The R&D tax credit has been around for quite a while. However, until recently, the credit was only available for larger companies that were profitable. Startups were SOL. But now, recent changes have made it possible for small companies without corporate profits to claim the tax credit.
This means that technology startups and other small companies that conduct research and development can receive the credit.
But first, what is the R&D tax credit exactly, and how can it benefit your business?
History of the R&D Tax Credit
The R&D tax credit is a federal and a state tax credit. This means that it gives companies the opportunity to claim the credit on both state and federal tax documents. However, not all states have an R&D tax credit, so make sure you work with a tax advisor to iron out any details.
The tax credit was introduced as part of the Economic Recovery Tax Act of 1981 and aimed to provide stimulus to companies that conducted business activities that increased productivity. It essentially provided stimulus and support to corporate entities in regards to their research and development initiatives in the private sector.
Only “qualified research and development” is eligible for the credit, and a four-part test is required out by the IRS to ensure that a company’s research and development efforts qualify for the tax credit. Each part has extensive regulations and documentation that evaluate the activities of the company claiming the credit.
The tax credit has traditionally been applied against corporate taxes, making companies that don’t turn a profit unable to claim the credit. However, recent changes under the Protecting Americans from Tax Hike (PATH) Act of 2015 have made it possible for non-profit earning corporations to take advantage of the R&D Tax Credit.
Changes to the R&D Tax Credit
The R&D Tax credit has been widened its usage. Before, the credit could only be applied to corporate income taxes. Now, the credit can be applied to offset payroll taxes. Therefore, any business - even the unprofitable ones - that pay employees in salaries and wages can benefit from the R&D tax credit.
Eligible companies can now claim up to $250,000 against their payroll taxes if they conduct research and development as part of their business operations. This means that startups can for the first time claim up to $1.25 million in tax credits against their payroll obligations. However, on average, the credit is expected to equal somewhere between six and 10 percent of a company’s R&D costs, dependent on the amount of quarterly payroll tax filings.
Making Sure You’re Eligible for the Credit
With salaries as high as they are, especially when it comes to technology research and development (think: engineers and developers), a tax credit that’s applied to payroll taxes can have huge and positive effects on the finances of a startup. Specifically, companies that have business efforts in app development, platform design, cryptocurrency, robotics, VR hardware and software, drones, and wearable technology, all have the opportunity to claim the credit.
Companies are eligible if there are five years or less of gross receipts, the gross receipts are less than $5 million for an elected year, and if qualifying research and development can be documented.
To ensure that your business activities qualify as research and development, make sure that your R&D expenses pass the four-part test, mentioned above. To help, your R&D activities should address the following:
Technical Uncertainty - Are you developing or improving a product, process, or method? You’ll have to show unknown elements that you now know through your R&D efforts.
Process of Experimentation - You’ll need to prove that your research and development went through trials, errors, and different ways of thinking.
Technical in Nature - R&D needs to include hard sciences, such as computer science, physics, engineering, or something similar.
Qualified Purpose - The end-result of your research and development efforts should an improvement that increases performance, ability, function, or quality.
If your company is doing the above four, then you’re probably eligible to claim your R&D expenses as a tax credit against your payroll taxes. Claimable research and development expenses include, but aren’t limited to wages, supplies, and contract research.
Claiming up to $250,000 a year in tax credits can have a huge impact on your business. That’s a total of $1.25 million for the allowable, five-year window. Further, you can carry forward the tax credit. So, if you’re eligible for an R&D tax credit that exceeds your annual payroll taxes, you can apply the remaining credit to the next year.
However, penalties for applying for the R&D tax credit and not meeting the IRS requirements are stiff. The IRS can fine a company more than 20 percent of the rejected amount claimed. It’s therefore important that you work with a tax specialist in this area to ensure you receive the maximum tax credit allowed without paying any penalties.