How to account for the R&D tax credit
Unlock your startup’s cash flow with the R&D tax credit!
Don’t leave money on the table – we can show you how to handle the accounting and claim every dollar your startup deserves. Companies that correctly account for their research expenses can earn a tax credit that’s applied against payroll taxes – and that can free up valuable cash your company can use to establish itself and build a marketplace. Here’s a step-by-step guide on how startups should handle documenting and booking their R&D tax credits
Summary
How to set up your accounting processes to claim the R&D tax credit
- Identify your startup’s qualifying R&D activities.
- Determine which expenses are associated with your R&D projects.
- Use time-tracking software to record employee time spent on R&D activities.
- Add appropriate categories and codes to your general ledger to help you identify R&D expenses.
- Use project accounting to track R&D expenses as they’re incurred and categorize them to the appropriate R&D project.
- Consult a CPA to make sure your R&D documentation process conforms to IRS standards and can be defended in an audit.
How to record your R&D tax credit in your general ledger
- First option: Apply the credit as a lump sum. This isn’t recommended.
- Second option: Use accrual accounting and put your credit in a tax receivable account.
- Apply the credit against your quarterly payroll tax by debiting your payroll tax payable account and crediting your tax receivable account.
- If you use a company that offers an advance on your tax credit (not recommended) you need to treat it as debt.
While the tax credit can be used against either income tax or payroll taxes, most startups will choose to use it against payroll taxes, since startups generally don’t generate income during their early growth stages. To do this, your startup will need to make an annual election to use your R&D tax credit against payroll taxes when you file your tax return, by completing Section D of IRS Form 6765, as well as Section A or B.
Starting with the 2024 tax year, the IRS is requiring more complex documentation for R&D expenses to claim the credit. The credit is documented using IRS Form 6765, and the new requirements include breaking out qualified research expenses by project, and breaking out the wages of company officers in the qualified research expenses.
That means that startups need to establish a detailed documentation and accounting process that clearly identifies and substantiates their qualifying research activities and associated expenses.
Identify your startup’s qualifying activities and expenses
The first step is understanding what activities qualify for the R&D tax credit. To do that, you’ll need to make sure the project meets IRS four-part test for eligibility:
- Permitted purpose. The activity aims to create new or improved functionality, performance, reliability, or quality of a business component.
- Elimination of uncertainty. Efforts to eliminate uncertainty about the capability, method, or appropriate design of a product or process.
- Process of experimentation. Systematic trial and error or other scientific methods to resolve technical challenges.
- Technological in nature. The activity relies on the principles of physical or biological sciences, engineering, or computer science.
Once you’ve identified your R&D projects, you’ll need to document your qualified expenses. Qualified expenses generally involve:
- Wages. Compensation to employees directly involved in R&D.
- Supplies. Costs of materials and supplies used in R&D activities.
- Contract research.Expenses paid to third-party contractors conducting R&D on your behalf.
- Computer rental costs. Expenses related to cloud computing or server rental for software development.
Maintain detailed and current documentation on your startup’s research
Documentation should be contemporaneous, meaning it’s created at the time the research activity occurs. Types of documentation you may need include:
- Time-tracking records for employees involved in R&D.
- Project notes, meeting minutes, and design documents that describe the research process.
- Prototypes, test results, and trial runs showing experimental activities.
- Invoices and receipts for all materials, supplies, and services purchased.
Tracking all this information requires organization and a lot of attention to detail. Some of the things you’ll need to do include tracking time, R&D expenses, and implementing a project accounting process.
Establish a time-tracking system for R&D activities
Accurate tracking and documentation is crucial when you’re filing for the R&D tax credit. A time tracking tool will help your staff log and document research activities more easily. Many are low-cost or even free. Without a tracking system, you’ll need to have employees write down activities and time spent on a daily or weekly basis – waiting longer than that might mean that some tasks get overlooked or miscategorized. Startups should:
- Choose a time-tracking software tool that fits your needs and budget.
- Make sure the tool can track time by project, task, and employee, and integrate with your project management and accounting software.
- Set up unique project codes for R&D projects, and establish any tasks or sub-categories that fit under that project, like “prototype development” or “software testing.”
- Make sure your employees log hours against these specific project codes to differentiate between R&D and other activities.
You should probably establish a time-tracking policy that emphasizes the importance of tracking R&D tasks accurately, and provide your team with training on how to log hours, select project codes, and submit their time. Regularly review the time reports to make sure employees are logging time and there aren’t any discrepancies. Remember, the more accurately you’re tracking R&D activities, the easier it will be to maximize your R&D tax credit and defend your claim against a possible audit.
