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The R&D tax credit: Everything startup owners need to know

Posted by Kanika Sinha

March 17, 2022    |     6-minute read (1231 words)

Research and development activities are routine at many of the 30 million-plus U.S. small businesses. Still, the majority of small-to-medium-sized businesses miss out on claiming the federal R&D tax credit because they don’t realize their operations qualify. Additionally, many startup founders are unaware this tax incentive applies to processes in which they are already engaged.

Contrary to popular perception, the R&D tax credit is not just for large companies from certain sectors or firms with a designated R&D department. It’s available to any company, irrespective of size, revenue or industry, that creates or improves a product or process in the course of business. 

In short, businesses from an array of industries may qualify for the R&D credit, giving them an opportunity to reduce their tax burden, simply by conducting their normal activities. However, the rules for claiming the R&D tax credit are complex and nuanced.

Below we’ll explain the intricacies of the R&D tax credit to help assess your startup’s eligibility.

What is the R&D tax credit program?

Synopsis: The R&D tax credit, also known as the Credit for Increasing Research Activities, aims to encourage U.S. businesses to develop new or improved products or processes. It rewards companies for increasing their investment in research and development with a tax credit that generally reduces the amount of tax owed or increases a tax refund.

Background: The R&D tax credit was introduced in 1981 as a temporary two-year incentive to foster innovation, but it has remained part of the IRS tax code ever since. Initially, its strict qualification provisions meant many small businesses and startups were ineligible. 

After the Protecting Americans from Tax Hikes Act was implemented in 2015, the R&D tax credit became a permanent part of the IRS tax code, with revised qualifications that greatly expanded eligibility to include startups as well as seasoned companies. However, many small businesses are unaware of the change and still assume they are ineligible.

How it works: The R&D tax credit provides businesses a dollar-for-dollar offset of federal income taxes and in certain circumstances, payroll taxes — based on the amount of qualified spending on research and development activities.

The credit calls for R&D costs to be capitalized and amortized over five years. Qualified startups can get back up to $250,000 in R&D tax credits each year for five years for use against payroll taxes, and more than $250,000 in R&D tax credits if they plan to use the credits against income taxes. 

One quick note here is that qualifying enterprises that have been collecting revenue for more than five years and/or had more than $5 million in revenue in the tax year would not be eligible for the payroll tax offset.

Four-part eligibility test

Section 41 (d) of the IRS tax code applies a four-pronged test to determine whether a company’s activities qualify for the R&D tax credit. To claim the R&D credit, the activity performed at your startup must meet these requirements:

1. The Section 174 test: The business must be able to prove the expenses were incurred in direct connection with its trade or business and that they represent a research and development cost in the experimental or laboratory sense. 

2. Technological information test: The business must be able to demonstrate that its research process fundamentally relies on hard sciences principles, such as engineering, physics, chemistry, computer science and other disciplines.

3. Business component test: The business must be able to tie the research being claimed for the tax credit to the relevant/specific business component. The business component is defined as any product, process, computer software, technique, formula or invention that is to be held for sale, lease, license or further used in trade or business of the company.

4. Experimentation test: The business must demonstrate that it has identified the uncertainty regarding the development or improvement of the specific business component. Additionally, it must be able to show it went through a process of elimination, simulation, systematic trial and error or other form of evaluation to arrive at the new or improved product or process.

A note about unsuccessful R&D efforts: The R&D effort does not have to succeed to be eligible. A failed attempt may illustrate the need for experimentation. Also, the new or improved product, functionality or process does not need to be groundbreaking for the industry. It only needs to be innovative for the business conducting the research. 

What expenses can you claim?

The IRS generally uses three expense buckets to determine eligible R&D credit savings. For your reference, the table below shows research expenses that qualify for the R&D tax credit and expenses that do not qualify.

Expenses eligible/ineligible for R&D tax credits
Qualified research expenses Excluded expenses
• Wages.
• Supplies.
• Contract research expenses.
• Payments made for the right to use computers for research.
• Cloud computing expenses.
• Research conducted outside the U.S.
• Routine data collection.
• Market research.
• Management.
• Consumer preference testing.
• Research paid by an unrelated third party.
• Duplication of existing product/process.

How the R&D tax credit is calculated

Once you’ve determined the activity passes the four-part eligibility test and identified qualified research expenses, the next step is the R&D tax credit calculation. 

Calculate your R&D tax credit using these five steps:

Step 1: Calculate your qualified research expenses for the preceding three years.

Step 2: Compute the average QRE using these figures.

Step 3: Multiply that average QRE by 50%. This number is your credit base.

Step 4: Subtract the credit base from your total R&D expenses for the current year.

Step 5: Multiply the result by 14% to find your R&D tax credit.

Example: A startup averages $100,000 in qualified R&D expenses for the past three years. That makes its credit base $50,000 (50% of $100,000). The startup spent $120,000 on R&D this year, meaning $70,000 over its base. Your R&D tax credit is 14% of $70,000 = $9,800. 

Startups without three years of R&D history: Businesses that don’t have three years of R&D history with which to calculate a credit base can calculate the R&D tax credit as a flat 6% of their total R&D expenses for that year. For the example above, the startup would have an R&D tax credit of $7,200 (6% of $120,000).

Documentation needed for you R&D tax credit claim

When submitting an R&D tax claim to the IRS, you must include substantiating documents. Your support documents should:

• Be relevant to the period in which the research activities were undertaken.
• Underscore the technical challenges encountered to show the research was done and that staff were involved.
• Provide corroboration in the form of emails; technical documents; whiteboard or product roadmaps; timesheets; invoices/receipts; contractors agreements; development/engineering notes, etc.

How to claim the R&D tax credit

You can claim the R&D tax credit by filing IRS Form 6765 with your income tax return.

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