Does My Business Qualify for the Startup R&D Tax Credit?
You may be able to deduct your startup R&D expenses from your payroll tax or income tax. Read on to learn if you qualify for the startup R&D tax credit.
Would it surprise you to learn that the federal government is on your side when it comes to innovation? Yes, the same federal government that so loves to collect taxes from you is actually ready to give you at least some of that money back, in the form of a particular tax credit.
The reason is simple: the government wants to retain U.S. leadership in the realm of technology. One of the instruments used to incentivize entrepreneurs to innovate is the Research and Experimentation (R&E) tax credit, which allows companies to deduct many expenses directly related to research and development (R&D). As you know, attempts at innovation are typically expensive and often go nowhere. Still, innovation remains a basic ingredient for sustainable growth in most industries. For this reason, the government—through what is also known as the R&D tax credit—helps make it less expensive to take the risks involved with innovation, especially for startups.
A good resource for understanding the details as to how startups can take advantage of this tax credit was published two years ago in The CPA Journal by U.S Re Yair Holtzman, CPA, CGMA.
The article points to three main areas to consider: (1) types of Qualified Research Expenses and the tests they must meet, (2) additional criteria for internal use software and (3) activities that do not fall within the parameters of qualified R&D activities (reproduced below in largely form).
Types of Qualified Research Expenses (QRE):
- Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes).
- Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process.
- Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred.
- Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
To Qualify, Innovation Activities Must:
- be intended to resolve technological uncertainty that exists at the outset of the project or initiative, related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;
- rely on a hard science, such as engineering, computer science, biological science, or physical science;
- relate to the development of a new or improved business component, defined as new or improved products, processes, internal use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business; and
- substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
Additional Criteria for Internal Use Software (IUS):
- The software must be innovative, resulting in a reduction of cost or an improvement in speed that is substantial and financially significant.
- Developing the software involves significant financial risk, requiring the commitment of substantial resources and subject to substantial uncertainty of recovery in a reasonable period of time.
- The software is not already commercially available, i.e.,.the taxpayer cannot purchase, lease, or license and use the software for the intended purpose without having to make significant modifications that satisfy the first two requirements.
10 Main Types of Non-Qualifying Activities:
- Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions).
- Adaptation or duplication of existing business components.
- Surveys, studies, or activities related to management functions or techniques.
- Market research, testing, or development (including advertising or promotions).
- Routine data collection.
- Routine or ordinary testing or inspection for quality control.
- Computer software, except where developed for internal use.
- Any research conducted outside of the United States.
- Any research in social sciences.
- Funded research.
The purpose of the startup R&D tax credit, in Holtzman's words, “is to reward U.S. companies for increasing their investment in R&D in the current tax year. It is available to any business that attempts to develop new, improved, or technologically advanced products or trade processes.” This is exactly what innovation is all about—and if your startup is like most, there is probably a way for you to take advantage of the startup R&D tax credit, to make your innovation more affordable.
For expert guidance, consult with an expert to determine the best way for your company to take full advantage of the R&D tax credit. Why pass up the opportunity to save on developing your competitive advantage in terms of innovation? Uncle Sam wants your company to live long and prosper. Don't disappoint him!
Ardy Esmaeili, CPA, Tax Practice Lead at Burkland, specializing in giving startups smarter finance, accounting and tax advice, to help them grow with confidence. For a free consultation email him at: