Each year, the US government provides billions of dollars to innovative businesses for developing new or improving existing technologies, products, materials, and processes under the US Research & Experimentation Tax Credit (R&D Tax Credit) program.
Startups are also eligible for R&D tax credits, which allow them to offset payroll taxes by up to $500,000 for each fiscal year. Previously, the limit was set at $250,000, but the US Congress doubled it as part of the Inflation Reduction Act. The new law applies for tax years beginning January 1, 2023.
If you want to take full advantage of R&D tax credits for startups, the first step is to understand what kind of work qualifies you for the tax credit. Then, you’ll need to compile the relevant documentation, which can be done manually or with the help of automated tools.
What Is the R&D Tax Credit?
The R&D tax credit is a tax incentive for businesses that perform research and development activities in the US. The US R&D tax credit has been around since 1981.
Previously, the program would periodically expire and be renewed by Congress. Businesses wishing to include this in their long-term budgeting plans couldn’t count on the credit being around. In 2015, Congress made the R&D tax credit permanent as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015 and also made key changes so that more businesses could benefit from the credit.
Historically, the R&D tax credit was designed as an income tax credit. While startups that weren’t paying federal income taxes could claim R&D tax credits, they would have to carry those credits forward on their corporate and/or shareholder returns until they could offset their income tax liabilities. This made it difficult for startups or businesses that weren’t profitable to benefit from the credits.
Once PATH came into effect, startups could apply the R&D tax credit against the employer portion of Social Security taxes each fiscal year.
Does My Startup Qualify for the R&D Tax Credit?
Startups need to fulfill the following criteria to qualify for the federal R&D tax credit program:
1. The business must have gross receipts of $5 million or less for the tax year.
2. The business has gross receipts for five years or less. The business must not have gross receipts for any tax year before the 5-tax-year period ending with the tax year they’re applying for. For example, businesses that generated gross receipts prior to 2018 are not eligible to claim for the 2022 tax year.
However, businesses that existed prior to 2018 but didn’t receive gross receipts could still qualify. Although the law is intended to benefit small businesses, larger businesses could also benefit from the rules as they’re written. For example, a significant percentage of life science companies have zero gross receipts for long periods of time until their drug receives US Food and Drug Administration approval.
3. The business is not a tax-exempt organization under section 501, such as a charitable organization.
State R&D Credits
Depending on the state your startup is operating in, you might be eligible for state R&D credits in addition to federal credits.
Some of the states that offer R&D tax credits include:
- Arizona provides a tax credit of 24% on $2.5 million in qualifying R&D expenses and a 15% credit on all expenses exceeding $2.5 million.
- California provides a non-refundable tax credit of 15% on R&D activity.
- New York provides a 6% tax credit on R&D expenses incurred in the state.
- Texas R&D tax incentives come in the form of franchise tax credits and sales tax exemptions.
What Kind of Work Qualifies for the R&D Tax Credit?
Qualified research is work intended to achieve innovation within a scientific or technological field. A startup’s R&D efforts must pass the 4-part IRS test in order to be eligible.
- The Section 174 Test
There are two criteria for the section 174 test:
- The research costs must be related to the startup’s business.
- The startup has incurred research and development costs in an “??experimental or laboratory sense,” meaning that the purpose of research activities was to remove uncertainties regarding product improvement or development. Uncertainty exists if the startup doesn’t have enough information to decide how to develop or improve a product.
- The Discovering Technological Information Test
To meet the requirements of this test, startups must prove that the research relied on the “principles of the physical or biological sciences, engineering, or computer science,” according to the IRS. Qualified research must also remove uncertainty, as explained in the section 174 test.
- The Business Component Test
Any information the startup discovers during research must be used for the development of a new business component or the improvement of an existing one. The IRS defines business components as “any product, process, computer software, technique, formula, or invention, which is to be held for sale, lease, license, or used in a trade or business of the taxpayer.”
- The Process of Experimentation Test
The process of experimentation test requires startups to:
- Identify the uncertainty that’s related to the development of a business component.
- Identify at least one alternative to remove the uncertainty.
- Identify and carry out an evaluation process of the alternatives.
What Kind of Work Does Not Qualify for the R&D Tax Credit?
The IRS excludes certain activities from qualified research, meaning that they’re not eligible for tax credits.
Exclusions apply to:
- Any research companies carry out after the start of commercial production.
- Any research conducted with the goal of adapting existing business components to the needs or requirements of a specific customer.
- Any research related to duplicating an existing business component.
How Do I Use the R&D Tax Credits to Offset Payroll Taxes?
The payroll tax credit election is an annual election made by a qualified small business specifying the amount of research credit, not to exceed $500,000 per year, which may be used against the employer portion of Social Security and Medicare payroll tax liability.
Businesses are required to pay the Social Security tax of 6.2% on up to $147,000 of each employee’s salary and the Medicare tax of 1.45% (no maximum wage limit). This means a business that employs 40 employees with an annual salary of $100,000 per person would pay approximately $248,000 in Social Security payroll taxes and $58,000 in Medicare taxes in 2022. Offsetting these taxes helps startups invest more money into the business.
It’s important to note that $500,000 cannot be used in its entirety towards a single tax liability. Instead, startups can apply $250,000 each to Social Security and Medicare taxes.
To offset payroll taxes, the IRS requires small businesses to follow the steps below:
- Fill out Form 6765 (Credit for Increasing Research Activities), make the payroll tax credit election, and submit the form along with your business income tax return.
- To claim the tax credit, fill out Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) and submit it with Form 941 (Employer’s Quarterly Federal Tax Return).
What Are the Deadlines to Claim?
To offset payroll taxes owing, the R&D tax credits must be specified and elected by a qualified small business with its timely filed (including extensions) income tax return for the taxable year for which the election applies. You can then begin offsetting your payroll taxes for the calendar quarter that begins after you file your income tax return with the payroll tax credit election.
C Corps with a December fiscal year end should claim on or before April 15. C Corps with fiscal year ends other than December should claim on or before 4.5 months following the end of the tax year.
S Corps with a December fiscal year should claim on or before March 15. S Corps with fiscal year ends other than December should claim on or before the 15th day of the 3rd month following the end of the tax year.
To offset income taxes owing, businesses have the flexibility to go back and amend all open tax years (usually the last three years).
How Much of My R&D Costs Can I Recover?
Let’s look at a business operating in California as an example.
Federal portion — ~10% of eligible expenditures.
State portion — 15% of eligible expenditures.
Startups could potentially use the credits towards payroll taxes for up to five years, with a maximum of $2.5 million in total credits claimed on their quarterly payroll tax returns.
For example, a startup with $500,000 in eligible software engineering expenses could credit $50,000 or more, while a company with over $2.5 million in eligible expenses could have a credit of $250,000.
While the payroll tax offset may be available to new businesses and startup companies for up to five years, any unused federal R&D credits that are not elected to offset payroll taxes may be carried forward for up to 20 years and used when the business becomes profitable.
California state R&D credits can only be applied against income taxes and may be carried forward indefinitely.
Simplify R&D Tax Claims With Boast
If you’ve not claimed the US R&D tax credit either because you didn’t think you qualified or you couldn’t use the credits, it’s a great time to reconsider.
While compiling all the necessary documentation might seem like a challenge, automated tools like BoastClaim can help you maximize your tax claims and save 60 hours per year on the claim process.
To learn how to calculate your potential R&D tax credits, download our free step-by-step guide or contact us for a complimentary no-obligation assessment. We’ll go through your projects in more detail, tell you what qualifies and what doesn’t, and provide an estimate of your potential return.