While other portions of the Inflation Reduction Act have garnered more media coverage, startups, particularly those involved in technology or biotech, should pay particular attention to the news around the expanded research and development tax credit benefits for startup companies.
Previously, the tax credit allowed eligible early-stage companies to use up to $250,000 of their research and development (R&D) tax credit to offset a portion of their federal payroll tax liability. This allows for startup companies without an income tax liability to quickly monetize their R&D tax credit.
Now startups with less than five years of revenue under their belt and less than $5 million of revenue in the tax credit year may be eligible for double that amount come 2023 — a $500,000 annual cap to put towards payroll tax. This is great for technology or biotech startups, among many others, so let’s expand on the credit and who may qualify.
What is the research and development tax credit?
The R&D tax credit, also alternatively known as the research and experimentation tax credit, is offered to companies who have costs associated with research and development. The purpose of the credit is to encourage innovation, particularly from newer companies.
Who qualifies?
Although technology and biotech startup companies will want to be first in line to apply for this tax credit, more businesses qualify for it. If a company continually manufactures, researches or engineers new processes and products, they may qualify.
Businesses that design and develop product alternatives or more efficient designs may also be eligible. As are companies that improve techniques, formulas, inventions or software. Companies that employ engineers, scientists and software programmers may also be eligible. Beyond wages paid to in-house R&D employees, there are several other eligible expenses that the credit can be applied towards, including contract R&D as well as certain supplies used in R&D.
What type of research does not qualify?
While many companies qualify for this tax credit, there are some exclusions that might be tricky for businesses to navigate on their own without the guidance of an experienced CPA. Not all research and development activities or expenses qualify, which is why it’s vital that you work with a CPA experienced with the R&D tax credit to ensure your specific technological or scientific expenses are covered.
For example, the following expenses do not qualify for the R&D tax credit:
- R&D funded through government grants or other subsidies.
- Research and development performed outside of the U.S.
- Computer software meant for internal use.
- Duplication or adaptation of existing business components, or surveys and studies.
There are other expenses and types of R&D that also aren’t covered by this credit, which is why a thorough review of a company’s total research efforts and research expenses is key to maximizing their possible credit.
How can you tell if you qualify?
The IRS provided a four-part test so startups could check whether they qualify for the program:
- Qualified purpose is the first on the list, which requires that the project worked on by your R&D department be specific and defined, not just tinkering around for science’s sake.
- The next part is elimination of uncertainty. Your team can’t just prove knowledge that already exists, their work must contribute to actual scientific advancement that may or may not have the intended outcome.
- The third part requires research to be conducted via a real scientific process. The scientific method or another process that evaluates different methodology or solutions both qualify.
- The last test is whether the research is technical or not. In other words, marketing surveys or other non-scientific work do not count toward the R&D tax credit.
Despite reviewing this test, some businesses may struggle with deciding if they qualify or determining just what parts of their R&D expenses apply to the credit calculation. For example, a startup behind a mental health app may be able to use the R&D tax credit towards their software developers, but maybe not towards the psychologists who also worked on the app. Again, this is where an experienced CPA’s guidance would prove invaluable.
How can you prove that your research qualifies?
Strengthen your proof for the IRS by documenting any patents or intellectual property that came about as a result of your research. If you’ve already secured funding from investors, that can also serve as proof that your research is a new and innovative technology. Investors wouldn’t have invested in your company in the first place unless you proved that your product is a new form of software or hardware that can provide a significant financial return. You can also use the pitch deck you used to secure that venture funding for your project as documentation for the IRS.
Anders CPAs + Advisors works with startups and entrepreneurs on their financial needs so they can focus on what they do best. Learn more about the Anders Startup Group to discuss capital raising options for your startup.
Every day at Anders, we serve as a catalyst for those striving to achieve their highest potential and carry this mentality on to our clients and community. Through a collaborative approach and a combination of tax, audit and advisory services, we help our clients achieve their goals.
Dave Finklang has specialized experience in tax planning and compliance, startup services and consulting, and accounting services. As a leader of the firm’s startup practice, Dave enjoys working with entrepreneurs and emerging companies, helping them raise capital, structure their businesses, implement accounting systems and minimize their tax burdens.
