Startup business tax credits you need to know

Tax credits are tax incentives that directly reduce the amount you owe. This makes them more valuable dollar-for-dollar than tax deductions, which only reduce your taxable income.

This explores business tax credits you need to know as a startup founder. We’ll also explore how they work and how to make the most of the benefits they provide. 

Tax deduction examples

You can claim a tax deduction for a business expense that is “ordinary and necessary.” In simple terms, this means that it must be common in your industry and helpful for your operation.

For example, say you generate $50,000 in revenue and claim a $1,000 deduction for business supplies. That would reduce your taxable income to $49,000 for the tax year.

Tax credit examples

You can only claim a tax credit if you meet its unique eligibility requirements, which are specific to each one. For instance, some examples of business credits and their criteria include:

• Work Opportunity Tax Credit: Hire from specific groups that historically face barriers to employment.
• California Competes Tax Credit: Create jobs and make capital investments in the state of California.
• New Markets Tax Credit: Invest in low-income communities to encourage economic development.
• Disabled Access Credit: Small businesses that spend money on improving accessibility for people with disabilities.
• Employee Retention Credit: Retain employees despite revenue declines during COVID-19 (part of the American Rescue Plan, alongside the Employer Child Care Credit for child care and Paid Leave Credit for paid family medical leave).

Generally, you can subtract your total tax credits—sometimes known as your general business credit—directly from your taxes. For example, if you owe $10,000, a $1,000 tax credit reduces your bill to $9,000.

Note that these credits can apply to more than just your income tax liability. In some cases, there may be options available for other types of taxes, such as payroll or sales and use tax.

Tax credits to pay attention to

Business tax credits often apply to a subset of startups based on their size, location, and type of business. However, some tax credits are commonly available to a broader range of companies.

It’s often best to start your tax incentive search with the latter category. Here are some of those to consider first.

1. State R&D tax credits

Any startup doing research and development (R&D) in the states listed below may be eligible. Startups that meet the criteria receive a specified percentage, dependent on state laws.

You can use State R&D tax credits in tandem with federal R&D tax credits, but each will reduce the tax cost based on qualified expenses on their associated return.

2. Retirement plans

Small businesses often set up company retirement plans, such as a 401k plan or Simple IRA, to help employees build retirement savings. Doing so may qualify you for multiple retirement plan tax credits, depending on your number of employees and their compensation.

If you have 50 or fewer employees, this employer credit can cover 100% of the startup costs to open, administer, and educate employees about the plan for the first three years, up to certain limits. If you have 51 to 100 employees, it’s worth 50% of your eligible startup costs.

In addition, you may qualify for an employer contribution tax credit, which covers a portion of any employer contributions you make for a non highly compensated employee in the plan’s first five years.

An eligible employer that adds an automatic enrollment feature to the plan can also claim a small business tax credit of $500 per year for three years.

3. Work opportunities

The federal government created the Work Opportunity Credit to aid in employment. Businesses can receive tax credits for hiring an employee from specific groups, including: 

• Recipients of state assistance

• Ex-felons

• Individuals who have completed a rehabilitation program

• Veterans. 

During the first year of employment, your business will be eligible for either $2,400 in credits or 40% of the employee's first $6,000 of wages.

4. Health care

The Small Business Health Care Tax Credit is potentially available to eligible employers who offer health plans through the Small Business Health Options Program Marketplace.

Qualifying startups that pay at least 50% of the health plan premiums may be eligible. Generally, the smaller the business, the larger the tax credit received.

5. Empowerment zone employment credit

Startup employers operating in specific regions of the United States may qualify for the empowerment zone (EZ) employment credit. The Internal Revenue Service (IRS) targets these areas to push economic development and heighten commerce traffic.

Empowerment Zones:

• Pulaski County, AR

• Tucson, AZ

• Fresno, CA

• Los Angeles, CA (city and county)

• Santa Ana, CA

• New Haven, CT

• Jacksonville, FL

• Miami/Dade County, FL

• Chicago, IL

• Gary/Hammond/East Chicago, IN

• Boston, MA

• Baltimore, MD

• Detroit, MI

• Minneapolis, MN

• St. Louis, MO/East St. Louis, IL

• Cumberland County, NJ

• New York, NY

• Syracuse, NY

• Yonkers, NY

• Cincinnati, OH

• Cleveland, OH

• Columbus, OH

• Oklahoma City, OK

• Philadelphia, PA/Camden, NJ

• Columbia/Sumter, SC

• Knoxville, TN

• El Paso, TX

• San Antonio, TX

• Norfolk/Portsmouth, VA

• Huntington, WV/Ironton, OH

6. Maryland biotechnology investment incentive tax credit (BIITC)

Startups operating in Maryland with a focus on biotechnology receive a tax credit of up to $250k. Maryland continues to encourage growth within this specific industry. If your startup is looking for an investment opportunity, this is a huge one. 

