How Your Startup Can Take Advantage Of The R&D Tax Credit

By Sam Leon

For founders, innovation is a necessity, but the financial burden of R&D activities can feel prohibitive when determining where to allocate funds. The R&D tax credit is a valuable tool designed to alleviate some of these costs. Introduced in 1981, it was made permanent in 2015 under the PATH Act, and it’s essential for many startups to fully understand how to leverage it.

An aspect of this credit exists in IRS Section 174, allowing the deduction of R&D expenditures. However, these deductions can vary, and recent changes may alter how they are applied.

Many startups overlook this opportunity, potentially missing out on savings of $500,000 or more annually. Let’s break down how founders can make the most of this credit.

Frequently asked questions

The R&D tax credit offers a dollar-for-dollar reduction in tax liability for qualifying research activities. Understanding what qualifies is key for startups.

1. What’s innovative? Many believe only groundbreaking research qualifies, but the credit covers a wide range of activities, such as improving products or technologies. What matters is showing that technological uncertainty existed and experimentation was used to resolve it.
2. What if you’re not profitable yet? Startups with less than $5 million in gross receipts can apply the credit against payroll taxes for up to $500,000 annually, even if they aren’t profitable.
3. What about overseas efforts? The credit applies only to research conducted in the U.S., so accurate documentation of where activities occur is essential.
4. When will the money come? While the benefits are significant, the process takes time. Startups must file the correct forms with their tax return, and the sooner they begin the documentation process, the quicker they can realize the benefits.

Maximizing the R&D tax credit

To fully capitalize on this credit, startups should follow these steps:

1. Documentation: Keep accurate, detailed records throughout the year, capturing R&D activities, financial records and related expenses like wages, supplies and contractor fees.
2. Review qualifying research: The IRS uses a four-part test to determine qualification:
   • Is the research technological in nature?
   • Does it aim to improve a product, process, software or formula?
   • Does it address uncertainty in development?
   • Does it involve a systematic experimentation process?
3. Qualified research expenses: Identify and include eligible expenses, such as wages for employees involved in R&D, supplies used in research, third-party contractor costs, and expenses related to hosting or server rentals.
4. Stay current on the law: Changes like the 2017 Tax Cuts and Jobs Act required R&D expenses to be amortized, and ongoing discussions could impact how credits are handled. Keep an eye on legislation that could affect the credit.
5. Enlist an expert: Engaging a tax professional early in the process ensures accurate documentation and maximizes benefits, especially given the complexity of R&D credits.

Strategic advantages

The R&D tax credit offers additional strategic advantages.

1. Cash flow: Reducing tax liabilities frees up capital for reinvestment in innovation and growth.
2. Competitive edge: More funds for R&D allow startups to continuously improve and differentiate themselves.
3. Investor appeal: A demonstrated ability to secure tax credits positions a startup as fiscally responsible, attracting investment.

Next Steps and additional resources

To take full advantage of the R&D tax credit, startups should stay informed and proactive. A tax professional can help navigate complex regulations, ensure thorough documentation and streamline the process. Additionally, reviewing common tax mistakes and exploring other tax break opportunities can help maximize savings.

The R&D tax credit is designed to reward investment in innovation — a core focus for startups. Don’t miss out on an opportunity to save and accelerate the growth of your business.

Sam Leon is the head of R&D credits and incentives at Burkland. He brings nearly a decade of accounting, tax and auditing experience, including years of experience preparing and filing R&D credits for tech companies.