Research and Development Tax Credit

Filing for the the research and development credit can reduce an early-stage company's burn rate by up to $250,000 per year. It makes sense to work with a good CPA who is experienced with US R&D work, as the documentation requirements are more complicated that a typical return - and the audit risk is real.

Section 382 is a part of the IRS code that the IRS created 20 or 30 years ago to try to limit how corporations could use their net operating losses to reduce their profits.

This is a difficult calculation, and we do not recommend you try to do a Section 382 calculation on your own. ANd startups really ought to work with a CPA who knows early-stage businesses, because part of the calculation involves looking at your company’s capitalization table. Unless your accountant works with venture-backed companies, they are going to have problems applying Section 382 to your VC backed cap table!

At a high level, there are 3 items or “triggers” to Section 382.

If you become profitable. You are going to want to start using your Net Operating Losses (NOLs) - so contact us or a CPA who knows early-stage companies.

If you are getting acquired. If a big company is buying your business, they are going to want to use those NOLs, and those NOLs have real value. You are going to want to capture those, so again, get a good accountant to help you. On average one to three of our clients are acquired each and every month, so we know how to negotiate with public company tax teams!

If you are liquidating some of your assets, you probably have valuable NOLs.

Watch the video to learn more.

Not all scientific or engineering expenses are considered qualified research expenditures. So it makes sense to work with an experienced preparer so that you count all qualifying activities. Remember, the goal of the incentive is to drive scientific research in the United States, so your expenses should be in the US. The IRS has a 4 Part Test that defines qualified research expenditure:

• Specific: Also known as the "The Business Component Test." The project must be defined and geared toward creating a product, process, formula, code, etc. that will benefit the business.
• Eliminate uncertainty: must be contributing real scientific advancement, not just proving existing knowledge.
• Experimental: a qualified research activity must be conducted as a real scientific process, either through a scientific method or through a process to evaluate different methods/solutions. The good news is that most software research can be classified in a way that fits this particular requirement
• Technical: surveys and other non-scientific work do not count.

Yes. The IRS does not consider all scientific, coding, development etc. expenditures by corporate taxpayers to be qualified research expenses. These are a few of the research expenses that your company likely undertakes that can not be included in the calculation:

• Research after commercial production.
• Adaptation of existing business components.
• Duplication of existing business component.
• Reverse Engineering.
• Surveys & studies.
• Computer software for internal use.
• Foreign research.
• Research in the Social Sciences, Arts, Humanities, etc. Funded research.

What goes into the calculation of an research and development expense to capture the incentive in the US? The internal revenue code has specific definitions of constitutes research activity, but we've found that most companies will have four major types of qualifying expenses. If you think you have other research expenses that are not on this list, contact us and we can help you see if there is room in the internal revenue code for your R&D efforts.

Wages/Salaries. This is the largest component for most companies that we work with. There are some nuances to which salaries count - for example, it's important that the employee expenses used in this calculation are engaged in scientific work.

Contractors. US-based contractors only, and again, only ones who are engaged in qualified research activities.

Supplies. This includes the hardware and other materials that goe into what you are developing.

Computer leases. This is not as typical, but some eligible small businesses have particular computer expenses that can be included.

There are a number of expenses that are typically classified as "research and development" on a company’s income statement that do NOT qualify under this tax credit. Here is a list of activities that do not qualify (remember to consult with your CPA, as your company’s particular circumstances may be unique):

• Research after commercial production, or after you’ve brought the product to market and/or begun collecting revenue.
• Adaptation or duplication of an existing business component.
• Reverse engineering of an existing product.
• Surveys & studies to see if an existing product works or if there is a market for the product—these fall into a market research/quality assurance and testing bucket .
• Efforts related to style, taste, and cosmetic or seasonal design factors.
• Computer software created exclusively for internal use inside the business.
• Work conducted outside the United States, including any teams located abroad including engineers who are overseas contractors. These workers may be dedicated fulltime to the company, but you cannot include their work in the calculation.
• Research in the Social Sciences, arts, humanities, etc. So if you’re developing, say, a new mental health app (which has a clear basis in psychology) the engineers you employ to build the app would be part of your R&D tax credit allowance, while the psychologists developing the content would not.
• Funded Research. Many startups receive funding from public organizations such as NIH, SBIR, NSF or DOD as well as grants from universities. These funded projects cannot be included in the tax credit.

VC backed startups should work with a CPA firm to prepare a research and development tax credit study. While there are non-CPA firms that claim to only work on these studies, when a company is audited or gets acquired by a large public company (the typical exits for VC-backed startups), the tax credits will be heavily due diligenced by competent tax CPA and/or attornies. So a business that is aiming for a big exit should make sure they work with a partner who has experience helping startups go through due diligence.

The first step is to file the Tax Credit on Form 6765 (Credit for Increasing Research Activities) which is a part of your annual corporate form 1120 (US Corporation Income Tax Return). Then claim your research and development credit on payroll tax form 941 (Employer’s Quarterly Federal Tax Return). Your payroll provider will have to be involved. This is another reason to work with a good CPA, as Kruze has noticed mistakes made by our clients’ payroll provider and has been able to help our clients get the payroll tax deductions they deserve.

For the 2019 tax year, which you will file in 2020, you'll want to begin working on calculating the amount as soon as your 2019 books are closed (or as soon as your 2020 books are closed for the tax year 2020 returns). When your CPA has calculated what the amount will be, they will add it to your 2019 annual corporate form 1120 and file the return (and if you are working on the 2020 tax year's return, they will add it to that filing). In the quarter following your 1120 filing, you can start applying those the credits to your payroll taxes.

A company can capture ~10% of eligible R&D costs, up to $250,000 per year, for 5 years. That may represent a meaningful improvement in cash flow!

Yes. In the United States, a "taxpayer" - i.e. your company - doesn't need to be net income positive, have taxable income (or generate cash flow/profits) to capture this research tax credit. That means that your Form 1120 can show no tax liability, but your company may still be eligible. The most important component to be an eligible small business is to engage in the "qualified activities."

Yes! Documenting any patents or IP that emerge as a result of your project can serve as strong proof that you’re doing something new and scientific that has been signed off on by an unbiased third party. And the fact that you’ve raised VC funding is also proof that the development project is indeed new technology, since VC firms specifically look for new software or hardware and wouldn't write a check if you were just recreating an existing product. In fact, any pitch deck that you use to secure venture funding for a research and development project is an excellent source of written documentation for the IRS. Any financial model you include in a deck can also strengthen your proof of a clear plan for the work, indicating what the projected spend will be, over what time period, and when a product will likely be ready to bring to market.