Every year, the US government allocates billions of dollars to support innovative companies that are developing or improving technologies, products, materials, and processes through the US Research & Experimentation Tax Credit (R&D Tax Credit) program.
Startups are eligible for R&D tax credits, allowing them to reduce their payroll taxes by up to $500,000 per fiscal year. Previously, the cap was $250,000, but Congress doubled it as part of the Inflation Reduction Act. This new rule applies to tax years starting January 1, 2023.
To make the most of R&D tax credits for startups, your first step is to understand which activities qualify. Next, gather the necessary documentation—either manually or with the help of automated solutions.
What Is the R&D Tax Credit?
The R&D tax credit is a government incentive for companies that carry out research and development activities in the US. This credit has been available since 1981.
In the past, the program would expire periodically and needed to be renewed by Congress. That made it hard for businesses to include the credit in their long-term planning. In 2015, Congress made the R&D tax credit permanent through the Protecting Americans from Tax Hikes (PATH) Act, and expanded access so more companies could benefit.
Originally, the R&D tax credit was only an income tax credit. Startups that didn’t owe federal income tax could claim credits, but had to carry them forward on their corporate or shareholder returns until they owed income tax. This meant startups and unprofitable businesses couldn’t benefit right away.
With the PATH Act, startups can now use the R&D tax credit to offset the employer portion of Social Security taxes each year.
Does My Startup Qualify for the R&D Tax Credit?
To qualify for the federal R&D tax credit, startups must meet these criteria:
1. The business must have gross receipts of $5 million or less for the tax year.
2. The business has gross receipts for five years or less. The business cannot have gross receipts for any tax year before the five-year period ending with the year of the claim. For example, if your business had gross receipts before 2018, you can’t claim for the 2022 tax year.
However, businesses that existed before 2018 but didn’t have gross receipts may still qualify. While the law is designed to help small businesses, some larger companies can also benefit. For instance, many life sciences companies have no gross receipts for years until their product is approved by the FDA.
3. The business is not a tax-exempt organization under section 501, such as a charity.
State R&D Credits
Depending on your state, your startup may also qualify for state-level R&D credits in addition to the federal program.
States offering R&D tax credits include:
- Arizona offers a 24% tax credit on the first $2.5 million of qualifying R&D expenses, and a 15% credit on expenses above that amount.
- California offers a non-refundable 15% tax credit on R&D activities.
- New York offers a 6% tax credit on R&D expenses incurred in the state.
- Texas provides R&D incentives through franchise tax credits and sales tax exemptions.
What Activities Qualify for the R&D Tax Credit?
Eligible research must aim to create innovation in a scientific or technological field. Your startup’s R&D activities must pass the 4-part IRS test to qualify.
- The Section 174 Test
The section 174 test has two requirements:
- Research expenses must be directly related to your startup’s business.
- Your startup must have incurred research and development costs in an “experimental or laboratory sense”—meaning the research aimed to resolve uncertainty about developing or improving a product. Uncertainty exists if you don’t yet know how to achieve the desired outcome.
- The Discovering Technological Information Test
To meet this test, you must show that your research relied on the principles of physical or biological sciences, engineering, or computer science, as defined by the IRS. The research must also resolve uncertainty, as described in the section 174 test.
- The Business Component Test
Any information your startup discovers during research must be used to develop a new business component or improve an existing one. The IRS defines business components as any product, process, computer software, technique, formula, or invention intended for sale, lease, license, or use in your business.
- The Process of Experimentation Test
The process of experimentation test requires startups to:
- Identify the uncertainty related to developing a business component.
- Identify at least one possible solution to resolve the uncertainty.
- Design and carry out a process to evaluate the alternatives.
What Activities Do Not Qualify for the R&D Tax Credit?
The IRS excludes certain activities from qualifying research, so they are not eligible for credits.
Exclusions include:
- Any research conducted after commercial production has started.
- Any research aimed at customizing existing business components for a specific customer’s needs.
- Any research focused on duplicating an existing business component.
How Can I Use R&D Tax Credits to Offset Payroll Taxes?
The payroll tax credit election is made annually by qualified small businesses, specifying the amount of research credit (up to $500,000 per year) that can be used to offset the employer portion of Social Security and Medicare payroll taxes.
Businesses must pay Social Security tax of 6.2% on up to $147,000 of each employee’s salary, and Medicare tax of 1.45% (with no wage cap). For example, a business with 40 employees earning $100,000 each would pay about $248,000 in Social Security payroll taxes and $58,000 in Medicare taxes in 2022. Offsetting these taxes frees up more cash for your business.
Note that you cannot apply the full $500,000 to just one tax. Instead, you can use $250,000 each for Social Security and Medicare taxes.
To offset payroll taxes, the IRS requires small businesses to follow these steps:
- Complete Form 6765 (Credit for Increasing Research Activities), make the payroll tax credit election, and submit it with your business income tax return.
- To claim the credit, complete Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) and file it with Form 941 (Employer’s Quarterly Federal Tax Return).
What Are the Deadlines to Claim?
To offset payroll taxes, you must specify and elect the R&D tax credits on your timely filed (including extensions) income tax return for the year you’re claiming. You can then start offsetting payroll taxes for the calendar quarter after you file your return with the payroll tax credit election.
C Corporations with a December year-end should file by April 15. C Corporations with other year-ends should file within 4.5 months after the end of their tax year.
S Corporations with a December year-end should file by March 15. S Corporations with other year-ends should file by the 15th day of the third month after their tax year ends.
To offset income taxes, you can amend all open tax years (usually the last three years) to claim credits.
How Much of My R&D Costs Can I Recover?
Let’s use a California business as an example.
Federal credit — about 10% of eligible expenses.
State credit — 15% of eligible expenses.
Startups can use these credits to offset payroll taxes for up to five years, with a maximum of $2.5 million in total credits claimed on quarterly payroll tax returns.
For example, a startup with $500,000 in eligible software engineering expenses could claim $50,000 or more, while a company with over $2.5 million in eligible expenses could claim $250,000.
Estimate your potential R&D tax credit
While the payroll tax offset is available to new and startup companies for up to five years, any unused federal R&D credits not applied to payroll taxes can be carried forward for up to 20 years and used once your business becomes profitable.
California state R&D credits can only be used to offset income taxes, but can be carried forward indefinitely.
Make R&D Tax Claims Easier With Boast
If you haven’t claimed the US R&D tax credit because you thought you weren’t eligible or couldn’t use the credits, now is a great time to take another look.
Even though gathering all the required documentation can seem overwhelming, automated solutions like BoastClaim help you maximize your tax claims and save 60 hours per year on the claim process.
To learn how to estimate your potential R&D tax credits, download our free step-by-step guide or contact us for a complimentary, no-obligation assessment. We’ll review your projects in detail, explain what qualifies and what doesn’t, and provide an estimate of your potential return.
