Federal R&D Tax Credit for Tech Founders

Founders, there is a powerful tax credit that can help put cash back into your startup, offsetting up to $250,000 of Payroll taxes per year for qualified small businesses. For businesses that don’t meet the qualified small business definition, they may still be able to offset the R&D taxes against corporate income taxes.  

For Seed to Series-A Tech companies, this is critical to extend runway and reduce burn. Check out the R&D calculator put together by our friends RetroAcDev to estimate what your credit may be worth.

To qualify for the R&D credit, Startups must document and substantiate the credit by meeting tests the IRS has put together. It’s important to save GitHub records, product roadmaps, and release notes, all of which substantiate the credit. 

The four-part test includes the following: 

• Section 174 Test – Permitted Purpose:
  • To meet this test, tech companies must be able to show that their expenses are: 
    • Incurred in connection with the taxpayers’ trade or business.
    • Represent an R&D cost in the experimental or laboratory sense.
• The Discovering Technological Information Test: 
  • Elimination of Uncertainty: Activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. 
  • Process of experimentation used to discover information must fundamentally rely on principles of the following:
    • Physical or Biological Sciences
    • Engineering
    • Computer Sciences
• The Business Component Test:
  • Tech companies must intend to apply the discovered knowledge to develop a new or improved business component. Defined as follows, held for sale, lease, license, or used in a trade or business: 
    • Product
    • Process
    • Computer Software
    • Technique
    • Formula
    • Invention
• Process of Experimentation:
  • Tech companies must show they have evaluated one, or more, alternatives to achieve a result. Such alternatives should include the capability, the appropriate design, and method of achieving that result. These results must be considered uncertain at the beginning of the taxpayers’ research activities. 

The credit, calculated on Form 6765, is attached to the Federal Tax Return. The form needs to careful preparation to include the following qualifying expenses: 

• Wages for Qualified Services incurred in the United States of America: This is often a percentage of salary for the calendar year for employees who worked on R&D activities. 
• Contract Research Expenses incurred in the United States of America: This may include a portion of expenses paid to subcontractors in the U.S. 
• Cost of Supplies: (must be tangible personal property – so think test tubes and beakers, etc.)
• Rental/Lease of computers used in qualified research: Computer must be located off-premises, and the company must not be the primary user. 

Below are some handy definitions from the IRS. 

Qualified Research: 

Qualified research means research for which costs may be treated as section 174 expenses. The taxpayer must undertake this research to discover information that is technological in nature. Its application must be intended to develop a new or improved business component of the taxpayer. 

Qualified Small Business: 

A qualified small business is a corporation (including an S-Corporation) or partnership with: 

1. Gross receipts of less than $5 million for the tax year and
2. No gross receipts for any tax year before the 5-tax-year period ending with the tax year. 

Payroll Tax Credit Election: 

The payroll tax credit election is an annual election made by a qualified small business specifying the amount of research credit, not to exceed $250,000, that may be used against the employer portion of social security liability. 

We help founders navigate the R&D Credit and ensure they have the documentation to back-up their credit. Contact us to get started. 

For additional information and resources, check out the following helpful links by the IRS: 

R&D Audit Guide

Form 6765 Instructions

Interim Guidance and Request for Comments; Election by Qualified Small Business to Claim Payroll Tax Credit for Increasing Research Activities