Did you know that your startup business could utilize the federal R&D tax credit to offset up to $250,000 of payroll tax liability? The federal R&D tax credit allows startups to do just that.
With such a significant financial tax incentive, it pays to start thinking about the research and development (R&D) tax credits well before tax time and from the earliest days of starting your business. In this article, you’ll learn the basics of qualifying for the federal R&D tax credit, plus how to calculate the amount for which you’re eligible.
Who Can Qualify For The Federal R&D Tax Credit?
Companies from various industries, such as engineering, manufacturing, and software developing new or improved products or processes can qualify for the R&D tax credit. You see if your business qualifies, you must first identify your business components and determine if they meet the following 4-part test:
- Permitted Purpose: The taxpayer is working to design and develop a new product or process, seeking to improve the functionality, reliability, or quality.
- Technological In Nature: The activities rely on the principles of engineering, biological, physical, or computer sciences.
- Technological Uncertainty: At the onset of the project, the taxpayer must be uncertain as to the method, capability, or design. Further uncertainties may occur during the project.
- Process of Experimentation: There must be an evaluation of one or more alternatives to eliminate the technical uncertainty.
In addition, startups that meet the following criteria each year may be eligible to offset payroll tax liability up to $250,000 annually for up to five years.
- Must have less than $5 million in gross receipts in the credit year.
- Must not have gross receipts or interest income from more than five years before the current tax year.
Which Business Expenses Could Qualify For The R&D Tax Credit?
If you’re eligible for the R&D tax credit for startups, you can use the money spent on certain research and development expenses to offset your tax liability, if any, or your payroll tax liability. R&D tax credit qualified research expenditures (QREs) include:
- The cost of tangible supplies consumed during the R&D process. This does not include depreciable capital items, licensing fees, subscription costs, or general and administrative supplies (office supplies).
- The cost of leasing computers used for R&D activities. These costs can include cloud storage fees for AWS, Azure, or Google Cloud, for example.
- Costs you pay to third-party consultants to do the R&D work for you. Consultants must perform the work in the United States and your company must retain rights and bear economic risk.
- Wages you pay employees who perform qualified research activities in the United States. Keep track of the time that employees from all departments spend on R&D-related activities, so you can include the relevant portion of their Box 1, W-2 wage amount as a QRE.
How To Calculate Your Startup R&D Tax Credit
Once you have identified your total qualified expenses, there are two methods for R&D tax credit calculation:
- Traditional method: The traditional method of calculation is 20% of the current year QREs that exceed a base amount. First, determine the Fixed Based Percentage, not to exceed 16%. Then determine the base by applying the percentage against the average of the prior four-year gross receipts. To determine the gross credit amount, multiply 20% by the smaller of the excess over the base or 50% of current year QREs.
- Alternative Simplified Credit (ASC) method: The ASC method of calculation is 14% of the current year’s qualified expenses that exceed 50% of the average qualified expenses for the past three years. If you do not have QREs in the prior three years, the credit is 6% of the current year’s QREs.
For both calculation methods, utilize Form 8974 to determine the amount of the credit the taxpayer can use to offset payroll tax liability. You can carry forward any unused credit for up to 20 years. Tax accountants calculate the R&D credit with both formulas and use the method that results in a larger credit for your business, so you may end up switching methods from year to year.
How To Claim The R&D Tax Credit
To apply for startup R&D tax credit:
- Keep granular records of every business expense throughout the year — As well as allowing you to monitor performance against the startup budget, this recordkeeping helps identify which expenses qualify for the credit and which do not. Without detailed records, your team will waste time clarifying the details of each expense before you can put together the necessary supporting documents for your application.
- Discuss your situation with an accountant — If you’re working with an accountant to file your taxes, arrange a meeting to explain your product, research processes, and team structure. Provide the necessary documentation before they begin the credit calculation on your behalf.
- Complete the applicable tax form — Complete Form 6765 (Credit for Increasing Research Activities), which is part of the annual corporate tax return, and submit the required documents as proof.
Claim the credit against payroll tax liability, if eligible — Complete the applicable Tax Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities), which is part of the annual corporate tax return.
If you are eligible, your tax accountant can claim the R&D credit against your income tax liability or if you qualify, against your payroll tax liability.
Need The Help Of A Startup Tax Expert?
The calculation and application process outlined above might seem complex for most businesses — it often is complex. Startups that try to apply for the R&D tax credit without the guidance of an accountant risk missing out on thousands of dollars of credit and are not adequately preparing for an IRS audit.
If you’re looking for an expert to help you navigate the confusing world of corporate tax, Zeni might be the solution your business needs.
Built specifically to meet the needs of startups, Zeni is an AI-powered finance concierge that manages all your bookkeeping, accounting, invoicing, bill pay, reporting, and more.
Our team maintains detailed, GAAP-compliant records for your business year-round. For a fixed fee, we can take care of all your federal, state, and local tax returns, so you can be confident that your business isn’t leaving money on the table.