There are many variables to building a successful startup, and at times it might seem impossible to come out ahead without drastically increasing or decreasing expenses. Founders must do their best to leverage and test strategies to increase their bottomline in an effort to maintain headcount, morale, and revenue all while remaining capital-efficient.
Taxes are likely the last thing founders consider as a viable financial savings strategy, and certainly familiarizing yourself with government incentive programs is even less likely to cross your mind.
But you’re not alone. It’s estimated that more than 80% of startups and small and midsize businesses are either completely unaware they’re eligible for government-sponsored tax credits or don’t have an easy way to get them. But the fact is these credits can save your company thousands of dollars every year. And it’s not just for big corporations.
What are R&D Tax Credits?
Regardless of a company’s size, success happens when minds are focused on change. Some of the world’s best innovations came at the 11th hour when it seemed like a breakthrough was impossible.
These breakthroughs can change the world, but in most cases, those “aha” moments didn’t happen over a long weekend. Instead, it took years of endless tweaking and testing, otherwise known as research and development.
In addition to the current stimulus programs, the research and development tax credit has actually been a long-standing government-funded program finally made permanent as part of the Protecting Americans Against Tax Hikes (PATH) Act of 2015. This specifically opened up enhanced benefits for startups.
From its origination in 1981, the R&D tax credit has helped companies remain competitive in the marketplace by allowing a dollar-for-dollar reduction of federal and state income taxes owed for qualified expenditures incident to the development or improvement of a product, process, formula, invention, software, or technology. The definition was made intentionally broad to allow for dozens of innovative industries to leverage it.
The PATH Act created important opportunities for taxpayers claiming the federal research credit. A permanent credit means that all businesses can engage in meaningful long-term planning for tax benefits. The expansion of the research credit to offset payroll tax liabilities means that many small businesses will now share in these benefits.
Unknown to most startups, however, is that they’re eligible to receive these credits for their annual investments in the innovative work they perform regardless of whether their product is in the marketplace or yielding revenue. Basically, this is the government’s way of rewarding companies for investing in innovation and continuing to build cool stuff!
Do you qualify?
The R&D credit isn’t just for companies that are heavy researchers. It’s best to think of innovative activities at a higher level, as the program is quite robust. Startups that can claim the credit come from a variety of industries. Some of these industries include but are not limited to:
- Big data
- Artificial intelligence
- Consumer packaged goods
- Software/Software as a Service (SaaS)
- Oil and gas
- Virtual reality
Additionally, a good rule of thumb is to ask yourself the following questions:
Do I make something?
At the most basic level, if you’re developing or improving upon technology or products, odds are you probably are entitled to some money back from the IRS!
Does my product change over time?
Businesses rarely make their products the exact same way year after year. So, if your company invests resources to make its own products, software, or processes cleaner, greener, quicker, or cheaper, you most likely qualify for the credit!
What expenses can you claim?
There are typically four buckets of expenses you can pull from to calculate your eligible R&D credit savings.
- W-2 Wages for employees who perform, directly supervise, or directly support R&D activities based in the U.S.
- Payments to U.S.-based contractors who are performing technical work for the company. This does not include payments to U.S.-based agencies that distribute work overseas. It’s no secret talent is global but the R&D credit is strictly for U.S. expenses.
- Supply expenses used for prototyping and development (think materials consumed pre-production).
- Cloud expenses as it relates to your staging and testing environment. Software companies can rack up fees for AWS, Google Cloud, Heroku, and the like.
What documentation do you need to support your R&D credit?
In order to substantiate your R&D credit, you need to provide the IRS with the proper documentation that supports your claim. This is an extremely important part of applying for the program every year. Lack of documentation is the number one reason why credit amounts could be adjusted.
Some things to keep in mind:
- The documentation should be from the time the R&D was done.
- It should prove that the work occurred in the fiscal year you are claiming.
- It should highlight the technical challenges to substantiate the R&D that was done and the personnel that were involved.
Some examples of documentation might include:
- Timesheets for technical staff
- Technical documents
- Whiteboard or product roadmaps
- Contractor agreements
- Development/engineering notes
Again, it’s important to start gathering this information as it occurs. This will help defend your claim should you ever be audited. If you choose to work with a specialized practitioner to help you put together your R&D Tax Credit Study, a well-documented report should always be included with your credit calculations for tax filing.
How much return on investment can you expect?
You have the potential to earn back up to 10% of what you spend developing products and technologies every year. Say for example, your company paid $200,000 in W-2 salaries to software engineers in 2020. Through the R&D study process, you can expect up to $20,000 in relief against your federal tax liabilities. If you spent $500,000 in W-2 salaries, you can expect up to $50,000 back, and so on.
Sometimes, however, this can vary based on the type of research activity and whether you do the work in house, or contract it out, as contractors hold a little less weight in the calculation than that of a wage earner.
For startups that are not yet profitable or are operating in losses, they specifically have the option to use their R&D credits as a payroll tax offset, meaning nearer term cash relief in the form of a FICA tax reduction. To qualify for this, a company must be five years old or less and have less than $5 million in gross receipts for the given claim year. Otherwise, it takes the original route to offset income tax liabilities.
Let’s say you do qualify as a startup. Using the same example above, your $200k in W-2 salaries would mean you owe $12,400 in FICA taxes annually. That $20k credit can wipe out that liability completely in 2021!
Also, it’s not a “if you don’t use it, you lose it” situation. Any unused credits can carry forward for up to 20 years, and further add to your long-term tax planning.
Take action to keep your company thriving
Things like runway, cash flow, and burn rate all matter for startups and need to be taken seriously. That’s why if you’re doing cutting edge work, creating new things, or challenging the status quo, the R&D tax credit is a lifesaver, especially for a young business.
And the best part? It can be claimed every year! For companies that have never claimed the credit, there may also be credits available for the prior three years. There is also a small amount of urgency here, particularly for the folks opting for the payroll application of the incentive. The program only allows for R&D tax credits as a payroll offset to be elected on an originally filed return, so if you think you qualify it’s best to get this item tackled and included within your regular or extension tax filing.
If your company meets the standards outlined above, a discussion with an R&D expert may be worthwhile. And who knows, maybe your tax savings will help fuel your company’s next big project, key hire, or simply give you some extra breathing room this year (exhale)!
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Ari Palmer is CEO and co-founder of TaxTaxer. Ari specializes in simplifying complex tax incentives so that entrepreneurs can focus on what they love best—running their companies.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.