Is Your Startup Claiming the R&D Tax Credit?
The federal research and development (R&D) tax credit continues to be a tremendous opportunity for entrepreneurs with new businesses that are pre-revenue by helping to generate much-needed cash to fund innovation. Startups and qualified small businesses in virtually all industries, regardless of whether the business is a C corporation or a flow-through entity, can qualify for this government-sponsored benefit simply by performing their normal day-to-day activities related to developing new or improved products, processes, methods, techniques, formulas, software, or inventions.
Is your startup business claiming this lucrative benefit? If not, your business could be missing out on refundable R&D tax credits!
Historically, businesses that generated an R&D credit could only use the credit in a year when the business was generating taxable income. Alternately, if a business had no tax liability, it would be required to first carry the credit back to the prior tax year and then forward up to 20 years when the business had taxable income. However, the passage of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) gave startups a new option. It allowed these qualified small businesses, which often have little to no taxable income during their early years of operations, to apply up to $250,000 of research credits per year against the employer portion of quarterly Old Age, Survivors, and Disability Insurance (OASDI) program payroll tax liability (commonly referred to as Social Security) for up to five years. That is potentially $1.25 million in refundable R&D tax credits to offset the cost of investments in innovation.
Which Business Activities Qualify for the R&D Tax Credit?
Originally enacted as part of the Economic Recovery Tax Act of 1981, the R&D credit is an activity-based credit. Since 1981, new legislation, taxpayer-favorable regulations, and judicial precedent have greatly expanded the number and types of businesses that can benefit from the credit. In addition to the federal credit, many states have R&D credits and incentives that businesses can take advantage of. The federal R&D credit is governed by Section 41 of the Internal Revenue Code, which outlines four basic tests that activities must meet to qualify for the credit. Qualified research activities must do all of the following:
- Be intended to develop new or improved functionality, performance, reliability, or quality of a product, process, software, technique, formula, or invention or result in a significant cost reduction
- Apply principles of a hard science, e.g., physical, biological, engineering, or computer science principles
- Be intended to eliminate technical uncertainty regarding capability, methodology, or appropriateness of design
- Be a part of a process of experimentation, meaning a systematic trial and error process capable of evaluating one or more alternatives to eliminate uncertainty
It is important to note that the research need not be successful to qualify for the credit. The research also is not required to involve the discovery of information that is new to the world nor the industry; it simply needs to be new to the business claiming the credit.
A wide variety of activities can qualify for the credit. Some examples include:
- New product development and improvements to existing products
- Process development and improvement
- Developing software applications for internal or external use
- Developing prototypes and experimental models
- Feasibility/beta testing
- Creating intellectual property, inventions, or patents
- Experimenting with new technologies
- Designing tools, jigs, and molds to manufacture products
- Designing and testing custom machinery and equipment or production lines
- Nongeneric and orphan drug development
- Research related data collection, analysis, and documentation
- Redesigning for efficiency or to meet external standards
What Costs Qualify for the Credit?
Once qualified research activities are identified, it’s important to capture all expenses associated with carrying out those activities. Qualified research expenses include:
- Wages for employees who directly perform, support, or supervise R&D activities
- Supplies and raw materials used in development processes
- Third-party contractors that performed R&D activities
- Computer rental or lease costs, including payments to cloud service providers
Which Businesses Can Offset Payroll Taxes with the R&D Credit?
For a business to be able to apply the R&D tax credit against its payroll tax liability, the business must meet both of the following criteria defining a qualified small business:
- A business having less than $5 million of annual gross receipts in the current year
- A business having no gross receipts prior to the five-year period ending with the current tax year
How Is the R&D Credit Applied to Payroll Taxes?
A business that meets the definition of a qualified small business may elect to use up to $250,000 of its research credit generated in a given year against the employer portion of Social Security (OASDI) tax. A business continuing to meet the definition of a qualified small business may continue to make this election for a total of five years.
To make the election, the business completes Section D, “Qualified Small Business Payroll Tax Election and Payroll Tax Credit,” of Form 6765, attaching the form to the taxpayer’s timely filed (including extensions) return for the tax year to which the election applies. In Section D of Form 6765, the business will check a box declaring the business to be a qualified small business (line 41) and then enter the portion of the research credit the business elects as a payroll tax credit, not to exceed $250,000 (line 42).
Beginning with the quarter following the filing of the income tax return, the company’s quarterly 941, Employers Quarterly Federal Tax Return, will need to include Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities. Part 2 of Form 8974 determines the amount of the payroll tax credit on Form 6765 that is credited against the taxpayer's payroll tax for the applicable quarter for which the Form 941 is filed. Where a qualified small business files only an annual 941 return, the payroll tax credit is claimed on its return that includes the first quarter beginning after the date on which the qualified small business filed its income tax return reflecting the election. Depending on the payroll provider, a qualified small business electing the payroll tax offset may request to receive the credit as a refund from the IRS, or it may be a real-time offset of payroll tax due for that quarter. Finally, where the payroll tax credit determined on Forms 8974 and credited on Form 941 exceeds the employer portion of the Social Security tax for a quarter, the excess is carried over to the next calendar quarter(s) subject to the same limitations for the subsequent quarter(s).
The R&D tax credit can be a tremendous tool to help startups and qualified small businesses to immediately recoup some of the cost of their early innovation efforts, regardless of whether they have generated taxable income. This is because qualified startups have the option of using their R&D credit to either offset income tax liability or payroll tax due.
The R&D tax credit is complex to analyze, calculate, and document. BKD’s national team of R&D tax credit advisors is here to help. The R&D tax credit professionals at BKD have helped businesses large and small across the U.S. secure the benefits they were entitled to and missing out on.
If you have any questions about whether your business qualifies for the R&D tax credit or the provision to apply the credit to offset payroll tax, or if you are interested in learning more, visit our R&D Tax Credit Services page or submit the Contact Us form below.