R&D Credit: One of the biggest tax credits small business owners could get
In terms of R&D (Research and Development) tax credit, large corporations, like SpaceX, Pfizer, and many others have received millions of dollars of the tax credit from the U.S government. However, large corporations are no longer the only group that could be benefited from R&D credit. The tax laws have made further changes to the tax credit that most small businesses are able to get the R&D credit.
You are correct. Small businesses like yourself, and the other startup and newly formed companies in your neighborhood could get the R&D credit. In this article, we only focus on small businesses and how could they get the tax credit.
How do you define small businesses that are qualified for R&D tax credit?
In term of R&D tax credit, a qualified small business is defined as any company with no more than 5 years of revenues and less than $5 million in the current year of revenues with qualifying research activities and expenditures.
In general, any startups with employee payroll that engage in research or technology development is a good candidate. It would be another bonus point if the startups often operate at a loss, because they can use the credit to enhance additional cash flow.
How do you determine if my small business is eligible for the R&D tax credit?
Eligibility depends largely on whether the work a company does meets the criteria established by a four-part test set forth in the Internal Revenue Code (IRC)
1. Qualified purpose - An activity intended to develop new or improved business component
2. Elimination of uncertainty - An activity intended to eliminate technical uncertainty concerning
3. Process of experimentation - A company must demonstrate in a method to show that it has evaluated one or more alternatives for achieving the desired result
4. Technological in nature - The process of experimentation must rely on the hard sciences, such as engineering, physics, chemistry, biology, or computer science
Which costs qualify for the R&D tax credit?
Any qualified expenses that meet the above 4 part test. For instance, salary and wages for employees who perform, support, and conduct the R&D activities, supplies, hardware and software purchase for the research and development, and others.
Which costs do not qualify for the R&D tax credit?
There are certain costs that will not qualify. For instance, research conducted outside of the U.S. research that is being done by a third party for which the business has no rights, and/or has not paid for, market research, training, and customized product or service for specific customers.
What documentation is necessary to claim the credit?
To claim this credit, qualified small businesses must evaluate and document their research activities contemporaneously to establish the amount of qualified research expenses paid for each qualified research activity. While taxpayers may estimate some research expenses, they must have a factual basis for the assumptions used to create the estimates.
Some common supporting documentations are payroll records, general ledger expense detail, research report, research note, and video or written record of research and development meeting.
How to receive the tax credit?
Small businesses can use the R&D tax credit in 2 major ways. First, qualified small businesses can claim tax credits for research expenses, and the tax credit would offset the tax liability. Second, if the qualified small business doesn’t have a tax liability, the credit can be used to offset the FICA portion of payroll taxes up to $250,000.
I have met all the requirements, so how to claim the credit?
You can follow the instructions and complete the IRS Form 6765, Credit for Increasing Research Activities to determine the credit amount and submission. For small businesses you must also file Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities; this will be filed once the IRS has approved your credit.
Also, small businesses would need to attach form 8974 with form 941 when it is filed.
***Case study: Startup Technology company saves $180,000 with the R&D Tax Credit ***
This case study is based on a real client that we have worked with. However, our clients’ confidentiality is of utmost importance to us. It would be an example of an actual company that is saved in tax by using our tax strategies.
ABC Inc is a Technology startup formed in 2019. The tech company worked on developing a software for businesses to use in the hospitality industry. Throughout the developing process, they spent over $300,000 in overall costs, and they have had a net loss since the first year of operation.
They have accumulated a good amount of NOL (Net Operation Loss) from the past year, so they have no worries about the tax liability for future years. However, they didn’t realize that they are qualified for R&D credit, and the R&D credit could offset the FICA portion of the payroll tax.
85% of their expenses are for salary and wage to software engineers and UI/UX designers, and the FICA they paid is almost $78,000 per year.
I have been working with the owner of ABC Inc for a few year, and I truly understand his business model and the product that he has been developing, so I adviced him that his company could get a R&D credit from the Federal and State. The credit can save him from the payroll tax that he have been paying for his employees.
ABC Inc has an unorganized bookkeeping system at that time, because they grouped all the payroll costs and salary together, so it is difficult to identify which portion of the payroll is for research and development, and which portion is for consulting. Same for the supplies, cloud hosting, and software cost, they are all grouped into one account. Therefore, the first challenge is to break down everything in detail in a very clear way to identify what the exact cost is for research and developing, consulting, and daily operation.
Our bookkeeping team helped them to break down every category of expense and prepared the financial statements in GAAP (Generally Accepted Accounting Principles). With accurate financial statements, I was able to analyze and figure out the qualified cost for R&D credit.
Finally, we helped them to prepare the requested documentation for claiming the credit, including payroll reports, state and federal tax returns, and project lists. As a result, ABC Inc received $180,000 in tax saving from payroll for 2020, 2021, and 2022. The saving has fastened ABC Inc’s development, because they added a few additional staff to finalize the software.