Flip Your Startup's R&D Expenses into $250K Tax Credit
Innovation pays in the long run, but how to sustain innovation and keep evolving if there’s a fund crunch pulling your startup down? Do you wish there’s help on cash flow to sustain innovation?
If you’re a startup, then the revised tax legislature has just promised to take better care of you! How about some tax credit – and the credit is BIG this time around – to sail you through your initial hiccup years of starting up? Read on to find more!
Starting 2016, a new tax credit is offer, and it’s a big one this time around. There’s huge money at stake, and businesses who qualify for the credit can claim up to $250,000 per fiscal year! What exactly defines the R&D tax credit, why is it big for startups, how startups can lay their hands on it, which startups are eligible – all your questions answered in the post. Read on to know more.
Earlier, startups that were not paying federal income taxes could claim R&D Tax Credits, but would had to carry them forward until they could offset their income tax liabilities. This made it difficult for startups or small businesses to benefit from the credits.
With the recent changes, startups can apply the R&D tax credit against the employer share of payroll tax up to $250,000 for each fiscal year. The new payroll tax offset allows qualified small businesses to receive a benefit for their research activities regardless of profitability. In order to make the most of the recent changes, let’s understand the tax credit program in depth and use it to our advantage.
What is the R&D Tax Credit?
While there are scores of tax deductions and other tax related processes that small businesses must be concerned about, there is none as important as the Research and Development Tax Credit. The Federal R&D Tax Credit is a tax credit for startups and small businesses to help offset their costs for research and development. It is a Government initiative to encourage nascent business to invest in research and development, and come up with products and technology that will benefit other businesses. Qualified small businesses may claim up to $250,000 per fiscal year, applying it against their Social Security taxes.
R&D Tax Credits have been benefiting companies which incur research and development expenses on new products in United States since 1981. Companies that are profitable, with Income Tax liability had the benefit of offsetting R&D Tax credit against the liability. Companies not profitable, had to carry forward the credit up to a maximum of 20 years, until they had taxes to offset against.
What are the amendments to the R&D Tax Credit?
Protecting Americans from Tax Hikes (PATH) Act of 2015 made these R&D Credits permanent. Key enhancement to the provisions in 2016 provides the opportunity to offset against alternative minimum tax and payroll taxes for eligible businesses. This a major change that largely benefits startups and small businesses, giving them positive cash flow. Tax credits are a dollar for dollar credit against taxes owed, Income and or Payroll Taxes.
How can startups benefit from the amended R&D Tax Credit law?
Startups with annual gross receipts of less than $5 million can apply up to $250,000 for research and development (R&D) credit to offset against payroll tax liability. The new legislation fits the bill of many small and medium-sized companies that had been earlier effectively barred from using it. As suggested by reports, most small startups operate at a loss during their formative years. Until the recent legislation, startups were unable to get a current cash benefit from the federal research credit because the credit could only be used to pay federal income tax liability. Since companies on losses hardly have any income tax liability, startups could only carry forward their credits for as long as they were allowed or till they got expired.
As opposed to the past legislation on tax credit when it was just a temporary part of the U.S. tax code, the Tax Hikes Act of 2015 - PATH Act - made the research credit a permanent benefit, helping qualified small businesses to use up to $250,000 of research credits to offset payroll tax liabilities.
The PATH Act now allows small to medium businesses to choose if they want to use the research credit to offset their payroll taxes. The total benefit is limited to $250,000 per year for up to five years. Employers can make the choice during payroll tax filing for the first quarter that begins after an annual income tax return. This is filed for tax years beginning after December 31, 2015, and on which a research credit is claimed.
Eligible taxpayers may specify the amount they plan to use to offset their payroll taxes. Excess unused credits will carry forward for use against subsequent quarterly payroll tax liabilities.
Qualified small businesses are categorically defined as corporations with gross receipts of less than $5 million for the current tax year and no history of gross receipts that extends beyond $5 million per year in the last 5 tax years.
Sole proprietorships can also qualify for the tax credit if they meet the gross receipts test with respect to all trades or businesses.
Startups from a variety of industries are claiming the tax credit and are making significant improvement, besides bringing in path-breaking innovation in their products. A few of these industries are on-demand economy, big data, chemistry, agriculture, technology, software, manufacturing, wine, oil & gas, aerospace subcontracting, pharmaceutical, and biotech. Simply put, any startup that is working on innovative ideas and relying on innovation and subsequent evolution can take advantage of this.
What are the benefits of the R&D Tax Credit?
Salaries, cost of supplies, contract research, and computer leasing can all qualify for the R&D tax credit.
Except pharmaceutical and construction companies, salaries paid to employees who conduct qualified activities are generally one of the largest claimers of the R&D credit claim. The cost of engineers who carry out qualified R&D activities, as well as their direct supervisors, also come under the precinct of R&D Tax Credit benefit. Interestingly, a portion of payments made to even Cloud service providers, if it is directly used to host an eligible R&D activity, also qualifies to claim the tax credit.
Credit Carryforward
Even if a business doesn’t have any current tax liability but its activities qualify, it’s essential to document its R&D expenses along the way. R&D costs If you don’t currently have a tax liability but your activities qualify, it’s still important you document R&D expenses along the way. It is during such a time that the R&D tax Credit can offset R&D costs incurred when the company doesn’t make any profit. In most cases, the tax credit can be carried forward to up to 20 years.
Retroactive Claims
Federal taxpayers are also eligible to claim the R&D credit retroactively by filing amended returns for the past three tax years, or even more if the company incurred losses during that period. This makes it an effective way to regain tax paid previously. Additionally, state taxpayers are also eligible to amend returns that go back even further.
