Fernway DiarySM

Aug 16, 2021

Here’s everything you need to know

The R&D tax credit can be a powerful tool for startups, especially in the technology space. Due to the prior limitations and recent changes, often startups are not aware of the benefits and applicability of this credit.
Let’s take a look at what the R&D tax credit is and how it could impact your business.

What is the R&D tax credit?

The research and development tax credit has been around for decades, but has recently become increasingly relevant for early-stage startups. It is intended to encourage and incentivize medical, scientific, and technological innovation to help the economy grow. Originally, it was designed as an income tax credit to help offset the costs of research and development projects, which is still true today.

Unfortunately, most early-stage startups are pre-revenue, or even operating at a loss. These startups were previously unable to claim any immediate tax benefit from the R&D credit.

Thankfully – with startups comprising a large part of the innovation economy – the R&D credit provisions have been given a makeover. In its newer form, even early-stage small businesses can instantly utilize the R&D credit as a payroll tax offset.

What if I don’t have revenue yet?

The lack of revenue is no longer a precondition with the R&D credit, as long as you’re a qualifying small business. Instead of claiming the credit against revenue (and having to wait several years to fully utilize it), you can now claim the credit as an immediate payroll offset even if your business has not generated any revenue.

The payroll tax offset option is a powerful change for the R&D credit, as it can provide a maximum benefit of as much as $250,000 per year without taking on burdensome debt or dilutive equity financing. If you qualify for this credit, it is essentially free government support to help you drive innovation or develop new technology.

Am I a qualifying small business?

In order for your startup to claim the R&D credit as a payroll tax offset, your business should meet a few simple criteria. In general, your business should generate less than $5M in annual revenue and it must be less than 5 years since your first gross receipts were recognized.

For most startups, the above criteria is not difficult to achieve and will likely be an easy fit. So, what happens if you’ve been operating longer or generating more revenue than this? If you’re researching and developing new innovations but your business itself isn’t new enough to meet this criteria, you can still claim the credit as an income-tax credit rather than a payroll tax offset. If you can’t use the entire credit, you can roll it forward to future years. If your business is in a loss position, you can create a deferred tax asset.

Although it may seem like a good idea to wait until your business is more established, the earlier you claim the R&D credit the better. You can only go back and amend for 3 years, which may lead you to lose out on early R&D costs by the time you become profitable. On the other hand, if you claim the credit right away, you can carry it forward into future years until the entire balance has been used up.

What activities qualify for a credit?

Determining what is and isn’t a qualifying R&D activity is crucial to making the most of this credit. There are four essential elements to a qualifying activity:

• It must relate to a new or improved business component you’re developing
• It must be technological in nature
• It must be intended to eliminate uncertainty in your new area of development
• It must involve a process of trial and error or scientific methodology

Put simply, your R&D project should be geared towards developing and testing a new product or process, or improving existing ones. The project needs to be directly related to researching and testing that new component of your business, in a measurable way, in preparation to bring it to market. It does not, however, need to be successful in bringing it to market. If you spend money on R&D only to discover you need to go a different route, your spend on the failed product still qualifies, as long as it meets the above requirements.

How much credit do I qualify for?

Calculating the Research & Development tax credit can be complicated, and should be done by a licensed CPA experienced in advising early-stage technology startups. The size of your credit would be based on the amount spent towards R&D initiatives, including wages, subcontractor expenses, and supplies. Based on these expenses, your CPA can calculate the credit, up to a maximum of $250,000 per year.

While most startups in the technology space are great candidates for R&D tax credits, working with an expert will help ensure regulations are applied accurately and drive the above analysis and application process effectively. Fernway Solutions has the expertise and experience to help your startup prepare for the R&D credit and other tax planning strategies. For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:
The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.