Many startup founders might be surprised to learn that qualifying for the R&D Tax credit doesn’t require a dedicated R&D department.
It’s not necessary to be on the cutting edge of the latest technologies, reinventing the wheel, or building a spaceship, either. All that’s necessary is to engage in activities intended to solve a technical uncertainty.
Of course, claiming the credit isn’t quite as simple as telling the IRS you did some research. The research activity must pass the IRS’s 4-part test and not be part of an excluded activity.
But many startups and software companies are indeed actively (and unknowingly) engaging in qualified research and development activities. In other words, they’re leaving tax credits on the table, a missed opportunity.
If your startup builds new products or creates new software tools, the R&D Tax Credit is worth researching.
What is the R&D Tax Credit?
But first, let’s take a step back. What is the R&D tax credit anyway?
Originally introduced in 1981 as the Research and Experimentation tax credit, the R&D tax credit was intended to incentivize companies engaging in R&D activities. The federal government could promote innovation and create high-paying technical jobs on US soil by encouraging companies to perform research.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act made the temporary measure permanent.
Unlike deductions, which reduce a company’s taxable income, the R&D tax credit improves cash flow by directly reducing tax liability for companies applying resources to solve technological uncertainty.
The credit applies to these three types of business tax liabilities:
- Business Income Tax
- Alternative Minimum Tax
- Social Security Taxes (for qualifying small businesses)
R&D tax credits aren’t limited to companies doing certain types of research in specific fields. When it comes to the industry, there is no exclusivity. It’s not a tax credit for specific kinds of technologies.
While there are certain exclusions, any company and activity could qualify: farming, software, manufacturing, you name it.
The 4-Part Test
To determine whether or not a specific activity qualifies, the IRS has a 4-part test.
- The activity should attempt to develop a new component or improve on an existing business. While “component” can have a variety of meanings, it needs to be something the company intends to monetize.
- The work is designed to discover new information. You don’t need to be building quantum computers, but you need to create something new or search for new ways of doing things.
- The research involves experimentation and testing to eliminate technological uncertainty.
- Testing and evaluation must rely on hard sciences, such as physical, biological, or computer science or computer engineering, to test the validity of your hypotheses.
However, certain activities are excluded from qualifying for the R&D tax credit, even if they pass the 4-part test.
It’s difficult for:
- Anything that isn’t functional to qualify: fashion, flavors, seasonal products
- Components that are already in production
- Efforts to copy or reverse-engineer other company’s existing products and processes
- Expenses outside of the US and its territories (i.e. payments to off-shore developers)
Expenses for software development can be a complicated topic. If you’d like to claim the credit for software development, make sure to get expert advice.
Software developed as a commercial product might qualify.
But when developed for internal day-to-day use, the expenses typically don’t qualify for the R&D tax credit.
However, software developed for internal use, but as part of qualifying, wider-reaching research may also qualify for the credit, complicating the matter.
Because the credits are intended to promote hiring on US soil, expenses paid to internal employees living in the US and its territories return the highest credit.
- 100% of eligible employee wages, certain types of supplies, and equipment qualify.
- Research that is contracted to a third party in the U.S. is allowed at 65%
- Payments to research organizations and qualified educational entities are allowed at 75%
As with any tax topic, the IRS has the right to audit you to confirm that the expenses you claimed are indeed eligible.
Does Your Business Qualify for R&D Tax Credits?
Many founders start their companies in order to solve a problem for their customers. By bringing their products to market, many startups naturally engage in activities that qualify for the R&D tax credit.
Not looking into the credit means leaving money on the table. The credits can have a significant impact on your business’s taxable income and cash flow.
But handling the credit on your own can be complicated, especially if you’re in the software space. You’re much better off with an experienced partner who can help navigate which activities qualify and how to claim them. If you’re building a startup that might have qualifying activities, contact us for a free consultation with one of our startup experts.