Who is eligible to claim R&D Tax Credit?
Under pre-2015 PATH Act law, the research credit wasn’t a specified with respect to any taxpayers. With the primary initiative to encourage technology and innovation, the government mandates the eligible companies to fall under a few yardsticks. A business will be eligible to claim R&D Tax Credit if –
It has less than $5 million of gross receipts
It has gross receipts for five years or less
It has qualified research and development costs
Companies that are mostly into technology and science are most likely to be eligible for the new credit. However, any business may qualify if it is into actively developing new products or processes.
Companies with potential R&D activities frequently undertake the following types of activities:
Refine, enhance, or redesign existing products
Develop processes, patents, formulas, techniques, prototypes, or software
Hire scientists, science instructors, researchers, analysts, designers, or engineers
Dedicate time and other resources to create, manufacture, or develop new products
Develop patents
Which activities qualify for the new R&D Tax Credit?
Activities qualify if they meet each element of a four part test:
Qualified purpose – General research cannot be the only ground to claim the credit. The research must be specifically aimed to improve functionality, performance, reliability or quality of a specific product or process.
Technological in nature – To claim the R&D Tax Credit, the intended research must centre around principles of engineering or science, therefore doing away with any kind of ambiguity.
Technical uncertainty – The research must be intended to discover by eliminating technical uncertainty of a business offerings
Experimentation process – Activities must be elements of a process of experimentation in evaluating one or more alternatives, develop, refine, test hypothesis, test by trial and error, etc.
What are the expenses that qualify to claim the credit?
Having understood the activities that qualify to claim the credit, it’s imperative to understand the type of expenses that can qualify well to claim the benefit.
Activities that involve –
Technical uncertainty
A process of experimentation
Technology, and/or
A qualified purpose, and
Isn’t –
Research performed after a product is manufactured commercially
Duplication of a pre-performed research
Custom-built for a customer
Routine data collection or general market research
Foreign research (research performed outside of the USA)
Research already funded by another organization
Research in humanities, social sciences, or arts
- qualify for to claim their expenses.
Expenses that compose of –
Wages:
That are W-2 taxable income
That are paid directly to employees who carry out the researches or to their direct supervisors
That meet the “substantially all” test
Supplies:
That are tangible individual property, or server leases
That aren’t tangible assets such as such as buildings, machinery, equipment, vehicles and tools or general administrative supplies
Contract research:
Performed by a direct employee
Performed under an agreement that puts the credit claimant at the risk of financial losses
Computer leasing:
Service charges paid to a cloud service provider for providing the space needed to host data directly related to the research
It’s a qualified cost if the expenses fall under/compose of all the qualifying conditions. Up to 10 percent of the total qualified costs can be claimed under the R&D Tax Credit law.
How can you claim R&D Tax Credit?
Documentation is the key to claim the tax credit.
If your business intends to claim the R&D Tax Credit now or in the future, you must start documenting right away – all potential projects, products, or processes that qualify must be documented. Evaluate your company’s research activities for potential eligibility, and start by analysing qualifying expenses and preparing supporting documents to show the costs incurred. Ready documents will save you time and other resources if and when you decide to pursue an R&D Tax Credit claim. It’s always advised to have ready documents for the tax credit claim even if you don’t plan to apply for the credits immediately, but have plans.
To start, collect documents that:
Substantiate amounts, including financial, tax, and payroll records
Relate amount and the activities performed, for example project accounting or time-tracking records
Identify and demonstrate qualified nature of activities, such as development reports, patents, testing documentation
The following documentation may also be helpful while registering a tax credit claim –
Timesheets of employees, tracking time taken to complete projects and surveys
Contemporaneous documentation that include project development notes, test reports, project designs, e-mail communications, and mock-ups or models
Information derived from project management tools or other tools that establish the process of experimentation involved in the research
Documentation Tips
The following documentation tips may facilitate a smooth tax credit claim.
Retain notes, design revisions, and other support related to potentially qualifying projects in one place.
Identify and track expenses related to potential R&D activities – Most often, engineers don’t want to be bothered with tracking time of projects, or documenting their work that may have qualified as an R&D activity, but it’s important to track these activities to register a successful tax credit claim. Using time tracking tools such as TSheets and Hubstaff, tracking scheduling employee time becomes a breeze and helps any business in leaps and bounds in the long run.
Pay special attention to contract agreements. For companies that have researchers and other employees on contract, the IRS and state authorities are likely to request you to see your contract paperwork. This is done to verify that your company bears the financial risk of those contracts – a mandate for R&D credit eligibility.
If you plan to carry your credits forward, be additionally cautious. Be particularly cautious if you plan to carry credits forward. Companies that are most likely to break even or to make a profit are particularly subjected to additional scrutiny if they’ve claimed credits on their tax returns to carry forward and use them later. Credits that are actually used to offset income tax are examined more closely and companies need to have ready and valid documentation to support their claims.
In today’s ubiquitous world, R&D-qualifying activities are pervasive. Companies have to be abreast about where they’re investing their valuable resources so that they don’t miss out on their due tax credit.
Seek Professional Advice
Though R&D Tax Credit has been extensively discussed and explained across all platforms, it shouldn’t come as a surprise that claiming it is not a cakewalk. Documenting expenses and subsequently registering for a tax credit claim can be challenging, to say the least. Leveraging on the tax credit laws requires intensive understanding of the IRS documentation requirements, along with technical understanding of products and processes that qualify as eligible tax credit activities.