The R&D tax credit is one of the most valuable tax incentives available for startups, offering potential savings of $500,000 or more per year.
Designed to reward innovation, this credit can help offset the costs of developing or improving products, processes, software, or other technical advancements. Eligible expenses can include wages for technical staff, costs for supplies used in R&D, and certain contracted research services. For early-stage startups, the credit is often applied as a payroll tax offset, providing much-needed cash flow relief.
To help your startup navigate the process, I’ve put together the following list of common R&D tax credit misconceptions that can make it difficult to identify eligible credits or lead to unnecessary challenges along the way.
4 Common Misconceptions About the R&D Tax Credit
1. Underestimating What Qualifies:
Many startups mistakenly believe their activities don’t meet the innovation threshold for the R&D tax credit. However, the credit isn’t reserved for groundbreaking inventions—it also applies to efforts that improve functionality, performance, reliability, or quality through a process of experimentation. For example, a digital marketplace startup I worked with initially assumed they had no qualifying expenses since being a marketplace isn’t inherently innovative. However, the unique features they developed for their platform qualified them for over $150,000 in R&D tax credits. The key takeaway? Don’t underestimate your potential to claim this valuable credit. Since you’re required to track and categorize R&D costs regardless of whether you claim the credit, you’ve already done much of the groundwork. Why not take the next step with a tax credit analysis to determine your eligibility and unlock potential savings?
2. Assuming Your Startup Must Be Profitable:
Startups often think they need to be profitable or owe taxes to benefit from the R&D tax credit. In reality, early-stage companies can use the credit as a payroll tax offset during their first five years, making it accessible even for pre-revenue businesses. For startups with less than $5 million in gross receipts during the current tax year—and no gross receipts for any tax year more than five years prior—the R&D tax credit can directly offset up to $500,000 of payroll taxes annually. This means even pre-revenue businesses or those operating at a loss can receive tangible financial benefits from the credit.
The R&D tax credit is also highly beneficial for profitable companies, as it directly offsets tax liability on a dollar-for-dollar basis. Additionally, the qualification thresholds are less restrictive—for instance, your company can be more than five years old and generate over $5 million in revenue. This makes the R&D Credit an excellent opportunity as your business progresses further into its lifecycle.
3. Counting International Workforce Costs:
The R&D tax credit has strict geographic requirements, which can often catch businesses by surprise. While international collaboration is a key part of many modern startup operations, the costs associated with outsourcing R&D activities to international teams do not qualify for the credit. The IRS mandates that only expenses incurred for research activities conducted within the United States are eligible.
Remember, the R&D tax credit is intended to incentivize domestic innovation and job creation. By restricting eligibility to U.S.-based research activities, the credit ensures that taxpayer funds support the American economy and workforce.
4. Expecting Immediate Payroll Credits After Filing:
Claiming the R&D tax credit involves more than just filing paperwork with the IRS—it requires additional steps to ensure the benefit is realized, particularly for early-stage startups using the credit as a payroll tax offset. After you’ve successfully calculated and documented your qualifying R&D expenses and prepared your tax return, you’ll need to coordinate with your payroll provider to apply the credit.
How the Process Works:
- Elect the Payroll Tax Offset on Form 6765: Eligible startups—those with less than $5 million in gross receipts and no gross receipts more than five years ago—can elect to apply the credit against payroll taxes.
- File Form 6765: This form is submitted with your federal tax return to calculate and claim the R&D tax credit.
- Coordinate With Your Payroll Provider: After the IRS processes your tax return and approves the credit, you must inform your payroll provider to integrate the credit into your payroll tax filings (Form 941). Without this step, the credit won’t offset your payroll tax liabilities.
The IRS applies the R&D credit to reduce payroll tax liabilities quarterly, based on the information submitted through your payroll provider. If this coordination does not occur, the credit cannot be applied, and your startup may miss out on cash flow savings.
As we head into 2025, the Section 174 capitalization adjustments introduced by the Tax Cuts & Jobs Act (TCJA) of 2017 remain in effect. This means that R&D expenses can no longer be deducted immediately but must be amortized over five years for domestic expenses and fifteen years for international expenses.
Don’t Miss Out: Take Action Today
The IRS has placed a strong focus on ensuring R&D tax credits are claimed appropriately, creating both an opportunity and a challenge for startups. The key to success is crafting a robust, well-documented claim—and that’s where hiring a tax expert can make all the difference. At Burkland, our experienced tax team specializes in helping startups navigate these complexities and maximize their R&D tax credit claims.
Don’t leave valuable incentives on the table. Contact Burkland’s tax team for a personalized R&D tax credit analysis.