By: Kacie Goff
Research and development (R&D) can help boost not just an individual business’s profitability, but also the economy around them. Dedicated R&D presents the opportunity to fine-tune innovations, allowing companies to forge new ground — and do so confidently.
The only problem is that R&D can be (and often is) expensive. So in 2015, the U.S. government permanently extended R&D tax credits to domestic businesses as part of the Protecting Americans from Tax Hikes (PATH) Act of 2015. While the R&D tax credit was by no means the core of the PATH Act, it presents an exciting opportunity to tech startups.
Understanding the R&D tax credit
For starters, you should know that the federal tax credit toward research and development is actually called a Research & Experimentation (R&E) credit, not an R&D credit. You can find the details of this tax credit in Internal Revenue Code (IRC) Section 41.
Basically, this credit allows you to reduce your tax liability by a certain percentage of everything you spend on R&D (assuming the expenses are eligible and with some exceptions, which we’ll outline later).
Specifically, there are three components of the tax credit that might apply to you:
- A credit worth 20% of the excess of your qualified research expenses (QREs) over your base amount (which generally looks at your last four years of QREs and gross receipts).
- 20% of any basic research payments you make (i.e., payments to another qualified party determined under subsection [e][A] of the aforementioned Section 41).
- 20% of any expenses you pay toward an energy research consortium for energy research.
Theoretically, you may be able to get a credit totaling the sum of all three of those components.
You should also know that the R&D credit has some versatile applications, particularly for tax startups who don’t yet have any federal tax liability. Thanks to the PATH Act, if you don’t have a federal tax liability and your gross receipts total less than $5 million, you can take this credit against your payroll taxes (up to $250,000). Businesses also have the option to apply this tax credit against their alternative minimum tax (AMT) liability.
In other words, plenty of businesses of all sizes can capitalize on this credit to reduce their tax liability. Before the PATH Act, R&D credits were reserved for large, well-established organizations. But now, startups have the opportunity to apply this credit, reducing what they need to pay in taxes while supporting the research and development they need.
The specifics of the federal R&D tax credit
Now, the trick with this — or any other tax credit — is understanding where you can apply it.
This starts by determining what counts as a QRE. Per Section 41, qualified research means anything “undertaken for the purpose of discovering information” that is “technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer.”
Section 41 specifically excludes the following from qualified research:
From there, the IRC breaks QREs into two categories: in-house expenses and contract expenses.
Per the code, any of the following can be added to your list of QREs:
- Employee wages when the employee is performing qualified research
- The cost of supplies used for your qualified research (land and land development are specifically excluded)
- The cost to use computers to conduct the qualified research
For tech startups, determining which technological resources can count as a QRE can be tricky. As we mentioned before, for example, computer software costs generally aren’t qualified, unless it’s an internally developed software. Our team can help you precisely pinpoint what can count toward your R&D tax credit.
Even if you don’t perform all of your R&D in-house, you can still deduct a portion of the expenses that result from contracting certain research work out — provided you hire a U.S.-based contractor. Generally, if you pay another domestically based person for the research work, you can apply up to 65 percent of that expense.
If you — along with at least one other party — pay a qualified research consortium (generally, a non-profit, research-focused institution like a university) for the research your business needs, you can apply up to 75 percent of that expense toward your tax credit.
All told, whether you perform your R&D in-house or hire it out, you can likely claim a tax credit for a portion of the cost, provided that the research centers in hard science and is focused on developing a new product or service for your business, not iterating on an existing one.
Getting your R&D tax credit
The main thing about this tax credit — along with pretty much all other tax credits — is that you need proof of your spending. That means diligently tracking which employee hours are being dedicated to R&D and keeping careful documentation around your R&D-related expenses. Don’t wait until tax season next year to start thinking about how this credit could reduce your tax liability.
Additionally, you should know that many states (including New York) offer R&D tax credits. In fact, New York also offers a sales tax exemption for certain R&D activities. All told, there are ample opportunities for tech startups to realize tax perks from their research and development activities.
If you think your startup could benefit from the R&D credit, get in touch with our team. We can advise you on the proper documentation and processes to make sure you maximize your R&D tax credit and keep more of your money where it can help your business thrive.
For more information about the federal R&D tax credit, state-specific offerings, and recordkeeping to claim these credits, don’t hesitate to contact our dedicated team of tech startup accountants at ShayCPA.