7. CA sales tax exemption

Startups in specified industries operating in California can apply for this exemption. Qualification depends on your startup’s NAICS classification. 

NAICS classification

• 3111 - 3399

• 541711 

• 541712

• 221118 - 221122

The codes above qualify for this exemption. There are specific tangible purchasing qualifications alongside the coding requirements.

Examples of qualified purchases

• Machinery

• Equipment used for repairs or maintenance

• Operational equipment (computers, printers, etc.)

• Tangible personal property used in pollution control

• Special-purpose buildings used in production

Similarly, clean vehicle credits may reward you for purchasing new or used electric cars.

The most important business startup tax credit: R&D

One major startup tax credit that all founders should know about is the federal R&D tax credit. You may qualify if your startup made less than $5 million in annual gross receipts and technology design.

Qualifying startups can receive a credit against their Social Security and Medicare payroll tax liability of up to $500,000. You can apply money spent on research and development costs, such as supplies, consultants, employees, and computer rentals. 

Startups, especially SaaS-based ones, often spend a lot of money on research and development. Just make sure you keep accurate records to track how much money is applicable.

Once launched, it may take a while to produce enough revenue to offset that startup expense. In the meantime, taking advantage of federal and state R&D credits can put money back into the company. 

Many startups qualify for this specific investment tax credit. If you’re working with a Certified Public Accountant (CPA), double-check that they’re utilizing it to the fullest.

Changes to the R&D tax credit section 174

In 2017, the Tax Cuts and Jobs Act updated businesses’ ability to expense their section 174 costs. Section 174 expenses now must be capitalized and amortized by domestic and foreign research. 

• Domestic Research - capitalize all costs over five years utilizing a half-year convention.

• Foreign Research - capitalize all costs over 15 years utilizing a half-year convention.

The changes implemented may affect your current taxable year. If you’re self-filing, research these changes thoroughly before applying for the federal tax credit. 

How to take advantage of tax credits

If you believe your startup qualifies for one or more tax credits, fill out IRS Form 3800. This is where the IRS requires you to list every tax credit you’re claiming and how much you believe it’s worth.

That said, you may also have to fill out supporting forms for each individual tax credit.

Due to the sheer volume of credits available to startups, the benefits of a tax professional often outweigh the cost. Their knowledge of state and federal tax laws can be invaluable.

Ideally, you should work with a highly experienced CPA in your vertical.

Things to avoid when claiming startup tax credits

When dealing with complicated business taxes, you can make plenty of mistakes. Potential missteps encompass all aspects of business taxes, including applying for tax credits. 

Here are some common pitfalls you'll want to avoid:

Poor record-keeping

Many tax credits depend on knowing how much you've spent on certain expenditures. The more you spend, the higher your tax credit. Others require you to know information about your employees' prior economic status. 

You need to keep track of this information correctly to understand how much of a tax credit you can claim. The last thing you want is to fill out a tax credit form and realize you need to know what information to enter.

Forgetting to apply for carryforward and carryback tax credits

Businesses can often qualify for more tax credits than they can apply to their taxes in a single year. To mitigate this, the IRS lets companies apply unused tax credits to future years. 

The IRS also allows startups to use certain unused tax credits for prior taxable years. Each credit has different rules for how far forward or backward you can apply it.

Ignoring their impact on estimated taxes

The IRS effectively forces businesses to pay taxes on an annual payment plan. Known as estimated taxes, these are manual payments you must make quarterly in lieu of employer withholding.

Tax credits can have a significant impact on how much you should be paying throughout the year. If you fail to take them into account, you could end up significantly overpaying.

While it’s primarily for individuals, the IRS tax withholding estimator tool can still help you assess how much to set aside as a business.

Why shouldn’t I apply on my own?

The short answer: Taxes are complex and rely heavily on proper filing. The advantages of using a tax professional far outweigh the benefits of doing your taxes, especially since mistakes can trigger penalties and fees. 

Professional services may have a cost, but the money you spend on hiring expenses pales in comparison to the money you could save using tax credits and deductions. 

Researching on your own uncovers a few, but experts know where to find those hidden gems. A tax professional can also save you the effort of combing through the many deductions and credits available to startups. 

We know from our tax filing blunders with our first startup. During our first tax cycle with a CPA, many credits were missed due to the CPA’s lack of experience with startups. We lost money and paid more.

Maximize your tax benefits 

Tax credits are meant to help you reduce your tax liability. The IRS designed startup-specific tax credits to offset qualified startup costs involved in opening and scaling a business.

If you’re filing your tax return and are not a CPA, there’s a high chance you’ll miss potential credits. That’s just money down the drain. Instead of fighting through your tax cycle, make the most of the tax year.

Consider hiring a tax professional or CPA focused solely on startups. Their entire job description is helping founders make the most of every tax credit.

In addition to the tax credits we’ve listed, there are many more industry-specific startup credits. We can help you find and claim the credits you deserve. Schedule a free consultation with us.