Set up your accounting system to track R&D expenses
Project accounting is a specialized accounting method that helps startups monitor the costs of specific business projects. Project accounting is more detailed and granular than overall financial reporting, so you may need to make adjustments to your accounting methodology if you’re not already using project accounting. Here’s a rundown of what you need to know:
- Select the right accounting software. You’ll need software that supports project-based accounting and integrates with your time-tracking tool. QuickBooks Online is a popular choice for startups and it supports project-based accounting.
- Create an R&D category in your chart of accounts (COA). This will help you to segregate R&D expenses from other operational spending. You’ll probably want to create sub-accounts in your R&D section for the different types of expenses, like R&D salaries and wages, R&D supplies and materials, R&D contract services, and R&D overhead.
- Establish an R&D expense approval process. Your process for approving and recording R&D expenses should include creating expense reports for all R&D activities, managerial approval, and storing expense documentation like receipts, invoices, and contracts.
- Allocate indirect costs to your R&D projects. Overhead costs that can be reasonably attributed to R&D, like rent for lab space, utilities, cloud computing, or depreciation of R&D equipment should be allocated to the appropriate projects.
Properly setting up your accounting system and creating dedicated general ledger accounts will make it easier to pull detailed expense reports when preparing your tax return or defending a claim during an audit.
Getting the R&D tax credit check
Receiving the check from the US Treasury is exciting, but that’s just the first step. That rebate check or deposit needs to be entered into your income statement, and that can be applied to your payroll tax account in a couple of different ways.
Apply the amount as a lump sum
This would normally be done in cash basis accounting, and it will essentially turn the payroll taxes paid in a given month negative, which does look a little odd. For example, a company may pay $25,000 in payroll taxes per month, but their rebate check was $40,000. The payroll tax expense line item on the income statement will turn negative. That can be disruptive to financial modeling and projections.
Use a tax receivable account
We prefer accrual accounting at Kruze Consulting, because it’s usually better for startups. With accrual accounting, your company will have a tax receivable account that shows the total balance of your R&D tax credit on your balance sheet. As you receive tax credit checks or deposits start coming in, they get applied to that receivable account. That receivable will be reduced as you collect those checks. Simultaneously, you will have an accrual on your income statement that applies part of those funds to your payroll taxes. This “smooths out” that benefit, so your company has smaller adjustments every month, which is more accurate and easier to understand.
Here’s an example of how the journal entries would look. For this example, assume the startup has an R&D tax credit of $100,000 and a quarterly tax liability of $25,000.:
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Recognizing the R&D tax credit. Once your startup is eligible for the tax credit, you should recognize it as a receivable.
- Debit: R&D Tax Credit Receivable (Balance Sheet) $100,000
- Credit: R&D Tax Credit Income (Income Statement) $100,000
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Applying the R&D tax credit to your quarterly payroll tax liability. As you apply the tax credit to your payroll taxes each quarter, the journal entry will reduce the payroll tax liability and the R&D tax credit receivable.
- Debit: Cash (Balance Sheet) $25,000
- Credit: R&D Tax Credit Receivable (Balance Sheet) $25,000
- Repeat until the credit is fully utilized. Since the credit is $100,000 and the quarterly payroll tax liability is $25,000, it will take four quarters to fully utilize the credit.
A third option would be to book the R&D tax credit like other income and expenses. We don’t recommend that option. Accounting for the credit on an accrual basis will reduce your payroll taxes evenly over a set time period, like six or nine months. It’s easier to understand and explain to your board, and you’ll get that rebate each month, giving you more money to reinvest in your company.
Accounting for R&D tax credit advances
Some startups work with providers who advance a portion of the R&D tax credit every month. We don’t generally recommend this, as these providers are incredibly expensive. Additionally, venture capitalists tend to view companies that need this credit advance as ones that are on the ropes – it’s a clear sign that your company is having problems raising capital. However, if you have one, how do you account for it on the balance sheet?
An R&D tax credit advance should be accounted for as debt – you will owe a portion of this to the company that is providing the loan to your business. To account for this:
- As you receive the cash, debit your cash account and credit your accounts payable.
- Once you file for your R&D tax credit, you would debit your accounts payable and credit federal income tax payable.
- After you collect the tax credit, then you would move it to the federal income tax expense or provision account.
Talk to an R&D tax credit expert
Having a well-organized system that provides clear records of R&D activities, costs, and the rationale for claiming the credit will support your claim. It’s important to work with a tax advisor or CPA firm that specializes in R&D tax credits for startups, like Kruze Consulting. The right partner will make sure your documentation and accounting processes meet IRS standards, and maximize your claim. And they’ll stand by you during an IRS audit of your R&D credit claim..If you have more questions about the R&D tax credit, contact us.
