products, processes, or software, regardless of whether the research is successful. This means that even if your R&D project doesn't yield the results you were hoping for, you may still be able to claim the credit. Furthermore, your business model doesn't have to be entirely focused on R&D to take advantage of these credits. Many companies engage in R&D activities as a means to improve their existing products or services, streamline their operations, or explore new market opportunities. If you can demonstrate that you are investing in qualified research activities, you could be eligible for the credit.
Finally, it's important to recognize that even if your company has an Alternative Minimum Tax (AMT) liability, you can still use R&D credits as the basis for offsetting this tax.
The AMT is a separate tax calculation that ensures businesses with significant deductions and credits pay a minimum amount of tax. However, the R&D credit is one of the few tax incentives that can be used to offset both regular tax and AMT liabilities.
Suppose you're running a privately held small business, like a sole proprietorship or partnership, and your average gross receipts over the past three years are under $50 million. In that case, you might be able to use the R&D credit to offset the AMT. However, your business must have engaged in qualified research activities as defined by the Internal Revenue Code (IRC) section 41.
How Your Company Can Benefit from the R&D Tax Credit
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As a business owner or executive, you're always looking for ways to reduce costs, increase cash flow, and invest in growth opportunities.
The R&D tax credit is a powerful tool that can help you achieve all of these goals while building a culture of innovation within your organization.
Here are just a few of the ways your company can benefit from claiming the R&D tax credit:
- Reduce your tax liability - The R&D tax credit provides a dollar-for-dollar reduction in your company's tax liability, which can result in significant savings. For example, if your company has $500,000 in qualified research expenses and a 10% credit rate, you could save $50,000 on your taxes.
- Offset payroll taxes - If your company is in its early stages and your gross receipts for the current year fall below the $5 million threshold, we have some exciting news for you. Even if your enterprise has been generating revenue for less than five years, you may still qualify for a valuable tax incentive. The R&D credit could allow your business to offset payroll taxes for up to five years. This means potential savings on your tax liabilities, allowing you to reinvest in your company's future.
- Reinvest in your business - Reducing your tax liability and increasing your cash flow allows you to reinvest in your business. You can use these savings to hire additional staff, purchase new equipment, expand your facilities, or fund new research projects.
- Improve your competitive position - In today's fast-paced business environment, innovation is essential for staying ahead of the competition. By investing in R&D activities and claiming the tax credit, you can develop new products, processes, and services that differentiate your company in the marketplace.
- Attract and retain top talent - Companies that prioritize innovation tend to be more attractive to top talent, particularly in technical fields such as engineering and science. By claiming the R&D tax credit and reinvesting in your research activities, you can create a work environment that appeals to the best and brightest minds in your industry.
- Improve your financial metrics - Claiming the R&D tax credit can have a positive impact on your company's financial metrics, such as earnings per share (EPS) and return on investment (ROI). This can make your company more attractive to investors and lenders, and improve your overall financial health.
To maximize the benefits of the R&D tax credit for your company, it's important to work with experienced tax professionals who can help you identify qualified research activities, calculate your potential savings, and navigate the claiming process.
At Strike Tax Advisory, we have a team of experts who specialize in helping businesses like yours take full advantage of this valuable tax incentive.
Expenses that Qualify for Startup R&D Tax Credit
alt text: R&D Tax Credits Free Up Capital
It's essential to understand which expenses qualify for the R&D tax credit. The following costs can be included when calculating your credit:
- Supplies and equipment used in the R&D process
- Computers and software utilized for R&D purposes
- Fees paid to third-party consultants in the U.S. for R&D services
- Wages paid to U.S. employees who dedicate time to R&D activities
You can maximize your potential tax savings and reinvest in your company's growth and innovation by properly identifying and documenting these expenses.
How to Calculate the R&D Credit
As a startup or small business, you have two methods to calculate your R&D tax credit:
- Traditional method - This method involves identifying qualified research expenses for the past four years and comparing your current year's R&D expenses to that average. The R&D credit amounts to 20% of your company's current year’s qualified research expenses over a base amount.
- Alternative Simplified Credit (ASC) method - The ASC method is a simplified calculation that allows you to claim a credit equal to 14% of your current year's R&D expenses that exceed 50% of your average R&D expenses for the past three years.
Choosing the right method for your startup depends on various factors, such as your company's age, revenue, and R&D spending history. It's essential to work with experienced tax professionals to determine the most advantageous method for your business.
What Documentation Do You Need?
To substantiate your R&D tax credit claim, it's crucial to maintain proper documentation of your research activities and expenses. This includes:
- Payroll records for employees involved in R&D
- Employee timesheets detailing time spent on R&D projects
- Project management notes and technical meeting minutes
- Emails discussing technical problem-solving and R&D challenges
- Expense details and invoices related to R&D activities
- Form 6765 filled out for tax filings
- details of your qualified research activities; trial & error or experimentation results and notes taken during research. These notes can be minutes or project management notes/emails etc (check with an expert to confirm eligibility)
By keeping detailed records of your R&D efforts, you can ensure that your credit claim is well-supported in the event of an IRS audit.
Claim your R&D tax credit now
If your startup is investing in research and development, you may be leaving significant money on the table by not claiming the R&D tax credit.
The worst that could happen is the government denies your credit claim. However, the best-case scenario is that you could save up to $500,000 in payroll taxes, per year, over five years, for unprofitable companies, and a virtually unlimited amount of savings for companies that are sold or highly profitable
At Strike Tax Advisory, we specialize in helping startups and small businesses navigate the complex world of R&D tax credits.
Our team of experienced tax professionals work closely with you to identify qualifying R&D activities, calculate your potential savings, and ensure that your credit claim is properly documented, supported and sustained under review.
Don't miss out on this valuable opportunity to reinvest in your startup's growth and innovation.
Contact Strike Tax Advisory today to schedule a consultation and learn how we can help you claim your full R&D tax credit. With our expertise and guidance, you can maximize your savings and take your startup to the next level.
