Many founders have never heard of the US R&D tax credit before. Unfortunately, they are potentially missing on up to $250,000 free money. Here’s why.
In this article we’ll explain you what exactly is the R&D tax credit, how it works and whether your startup is eligible. Can your startup take advantage of the federal R&D tax credit? What does it mean for your runway? Let’s dive in!
What Is The US R&D Tax Credit?
The R&D tax credit is a federal corporate tax solution that allows small and medium-size businesses to offset a portion of their corporate taxes with research and development (R&D) expenses.
Historically, the US R&D tax credit was only applicable for use against corporate taxes. Since startups are often unprofitable, especially early-stage startups, they wouldn’t benefit from it. Indeed, no profits, no corporate taxes, therefore no R&D tax credit.
This changed in 2015 with the extension of the law to include payroll taxes as well. This truly is a game changer for most startups, as they can now benefit from the US tax credit.
Therefore, since then startups now can potentially receive up to $250,000 tax credit (free money) that reduces their payroll taxes.
This is all the more important for tech startups as most of their expenses are actually payroll expenses, part of it being payroll taxes. Note here that the payroll tax offset can only be applied to Social Security (6.2% of total wages usually).
Is Your Startup Eligible?
First, you need to figure out whether your startup is eligible for the payroll tax offset. Companies must meet the following qualifications:
- Have been in activity for less than 5 years
- Have less than $5 million revenues in the last tax year
- Conduct qualifying research & development (R&D)
What is qualifying R&D?
The IRS actually provides a 4-part test to help determine if a company’s R&D qualifies. The test assesses whether the R&D actually is qualifying for the tax credit.
If so, any expense related to R&D are claimable. Eligible costs include:
- Wages for employees offering support and research supervision
- Supplies used in research
- Subcontractor expenses (only if the tasks also qualify when performed by an employee). These expenses can include both outsourced labor or research
- Software hosting and infrastructure costs
How Much Can You Actually Get?
If your startup qualifies for the US R&D payroll tax credit, you can get back up to $250,000 in tax credit that you can use to offset payroll taxes or corporate taxes in the future.
Of course, this only applies to corporate taxes (if you have any) and payroll taxes. Again, note that the payroll tax offset can only be applied to Social Security (6.2% of total wages usually).
Yet, even if you’re not profitable, you can still claim R&D tax credit that you can carry forward for up to 20 years!
That’s where most startups miss on significant free money: although the R&D tax credit can only be used for payroll taxes today for loss-making businesses, startups can also carry forward the credit up to 20 years in the future and use it when they become profitable to offset corporate taxes.
R&D / Payroll Tax Credit: A Case study
Let’s use an example with a startup that has only 2 years of operations and the financials below:
|R&D qualifying expenses||$250,000||$500,000|
|(of which payroll taxes)||$49,600||$86,800|
|Net profit / (losses)||$(500,000)||$(200,000)|
First, because the business is in losses, there is no corporate tax. Hence, the R&D tax credit can’t be applied to corporate taxes, at least not today. Instead, the R&D tax credit can be used for payroll taxes.
Assuming the startup has no R&D tax credit today and is filing a claim for the first time:
- They can claim up to $250,000 in R&D tax credit today (the maximum as total R&D qualifying expenses are $750,000 total)
- The $250,000 can be used to reduce future payroll taxes (the $86,800 they already paid for that current fiscal year)
- The remainder of the $250,000 can be carried forward to be used against both payroll taxes, and future corporate taxes (if the business turns a profit, and therefore, incur corporate taxes)
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Why Does It Matter For Your Runway?
Understanding how the US R&D tax credit works, including for loss-making businesses (e.g. early-stage startups) is key. Indeed, if used correctly, the R&D tax credit can save startups up to $250,000 per year, decreasing cash burn and significantly improving cash runway.
That’s why founders should always be mindful of taking into consideration potential US tax credit benefits in their cash flow forecasts.
Yet, don’t be too optimistic either: you can’t reasonably assume all your R&D expenses qualify under the IRS 4-test guidelines if you don’t understand it well. If you’re too optimistic, you might have some bad surprises down the road.
So when it comes to forecasting tax credits in general, make sure to ask your accountant whether you qualify to avoid mistakes.
Note: most startups capitalise a part of their R&D expenses. Indeed, there are clear advantages to capitalise your R&D expenses as a startup. If you aren’t familiar with R&D capitalisation, you might be missing on significant savings. For more information, read our article here.