Innovative new ideas and cutting-edge methodologies drive successful startups. But as every startup owner knows, it takes time and money to develop successful innovations. This can challenge early-growth startups, especially those operating on a lean budget.
Fortunately, the R&D tax credit can help grow startup finances. The credit helps businesses pay for the research and development they need to keep coming up with innovative new products and services. Many startup owners meet the R&D tax credit qualifications, even if they don’t realize it.
This article will explain exactly what the R&D tax credit is, how it works, and who is eligible. Keep reading to learn more about the R&D tax credit, how the R&D tax credit for startups works, and what the R&D tax credit for small businesses can do for you.
What Is the Research and Development (R&D) Tax Credit?
The research and development, or R&D tax credit, was first established in 1981 with the goal of increasing innovative research and development throughout the United States. In 2015, Congress made the R&D tax credit available to startups as well as to larger businesses. Congress made the R&D tax credit permanent at the same time.
The R&D tax credit has a broad application and can be used by companies in just about every business sector. Companies can use the credit to pay employees, rent or buy facilities, purchase equipment, or carry out experiments, as long as it's to research and develop new products or processes.
Of course, not every business activity qualifies as research and development. The IRS specifically disallows claiming the R&D tax credit for activities that do not encourage innovation. Those disallowed activities include:
- Testing or inspection of materials or products for the purpose of quality control
- Carrying out efficiency studies
- Carrying out management studies
- Carrying out consumer surveys
- Advertising or promotional campaigns
- Acquiring an already-existing patent, model, production or process
- Carrying out research into subjects like literature or history
Many startups are already pursuing research and development activities because it’s in the nature of an R&D startup to pursue new methods and ideas. However, the US Chamber of Commerce reports that most qualifying businesses do not claim the R&D startup tax credit, perhaps because they are not aware that they qualify for it. This is unfortunate because the R&D tax credit reduces a business’s taxable income and can significantly affect a company’s startup finances.
Eligibility Criteria for R&D Tax Credit
When most people think of research and development, they picture scientists in white lab coats. In fact, the R&D tax credit for small businesses isn’t only for people working in labs. It has a much wider applicability.
Broadly, a business may qualify for the R&D tax credit if it conducts research or experimentation to develop new products or improve existing products. The R&D tax credit can also be used to pay for creating new formulas and techniques, processes, or software. Companies in any vertical may qualify for the R&D tax credit.
The IRS has elaborated a set of criteria for determining R&D tax credit qualifications. They include the following:
In order to qualify for the R&D tax credit, you must be able to point to at least one project carried out that involved a technical challenge. Furthermore, the technical challenge must require either experimentation or trial and error to overcome.
Technical uncertainty means that, at the outset, it’s not known whether a certain goal can be achieved or how it can be achieved. Examples of technical uncertainty might look like, “Can this product be developed?” or “Can this feature be successfully added to our software?”
It’s a good idea to document all of the technical uncertainties at the outset in order to make applying for the R&D tax credit easier.
Process of Experimentation
Once the technical uncertainty has been identified, the process of experimentation follows naturally. Tinkering, trying new approaches, and playing around are all different ways to describe the process of experimentation.
Identify at least one potential method to resolve the uncertainty. In other words, if your uncertainty was about whether you could add a feature to your existing software, identify at least one approach that might work. In most cases, the process of experimenting will involve multiple different attempts.
Finally, assess the methods to see whether one of them works.
New or Improved Product, Process, or Software
Developing a new or improved product, process, or software may qualify your business for the R&D tax credit.
Digitizing an existing workflow may qualify as an improved process, for example. Creating environmentally friendly packaging may qualify as an improved product. Updates to existing software may qualify as well.
It’s not necessary to introduce a scientific breakthrough to qualify for the R&D tax credit. All that matters is that you build something new or improve on something that already exists.
Benefits of R&D Tax Credits for Startups
The R&D tax credit can yield a range of impressive benefits for startups. The short-term financial benefits on your income tax return are the most obvious, but the tax incentives can also result in several long-term benefits. Applying for the R&D tax credit can boost productivity and lead to a more successful business model.
The IRS allows companies to claim a credit against income tax for up to 20% of their qualified research activity. The tax credit benefits business owners in a few different ways. This includes the following:
Reduce Tax Liability
The R&D tax credit was originally designed to reduce businesses' income tax liability. Companies can calculate R&D tax credit and then apply the credit to reduce their taxable income, dollar for dollar.
The tax credit can make a serious dent in a company’s tax liability, freeing up funds that can be used to grow the business, hire new personnel, or expand market reach. However, it’s worth noting that this benefit may not be as valuable for early-stage startups, which may not yet have a large tax liability.
Offset Payroll Taxes
In 2015, Congress passed the Protecting Americans from Tax Hikes (PATH) Act, which was intended, in part, to give startups greater access to the R&D tax credit.
The PATH Act allows startups and small businesses to apply part of the R&D tax credit directly to their payroll tax to offset the employer portion of social security taxes. This means that even startups that are not yet turning a profit – and therefore have no tax liability – can still benefit from the R&D tax credit if they correctly complete an R&D tax credit form.
Increase Cash Flow
The IRS allows qualifying small businesses to apply up to $500,000 of the R&D tax credit to their payroll taxes. If there is a surplus after payroll taxes, the business may apply the rest of the tax credit to their Medicare obligations.
The result means that qualifying businesses will greatly reduce their tax burden, leaving them with increased cash flow to use for other business expenses.
Besides the clear financial benefits of the R&D tax credit, the credit can confer a number of strategic benefits. Here are some of the most prominent of those benefits.
The R&D tax credit provides a clear incentive for startups to invest in innovation and develop new products or processes. Instead of relying on traditional methods and approaches, companies are incentivized to experiment with new products and processes. This can create a culture of innovation throughout the company, which will almost certainly lead to better goods and services and more efficient workflows.
Startups offering R&D tax benefits may be more attractive to talented researchers and engineers. Younger employees say that they value the ability to learn and develop new skills while on the job. Gallup reports that 59% of millennials cite learning and development as crucial when job-hunting. Developing a culture of innovation throughout the business may help to attract young, energetic workers. In a similar way, offering R&D tax benefits may help your company to retain the best and brightest employees.
Enhance Company Reputation
A commitment to R&D can enhance a startup's reputation and credibility, making it more attractive to investors. Investors want to be reassured that the company will keep growing and increasing its customer base. One of the best ways to show investors your company’s potential is to highlight your R&D commitments.
Maximize Your Startup's Financial Potential
Achieving your startup’s maximum financial potential means deepening your understanding of all available resources. Taking advantage of the R&D tax credit is one example of the kind of resource you can leverage to make your business successful.
Maximizing your potential also requires the right administrative and finance tools. It can be challenging to manage without an R&D accountant or R&D tax credit software. That's why successful businesses use accounting tools to keep their finances in order and gather data that can yield smarter decision-making. They also draw on experienced strategists to build investment plans to move their businesses forward.
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