How does the r&d tax credit’s “startup provision” work?

Alex Pak | Source Advisors

13 Nov, 2021. 6 min read

R&D TAX CREDIT STARTUP ACTIVITIES AND INDUSTRIES

With the expansion of the research and development tax credit over the years, more businesses than ever before engage in activities making them eligible to claim the R&D tax credit. Listed below are examples of activities that may be considered qualifying research activities:

  • Add equipment that improves a process
  • Conduct environmental testing
  • Conduct testing of new concepts and technology
  • Conducting research aimed to obtain more efficient designs
  • Conducting research aimed to significantly cut a product’s time-to-market
  • Conducting system and functional requirements analysis
  • Design for LEED/green initiatives
  • Designing product alternatives
  • Develop new software
  • Develop new, improved, or more reliable products, processes, or formulas
  • Develop or apply for patents
  • Develop prototypes and models
  • Developing and modifying research methods / formulations / products
  • HVAC concept and design
  • Paying outside consultants / contractors to do any of the above activities
  • Searching for ways to apply new research findings
  • Streamline your manufacturing process
  • Utilizing integration analysis

More traditional scientific work, like one might imagine in pharmaceutical product development, is naturally considered qualified research. Here are examples of various industries that often engage in R&D tax credit eligible work:

  • Aerospace
  • Apparel
  • Chemical
  • Consumer products
  • Cosmetics
  • Engineering
  • Food & Beverage
  • Manufacturing
  • Medical devices
  • Pharmaceuticals
  • Software development
  • Telecommunications

Startups and small businesses may qualify for up to $1.25 million (or $250,000 each year for up to five years) of the federal R&D Tax Credit to offset the Federal Insurance Contributions Act (FICA) portion of their annual payroll taxes.

To be eligible, a company must:

  • Have less than $5 million in gross receipts for the credit year
  • Have no more than five years of gross receipts
Those taxpayers, however, might fail to consider their eligibility for the R&D tax credit program for multiple reasons. Still, many startups don’t understand they’re eligible to claim the R&D tax credit and continue to miss out on money they’ve already earned. Some of the reasons may be:

TOO COMPLICATED

Some entrepreneurs assume the program sounds too good to be true and, therefore, complicated.

NO REVENUE

A friendly reminder – companies don’t have to demonstrate income (or pay income taxes) to qualify for the credit. Qualifying smaller companies and startups can take the benefit as a payroll tax offset, claiming up to $250,000 every year. This applies to small businesses showing less than $5 million in the credit year, with no gross receipts in the previous five years.

NO EMPLOYEES

Sure, using the credit to offset payroll taxes does make it seem as if you’d have to have employees to pay. While wages generally contribute most heavily to the final credit calculation, other costs, like supply expenses and contractor payments, are also eligible. You can carry the credit forward for up to 20 years if you take the research and development credit as a payroll tax offset without actual payroll.

THE BUSINESS DOESN’T DO RESEARCH

Perhaps the greatest misconception about the R&D tax credit eligibility is that businesses need to perform research to qualify.

THE BUSINESS IS NOT SUCCESSFUL

A business does not have to be successful to qualify for the benefit. Riskier initiatives often fail with no return on investment. Recognizing that, the federal government provides incentives like the R&D credit to lessen the burden. Consequently, you will be rewarded for facing technical challenges and pushing forward on innovative solutions. These technological breakthroughs are all part of the research and development terrain. Even if the work isn’t successful, the effort itself, as well as the costs associated with it, may make your business eligible to receive the credit.

BUSINESS DOES RESEARCH BUT ISN’T DEVELOPING ANYTHING NEW

The R&D tax credit is for taxpayers that design, develop, or improve products, processes, techniques, formulas, or software. It’s calculated based on increases in research activities and expenditures, and as a result, it’s intended to reward companies that pursue innovation with increasing investment. R&D doesn’t have to be new to the industry. It simply needs to be new to the company, which must have activities that meet the four-part IRS.

MYTHS ABOUT R&D TAX CREDITS AND PROFITS FOR STARTUPS

Every year, eligible businesses don’t avail themselves of the benefits of the R&D tax credit. IRS statistics show that R&D tax credits worth over $12 billion were claimed in 2014, the latest year for which data is available. While this sounds significant, many eligible entities, especially small businesses and startups with no shown profit, neglect to claim the R&D credit. One of the biggest drivers for the underutilization is likely a lack of knowledge by both taxpayers and their advisers. Many are unaware of the R&D tax credit or otherwise believe their business activities are not eligible. Some of the common myths about R&D tax credits for startups and small businesses include:

MYTH #1

I don’t qualify.

Many businesses perform activities that qualify for the R&D tax credit without realizing it. The R&D tax credit can be used by companies of any size in industries ranging from software development to breweries. If you do anything technology-based, improve it, and sell it to customers, you probably qualify.

MYTH #2

It can only be applied to income tax.

The credit can be taken as a payroll tax offset, up to $250K per year, by qualified small businesses. You are considered a qualified small business if you have less than $5 million in revenue and are within five years of your first gross receipt. If you have no payroll, the credit can be carried forward to the next quarterly return. The credit doesn’t expire and continues to be available until it can be fully used against payroll tax. Unused credits can also be useful upon exit.

MYTH #3

The savings aren’t worth it.

We have many examples of companies saving tens and even hundreds of thousands of dollars with the R&D tax credit. Remember, this is a credit, not a deduction. It’s applied directly against taxes owed. Plus, our technology-driven solution simplifies the process of claiming the credit and reduces overall fees.

Source Advisors can help provide clarification on the applicability of the research and development credit, walk you and your small business or startup team through a study and calculation, and can be there to support you in times of an audit.

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