Millions of startups in the United States routinely conduct research and development (R&D) activities. However, there is a large percentage of them that are still not filing for the R&D tax credit. Many of them don’t know if their operations qualify for this tax credit, while others are unfamiliar with the process. By developing a better understanding of this tax incentive, many startups will find that the R&D tax credit applies to several processes they are already engaged in.
R&D tax credit is not only for large businesses from specific industries or sectors which have a dedicated R&D wing. If a startup is creating or improving a process or product in the course of their business, they can avail of the R&D tax incentive. Businesses from a wide range of industries can qualify for the R&D tax credit. This can give the startup financials an opportunity to reduce their tax liability. However, the problem faced by many startups is that the rules of filing and claiming this tax credit are nuanced and complex. In the following sections, we’ll guide you through these rules and also the intricacies of this process. Without further ado, let’s begin.
What is R&D Tax Credit?
The Research and Development Tax Credit is a great opportunity for startups in the US that want to substantially reduce the burden of their taxes. The R&D payroll tax credit was introduced with the PATH (Protecting Americans from Tax Hikes) Act, which came out in 2015. With this Bill, eligible businesses were offered payroll and alternative minimum tax offsets. It can be claimed by any tax-paying startup that designs, develops, or improves processes, products, software, or formulas. This means that startups can qualify for this tax incentive just by performing their regular activities.
How does it work?
The R&D tax credit essentially offsets the federal incomes and payroll taxes of a startup, based on the amount of spending it is doing on research and development activities. As per the rules, the R&D costs for this tax credit can be capitalized over 5 years. In fact, startups can get a maximum of $250,000 in tax credits every year for 5 years to use against payroll taxes. The payroll tax offset is available on a quarterly basis starting from the beginning of the calendar quarter after the federal income tax return has been filed.
Which Startups Qualify for R&D Tax Credit?
Startups from different industries like manufacturing, engineering, and software that are involved in the development of new or improved processes/products can qualify for the R&D tax credit. There is also a 4-part test startup financials can conduct to see if a business qualifies for the R&D tax credit. It covers the following points –
- Permitted purpose: If the startup is working to develop and design a process or product, or trying to improve its reliability, functionality, or quality.
- Nature of activities: If the activities undertaken by a startup are technological in nature, and rely on the principles of engineering, physical, computer, or biological sciences.
- Uncertainty: At the beginning of a project, there must be uncertainty about the design, capabilities, or methods.
- Experimentation: The startup should be evaluating one or more alternatives to eliminate technical uncertainty.
Besides this, startups should also meet set certain criteria to reduce their payroll tax liability for up to 5 years up to a maximum of $250,000:
- The gross receipts in the tax credit should be less than $5 million.
- There should be no interest income or gross receipts from more than 5 years before the current financial year.
How to file the R&D tax credit?
For the quarterly filing of R&D tax credit, startups need to do the following –
1. Keep a record of all business expenses
To file for the R&D tax credit it is important to monitor the performance against the budget of the startup. With consistent record-keeping, startup financials will be able to identify the expenses that qualify for the credit. If a record is not kept, it can take up a valuable amount of time to collect the supporting documents later.
2. Hold discussions with your accountant
If an accountant is helping in the process of filing taxes, the startup would need to hold a meeting with them to explain the research process, teams, and product. It is also important to provide the accountant with the required documents so that they can start with the credit calculation on your behalf.
3. Complete the Tax Form 6765
The next step is to complete Form 6765, which is concerned with the Credit for Increasing Research Activities. Also, submit the necessary documents as proof.
4. Claim tax credit against payroll
Complete the Form 8974, which is for Qualified Small Business Payroll Tax Credit for Increasing Research Activities. If a startup is found to be eligible for the R&D tax credit, it can claim the incentive against its payroll tax liability or income tax liability.
Keep in mind the quarterly filing dates to ensure that your tax credit is processed at the earliest.
With this, we’ve covered everything there is to know about filing R&D tax credits for startup financials. This comprehensive guide can help qualified startups in availing this excellent tax incentive and reducing their tax burden.