If you are an entrepreneur with a new business that is developing products to bring to market, the federal Research and Development (R&D) tax credit can benefit you. Historically, the R&D tax credit was meant to offset federal income tax liability. This restriction meant that start-ups could not benefit from R&D tax credits until they earned revenue. However, since 2016, companies that meet the below definition of a start-up company can use federal R&D tax credits to offset a significant portion of their federal payroll taxes. As a result, even though most new innovative companies are pre-revenue and not paying income taxes, they can still utilize this significant tax incentive if they have employees earning wages. The maximum benefit a start-up can claim against payroll taxes is $250,000 per year, for up to a total $1.25 million over a five-year period.
The Value of R&D Tax Credits
Originally enacted as part of the Economic Recovery Tax Act of 1981, the R&D tax credit is intended to encourage innovation in the U.S. R&D activities include new processes, formulas and techniques. Costs that qualify include employee wages directly associated with the development of new or improved processes or products and even fees paid to contractors who provide qualifying activities on behalf of the start-up company.
The R&D tax credit provides tremendous benefits as a source for reinvesting and growing the start-up business or as a reduction to current and future tax liabilities. The bottom line—R&D is a tremendous tax-savings vehicle.
How Does a New Business Qualify?
To qualify as a start-up company for the federal payroll tax offset, a company must have less than $5 million in annual gross receipts. Additionally, it can have no gross receipts prior to the five-year period ending with the year in question.
When a company meets that definition and qualifies for the federal R&D tax credit, it can elect to use a portion or all of its federal R&D tax credits to reduce the employer’s Social Security (6.2%) portion of FICA taxes. This reduction to its federal payroll taxes will begin in the calendar quarter that starts after the date that the corporate return is filed, including this election. Any unused credits in a respective quarter will carry forward to the following quarter to be used until exhausted (20-year carryforward).
A company can make this election for up to five years, as long as it continues to meet the definition of a start-up company for these purposes. Ever since 2017, this election needs to be made on an originally filed, non-amended, return. A company making this proper election can use up to $250,000 of R&D tax credits per year to offset payroll taxes.
While the IRS has offered guidance for small businesses and start-ups that want to claim the R&D credit, the guidance still leaves some questions unanswered. A qualified tax professional with R&D tax credit expertise can help to navigate the rules and requirements.
The R&D tax experts at Engineered Tax Services have helped companies of all sizes across the U.S. identify and qualify these expenditures and receive the tax benefits they have been missing. Our process begins with an R&D Tax Credit Qualification Analysis to make sure your company qualifies for the R&D tax credit.
To learn more about R&D tax credits for startups, please complete the form on this page. For immediate questions about tax deductions for start-up businesses, call Heidi Henderson at Engineered Tax Services at (800) 236-6519 or check out our R&D tax credit page for more information.