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Startups and business owners oftentimes overlook the lucrative incentives that exist within the US Tax Code (the IRC). The tax code is written specifically for the government to implement certain policies. For years, the government has been incentivizing startups and small businesses to invest in research and development to stay up with the competitive global landscape. 

Having worked with both bootstrapped and venture-backed startups my entire career, I’ve personally witnessed the power of these tax credits to put cash back into the business (whether directly or indirectly).

What is the R&D tax credit in the US?

Tax deductions usually get all the fame in the tax code. However, a tax deduction is really just a coupon while a tax credit is akin to a gift card. A big misconception among startup founders is that “we don’t pay tax, so we’re not worried about tax credits.” That logic is flawed for several reasons, the main one being that this credit can offset alternative taxes as well. 

Startups and small businesses of nearly any size across various industries can qualify for this tax credit. Industries who have qualified for this credit range from software, to life sciences, to engineering to niche product innovators.  

At its most basic level, the company must be engaged in activities aimed at developing new or improved products, processes, or software. The key here is undertaking projects that resolve technological uncertainties (experimentation), which means solving problems where the solution isn't immediately apparent (you have risk).  The R&D credit is not for “new to the world”.  Rather, it is for “new to your company”. You don't need to be changing the world to qualify for this lucrative tax credit.

The credit can work in two ways. First, if you’re profitable, the credit will offset income taxes whether corporate or individual (from a flow-through entity such as a partnership).  If your business is in startup mode and not generating a profit yet, you can elect to take the “payroll tax credit” which will offset the business portion of FICA (payroll taxes) beginning on the 1st day of the next quarter after you submit your claim.  We have seen the payroll tax credit offset hundreds of thousands in payroll taxes for growing startups, allowing them to double down and hire a few additional employees they otherwise wouldn't have been able to. 

How do you qualify for this credit?

The IRS has a four-part test to apply to all projects undertaken within the research and development realm.  Understanding the ins and outs of the four-part test will allow you to proactively maximize this tax credit during the year, instead of leaving it to chance.

Overview of the four-part test:

  1. Permitted purpose: The research must aim to improve the functionality, performance, reliability, or quality of a business component. Simply improving aesthetics will not count.
    • A business component refers to any product, process, software, technique, formula, or invention which is to be held for sale, lease, or license, or used in the taxpayer’s business.
  1. Technological in nature: The research activities must fundamentally rely on principles of physical or biological science, engineering, or computer science.
    • This ensures that the research has a solid basis in the hard sciences and is not purely aesthetic or subjective in nature.
  1. Elimination of uncertainty: The activities must be intended to discover information to eliminate technical uncertainty regarding the development or improvement of a product.
    • This includes uncertainty about the appropriate design, methodology, or capability of achieving a desired outcome.
  1. Process of experimentation: The research must involve a process of experimentation designed to evaluate one or more alternatives to achieve a result. In other words, you cannot know the results going in.
    • This process includes identifying uncertainties, conducting experiments to eliminate those uncertainties, and refining or changing hypotheses as necessary based on the results of these experiments.

The key is to remember that the four-part test isn't applied to your overall business. Rather, they're applied to each project in your business.  For example, if you are building a new application, you may have 4–5 simultaneous projects that are going at the same time. The IRS requires you to use this four-part test on each project.

Which expenses qualify for the credit?

The next step in the process is to track and account for the allowable expenses.  The IRS outlines specific categories that will qualify for the credit.  It's important to note, there are nuances to some of these categories that should be discussed with your company’s tax advisor. 

Wages

Salaries paid to employees directly involved in R&D activities, including employees or managers who provide direct supervision or support. 

This can encompass software engineers, developers, project managers, management and other personnel engaged in the research or development process. Further, the wages paid to the business owner can indeed count.  

The rules states that if you can qualify 80% of an employee’s time as research and development, then you can use 100% of these wages towards the tax credit.  This nuance is often overlooked by tax advisors, which can leave money on the table.

Supplies

Tangible property used in the R&D process. This may include materials used in the product prototypes, testing supplies, and supplies consumed during experimentation. Fixed assets don't count.

Contract research expenses

Payments made to third parties for conducting qualified research on behalf of the company will qualify, but there are substantial nuances. The company can claim 65% of these payments so long as they are to domestic (US-based) companies or individuals.  Further, your company must bear the risk in the contract. 

For example, if you paid a developer $100,000 for a fixed contract where your company maintained the risk of forfeiture and failure, $65,000 of this would qualify towards the credit. 

Computing expenses

Costs for processing and storing data for research purposes will count towards the credit. For example, companies with significant AWS spend may benefit from allocating the R&D vs non-R&D spend in this category. 

Quantifying and reporting the tax credit

The actual quantifying and reporting of the tax credit can be quite complex and should be left to a tax professional versed in IRC 41. However, practitioners will often use a ballpark metric to help their clients understand the benefit.  In general, about 10–12% of the qualifying costs will be the tax credit.  Further, recent changes to the deduction of R&D expenses (IRC 174) have made this reporting even more complex, especially for profitable companies.  

It's important to note that the deduction of research and development expenses is separate from the tax credit.  

Your tax advisor will report this credit on Form 6765 of your business tax return.  If you elect the payroll tax credit, you'll receive a separate form to supply to your payroll company as soon as possible.

Putting it together

The research and development tax credit is one of the most powerful and often overlooked incentives for business owners. There are dozens of industries that qualify and advanced strategies to make sure you’re maximizing your credit each tax year. Remember, keep the four-part test in mind with all of your projects and document everything you can.

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The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.

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Co-CEO, Anomaly
Greg co-founded Anomaly CPA with John Malone, JD to specialize in working with entrepreneurial clients who own startups, high growth small businesses, and real estate investors growing into more complex tax and financial issues. His experience includes advanced tax planning and business advisory for a wide array of individuals, start ups and real estate investors. In 2020, Greg was named a Top 5 National Finalist for the Tax Planner of the Year by the AICTC, from a pool of over 850 qualified Tax Planners from across the US and Greg was named the #1 Tax Strategist in the United States by the AICTC in 2023. Greg was a 2023 and 2022 40 Under 40 and has helped lead Anomaly to the #1186 ranking on Inc5000 list.
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