For startups, every dollar counts. That’s why R&D tax credits should be on your radar. Far too many startups overlook these credits, missing out on major cash flow benefits.
Here’s everything you need to know about how to maximize your startup’s R&D tax benefits.
Eligibility Criteria: The Four-Part Test
To qualify for R&D tax credits, your startup must meet the IRS's four-part test. This includes demonstrating technological uncertainty, a process of experimentation and the ultimate goal of developing a new or improved product, process, software, technique or formula.
Still unsure if your work qualifies? Check out our detailed guide on the four-part test
Unique Provisions for Startups
The Protecting Americans from Tax Hikes (PATH) Act of 2015 was a landmark piece of legislation for startups seeking R&D tax credits. Before, these credits were often out of reach for early-stage companies without profits or tax liability. But the PATH Act opened the door by making it easier for startups to benefit.
Payroll Tax Offset
One huge opportunity is the ability to offset payroll taxes with R&D credits. For their first five taxable years, startups can offset up to $500,000 of the employer’s portion of FICA and Medicare taxes annually. This immediate cash benefit is invaluable pre-profitability.
Eligibility Criteria
To be eligible for the payroll tax offset, you must:
- Have gross receipts under $5 million in the tax credit year
- Have no gross receipts more than five taxable years preceding the tax credit year
How to Apply
Applying for the payroll tax offset involves specific forms and documentation. It's crucial to consult with tax professionals to ensure not only that you’re eligible but also that you maximize your benefits. Contact us for a detailed guide on how to apply.
Understanding Qualified Research Expenses (QREs)
Understanding what constitutes a Qualified Research Expense (QRE) is crucial for maximizing R&D tax credits for startups. QREs are the backbone of R&D tax credit calculation and can significantly impact the amount you're eligible to claim.
Types of QREs
Wages
This category represents all salaries and wages paid to employees directly involved in R&D activities, including engineers, scientists and even support staff who are part of the R&D process.
Contractor Costs
Another QRE category is expenses incurred for third-party contractors engaged in R&D activities. Note that only 65% of the amounts paid to contractors can be claimed as QREs, as opposed to 100% for full-time employees.
Supply Costs
As the name suggests, this QRE category is for costs of supplies used exclusively in the R&D process. This can include materials for prototypes, testing equipment and specialized software.
How to Calculate QREs
- Identify Eligible Activities: Identify the activities that meet the IRS's four-part test for R&D.
- Allocate Costs: Allocate the costs associated with these activities to their respective QRE categories.
- Maintain Documentation: Maintain meticulous records of all expenses, as you may need to substantiate your claims in case of an audit.
Unused R&D Tax Credit Carryforwards
If your startup has little or no income or current-year tax liability, you may not be able to reap immediate benefits from the R&D tax credit. However, you can carry forward unused R&D tax credits to future years when your startup becomes profitable. These carryforwards can be a valuable asset, essentially serving as a savings account for future tax liabilities. Or, if eligible, opt for the payroll tax offset election.
Time Limit for Carryforwards
The IRS allows you to carry forward unused R&D tax credits for up to 20 years. This extended timeframe provides startups with a long-term opportunity to benefit from their R&D activities, even if they are not immediately profitable.
Fixed-Base Percentage Rules
The fixed-base percentage is used to gauge a taxpayer's increase in R&D expenditures. For startups, they may be automatically assigned a fixed-base percentage set at 3% for the first five taxable years in which the startup has both gross receipts and qualified research expenses. This percentage is used to calculate the startup's base amount, which in turn affects the R&D tax credit amount.
The 3% fixed-base percentage is generally favorable for startups as it often results in a lower base amount and, consequently, a higher R&D tax credit. But remember, this percentage will be re-evaluated after those first five tax years.
Alternative Simplified Credit (ASC) Rules
The Alternative Simplified Credit (ASC) offers startups a more straightforward way to calculate R&D tax credits. But just as with the fixed-base percentage rules, there are both pros and cons to using ASC rules.
What is the ASC?
The ASC calculation takes 14% of current QREs over 50% of the prior three years' average QREs. Startups under three years old use a reduced 6% rate.
Benefits of ASC
- Simplification: The ASC method is generally simpler and requires less documentation compared to the traditional method.
- Flexibility: Startups that don't have sufficient historical data for the traditional calculation can opt for the ASC.
Limitations for Startups
- Reduced Rate: Startups that haven't been in existence for more than three years can only claim the ASC at a reduced rate of 6%.
- No Double Dipping: If you opt for the ASC, you cannot also claim R&D tax credits using the traditional method for that tax year.
Other Considerations for Startup
As with all things related to taxes, claiming R&D tax credits can get tricky fast. Here are some key nuances startups need to know:
Outsourcing R&D
Contracted work counts as QREs, but with limitations. Only 65% of fees paid to contractors are included as qualified research expenses.
State-Level Credits
Many states offer regional R&D tax credits on top of the federal program. Each state has its own requirements, so it’s important to consult with an expert on your startup’s specific tax situation.
Records and Documentation
Companies claiming R&D tax credits must thoroughly track employee time, supplies and financials tied to R&D work.
Don't Miss Out on Your Startup's Growth Catalyst
Navigating R&D tax credits can seem complicated. But for startups, the payoff makes it well worth the effort.
Don't leave money on the table! The complexities of R&D tax credits require expert guidance to navigate successfully. If you're serious about fueling your startup's growth, the next step is clear:
Contact Engineered Tax Services today to maximize your startup's R&D tax credits and set your growth trajectory on fire.
