The R&D Tax Credit, & Why Every Startup Wants to Claim It for Up to $250,000
A Message from Pilot:
Many businesses have never heard of the R&D tax credit before, and that’s understandable.
The R&D (Research & Development) tax credit is a corporate tax solution for small and mid sized businesses that incur research and development costs in the U.S. It was intended to encourage American innovation by allowing companies to claim a federal tax credit for qualified research expenses.
For many of Brex’s customers, this is a valuable way to increase cash runway. Companies who qualify are essentially getting “free money” back from the U.S. government for R&D work that they would have done anyway, and have already completed.
The credit has been in existence for decades, but was originally only applicable for use against income taxes. Since startups usually aren’t profitable, they usually don’t owe income tax, and so this credit wasn’t applicable.
As such, few in the startup community were even aware of these credits. However, in 2016, Congress passed a law which allowed the R&D tax credit to be used to offset payroll taxes. This led to a huge spike in interest in the R&D tax credit, and a proliferation of companies offering R&D tax credit services.
We’ll walk you through the essentials of how to get this R&D tax credit for your company.
How do you know whether you can claim this R&D tax credit?
The IRS has a 4-part test that determines if a company’s R&D work qualifies. The 4-part test examines if the work is truly new and improved R&D, which means that simply recreating what another company has innovated doesn’t count. Once that R&D project is deemed to qualify, the expenses that went into carrying out that project (e.g., wages, prototype materials, software hosting costs, patent costs, contractor costs) would be “Qualified Research Expenses” and claimable.
How much of this R&D tax credit can you get back?
You can get back up to $250,000 in R&D tax credits for use against payroll taxes (the social security tax portion) and more than $250,000 in R&D tax credits if you plan to use the credits against income taxes. One quick note here is that if you have been collecting revenue for more than 5 years and/or had more than $5M in revenue in the last tax year, you would no longer be eligible for the payroll tax offset.
Even if you are not currently profitable, you should seriously consider claiming the R&D tax credit if you intend to be profitable within the next 20 years. Once the credit is claimed, it can be carried forward 20 years, and will just roll over each year until you use it.
However, you can’t go back and retroactively claim the R&D tax credits after 3 years have passed for that tax year’s filing date (e.g., in 2021, the furthest back you can claim is likely 2018, unless you had a late filing deadline for 2017 tax year). For this reason, it pays to think ahead, and claim the credit even if you don’t intend to use it right away.
What are some pitfalls you should avoid?
The R&D credit is valuable, but the process to claim it is also quite complex. One of the biggest pitfalls that businesses run into is either trying to apply without help - or getting the wrong kind of help, from an under qualified R&D provider.
What many companies miss when looking at R&D providers is that the U.S. government's R&D tax credit program is a technical one as much as a financial one. It requires a technical justification of your R&D work and how it qualifies per the IRS 4-part test.
This can be a problem if your tax provider does not have the technical expertise to truly understand how your company’s activities do or don’t qualify. If your R&D tax provider makes a mistake on whether you meet the requirements, it can open you up to dangerous liability - you could essentially be claiming unqualified tax credits from the government.
Because of its high value, the R&D tax credit is unfortunately also popular with scammers. As a result, the IRS pays extra attention to tax filings that include it (and in fact, the R&D credit is listed on the IRS Dirty Dozen list of tax scams). So not only are there complex requirements for claiming it correctly, but you’re also more likely to trigger an audit to check that you met them.
What questions should you ask when you research your provider?
1. Technical background. As we’ve covered, the technical aspects of the R&D tax credit can be challenging for people without a technical background. Some R&D tax credit providers do have technical staff for this very reason (including the R&D team at Pilot), so it’s a good thing to ask about when researching your options.
2. R&D Study. As part of R&D tax credit service, your provider will likely provide an “R&D Study” that substantiates your claim. However, these can vary in depth between service providers, so it’s important to ask about what you’re actually getting. Will they produce rigorous documentation for you, at the time you claim the credit?
Will your provider do all of the work for this, or will you be expected to assemble some or all of the study yourself? It’s a good idea to ask for a sample of that report so that you know what to expect, and also for when they commit to delivering it. The study is a large part of what you’re paying your provider to do - make sure you’re getting the right value!
3. Audit experience. R&D claims do unfortunately have a higher chance of being audited. If that happens, your provider should be able to have your back. Ask if the provider has actually gone through an audit cycle before.
Many providers in this space are new, and some may not have real-world experience assisting clients in an audit. What you want in an R&D provider is someone who is able to defend all your claims in an audit, and assist you in resolving any issues with the IRS. This is highly important for you to consider as you choose an R&D provider because ultimately, you are responsible for everything submitted to the IRS.
To recap, the three questions that you should ask R&D providers are:
- What is your technical expertise to justify my R&D claim to the IRS? i.e. how will you know that I’m doing real R&D and not just creating a new website using Squarespace
- What will I get when doing the R&D study? Will you produce rigorous documentation for me and can I see a sample report?
- Have you and your customers gone through an audit cycle before? Even if they have hundreds or thousands of customers, if none of them have been audited before, you should be wary.
Pilot handles back-office needs like the R&D tax credit, bookkeeping, CFO services, and tax prep, to help you focus on growing your business. To learn more about our experienced R&D Credit team, visit us today.