Startup R&D Tax Credit: What is it and How Can You Claim it?
What is the Startup R&D Tax Credit?
Many new business owners overlook the Startup R&D Tax Credit to reduce small business taxes. This could be due to many small business owners thinking (incorrectly) that it doesn’t apply to their business. You don’t need a lab coat, beakers, and a fancy title like data scientist to claim the “research & development” credit.
In 26 U.S.C. Section 41, the text of the credit says that it “may be claimed by taxpaying businesses that develop, design, or improve products, processes, formulas, or software.” Business owners in many industries can claim the credit. It’s designed to incentivize businesses to innovate and improve products, services, and processes. Innovation creates a competitive economy where consumers reap the benefits of a better product and better overall experience.
The credit applies against payroll taxes on the federal tax return. It’s a 25% credit against payroll taxes up to $1.25 million for up to a $250,000 savings in payroll taxes. Many business owners are surprised at the activities that would qualify them for the credit. Examples include:
- In food and beverage related businesses, the IRS has generally approved the credit for developing new flavors, appearances, textures, or health benefits.
- Businesses that developed new or improved construction techniques generally qualify.
- Designing or developing fixtures in retail businesses such as displays, lighting, and shelving.
- Technology and software open many opportunities. Developing code or software applications, even if only to be used internally, or to work with customers or vendors.
There’s no requirement to be a business focused on research and development. Development of new processes, software, or equipment that are for internal business use can qualify for the credit.
Qualifying for the Startup R&D Tax Credit
Business owners are often surprised that activities they considered “business as usual” is eligible for the R&D credit. There’s a four-part test to determine R&D eligibility.
- There must be a qualified purpose – the research and development activities must be focused on improving a business component or activity:
- Resulting in a new or improved function
- Achieving better performance
- Improving reliability or quality
- Start with elimination of uncertainty – the business should set up or design the research or development with a reasonable expectation of success. Planning and design at the start of the project should set out the expectation of success.
- Experimentation throughout the activities – the business must demonstrate a process of experimentation, modeling, simulation, or trial-and-error to evaluate that the processes have looked at different alternatives to achieve the desired results.
- Technological in nature – while businesses are not expected to exceed or expand on existing science, they are expected to rely on hard sciences throughout the process:
- Computer science
If the development is related to software for internal use in the business, there are three other qualifying tests:
- Innovative software should result in cost reductions, improvement in business processes, or increase the speed or quality of output.
- Substantial resources representing financial risk should be involved and there should be uncertainty of recovery of investment within a reasonable time period.
- Consumers cannot purchase, lease, or license the software commercially for the intended purpose without extensive modifications.
Startup businesses are often researching and developing as they enter a new market and industry – they look for a niche that will help set them apart. In the process of business planning, the owners should examine their business plan and processes with respect to qualifying for the Startup R&D Tax Credit.
What Qualifies as Qualified Research Expenses (QRE)?
Now that you know the types of activities that can qualify as startup research and development, here are types of Qualified Research Expenses (QRE):
- Wages for employees engaged in qualified activities are deemed QRE for federal income tax withholding.
- Supplies or tangible property used or consumed in the R&D process. This includes depreciable property.
- Contracted services paid to third parties for Qualified Research Activities (QRAs), performed for the taxpayer. This applies even if the research doesn’t produce the desired results. These expenses are allowed at 65% of the actual cost.
- Allowed at 75% of the actual cost are payments made to qualified educational institutions and scientific research organizations.
These expenses can add up to a considerable tax credit, so track them well.
What are other Advantages to Claiming the R&D Tax Credit?
Obviously, the opportunity to take direct credits against federal taxes owed is a great advantage of the Startup R&D Tax Credit. Here are a couple other significant advantages to consider:
- If your business hasn’t taken advantage of the credit before, you have the option to look back at all open tax years to see if you can qualify. This is usually a period of three to four years depending on when you filed your taxes.
- If your business doesn’t currently have taxable income or is limited in how much credit it can take, you can carry forward the credit for up to 20 years. This could apply to state taxes as well.
What Documentation Does Your Business Need?
The ability to claim R&D credits for current, prior, and future tax years means you should be maintaining documentation of activities that may qualify. You can be ready when and if you qualify to save a lot of tax money.
The documentation necessary to qualify activities for the R & D credit includes:
- Project lists and descriptions
- Project notes
- Payroll records
- Lab and test results
- Detail in expense ledgers
- Emails that document projects, goals, processes, and results.
Credible employee testimony can help in documenting R&D to qualify for the tax credit.
IRS Scrutiny and Court Cases Suggest Care in Documentation
It’s a real positive for the business to get the Research and Development Tax Credit, but it’s a real downer to have it disallowed by the IRS. When you’re calculating and building documentation for the credit, it’s worth extra time and effort to get it right.
In the court ruling in Siemer Milling Company v. Commissioner of Internal Revenue, the U.S. Tax Court ruled in favor of the IRS. The ruling was that Siemer Milling lacked sufficient documentation to support the R&D credits claimed.
The IRS disallowed more than $235,000 in R&D credits claimed by Siemer Milling. The ruling stated that the disallowance was due in large part to the failure of the taxpayer to provide sufficient documentation demonstrating how they had met the four necessary steps to qualify.
There were some taxpayer-friendly things that came out of this decision, including:
- Uncertainties related to technical issues do not necessarily need to be resolved during the tax credit year, and they can span more than one tax year.
- The company did not necessarily need to employ specialized degreed professionals.
- The court did specify the types of documentation necessary to support the tax credit qualification.
The lesson to be learned is that you should do everything you can to build documentation for your claim to the R&D tax credit.
What Does Not Qualify for the Credit?
Businesses file for the Startup R&D Tax Credit on IRS Form 6765. In the Definitions section, the form sets out some examples of types of activities that generally do not qualify for the credit, including:
- The duplication of existing process or product would not qualify.
- Generally, surveys or studies of any type would not qualify.
- After commercial production has begun, research activities would not qualify.
- You would not qualify for the credit for research adapting an existing product or process to the needs of your business.
- Some software for internal use would not qualify but see the three tests above for what may qualify.
- You would not qualify if the research was done outside the U.S., its possessions, or Puerto Rico.
- Social sciences, humanities, or the arts research would not qualify.
- Any research funded by entities other than the business would be disqualified.
The complexity of the rules turn off many business owners from applying for this great tax break. It shouldn’t, as there are tax advisors with experience in filing for the credit who can help.
Sure, it’s a bit complicated, but well worth checking out. Business tax deductions help to reduce taxes, but credits are dollar-for-dollar reductions of taxes owed.
A direct 25% credit against payroll taxes is no small matter. It is worth your time if starting a new business to investigate the startup Research & Development Credit.