The Inflation Reduction Act of 2022, passed August 12, 2022, increases the R&D Tax Credit amount from $250,000 to $500,000. We will update our website’s content in the coming days. Visit our already updated R&D Tax Credit Calculator to estimate your startup’s possible tax credit under this new legislation.
The research and development tax credit is a US government-sponsored tax incentive that rewards companies for conducting research and development activities within the United States. Even unprofitable technology startups can use this incentive to reduce their burn rate. Kruze has helped clients reduce their burn rates over $40 million through our work on this government incentive program.
We’ll explain how this program works, and how your startup can offset your expenses up to $250,000 a year (doubled to $500,000 starting in the tax year 2023). And if you are interested, contact us now to see how we can help your business!
Caveat: The information on this page intended as general guidance and it doesn’t substitute the need to work with a professional. It’s also a high level overview and is in no way complete. Your company is unique, contact Kruze Consulting.
It may seem counterintuitive that a company that is losing money pays taxes - but in the United States, taxable income isn’t the only way that a business pays the IRS. All companies with employee payroll in the US pay payroll taxes - and updates to the tax code now allow unprofitable, technology and biotech startups to reduce the payroll taxes they pay up to a quarter of a million dollars a year.
Unprofitable companies with qualified research expenditures in the US can now use those qualified expenditures as credits to reduce the amount of payroll taxes they pay - reducing their burn rate.
Visit our R&D Tax Credit Calculator to estimate how much your company can save.
There are very specific deadlines for the filings required to get this federal credit. Working with a qualified CPA is very important, to both avoid missing paperwork deadlines and forfeiting the benefit - and to reduce the liability that the company (and founders/directors) will take on. Remember, the IRS likes to get paid, so if your startup finds a way to pay less in payroll taxes, you’d better have followed the rules and executed the filings correctly so that you’ll survive an audit!
Here are the basic steps:
Find a qualified CPA
In order to claim this payroll taxes offset, the business needs to conduct an R&D tax credit study. Work with an experienced CPA to minimize the risk of an audit, which can take up valuable founder’s time. And most tax CPAs will not accept a study conducted by a non-CPA, as it puts tremendous liability risk onto your tax preparer. Learn more about why the best CPA’s won’t take a third-party tax credit study.
Claim the credit on the annual tax filing
The business’ tax CPA will use this study to claim the credit on the company’s annual returns. This needs to be done prior to finalizing and filing your annual return.
Instruct the payroll provider to get the credit
The company’s payroll provider can then be instructed to reduce the company’s payroll taxes.
Monitor payroll provider for execution of the credit
Every payroll provider has a slightly different way to do this, but Kruze Consulting has helped startups’ using the most popular payroll providers, and has the experience to get this done smoothly.
Not every startup is a qualified small business in the eyes of the IRS, and not every R&D expense “counts” toward this program. The government expects that your CPA will follow the internal revenue code to confirm and document that your company, and expenses, count toward this credit. Remember, you are “taking” money from the IRS, so your chance of an audit is real. If you don’t feel confident in your preparer’s experience, reach out to us and we’ll see if we can help you!
First, what does the IRS consider qualifying expenses? The basic premise is that your startup must be creating something new - no tinkering. The IRS has a four part test:
Quick aside: R&D activities that don’t qualify
Not all expenses qualify. You should work with an experienced CPA to make sure your scientific and technical expenses work for the deduction, but here are some examples of expenses that do not qualify:
Traditionally, only companies generating income were eligible for R&D tax credits. However, the PATH Act of 2015 now allows unprofitable startups to also take advantage of this program. Contact us to find out if your company qualifies.
Under new requirements created by the IRS, startups that claim research and development tax credits will need to document how each activity meets the IRS qualifications. Beginning in 2022, the new documentation requirements will need to be submitted when filing an amended tax return refund claim for the R&D tax credit.
To substantiate your startup’s R&D claim, you will need to document:
These new requirements are a significant burden for startups, and you should consult an R&D tax professional.
Many states have incentives to drive technology innovation. However, not all of these are designed for early-stage startups - check with us or your CPA to see if your company can take advantage of these incentives.
This is for informational purposes only - state credit data changes often, so check with your CPA for current incentives.
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Filing for the the research and development credit can reduce an early-stage company’s burn rate by up to $250,000 per year. This amount will double to half a million per year for the tax year 2023. 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:
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:
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):
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.
Any company that develops new or improved products, processes, or software could qualify and be eligible to claim the R&D tax credit. And this incentive isn’t just for big companies with huge R&D departments. Startups and small businesses that aren’t profitable can benefit from the credit – but how do you get the money? The incentive is first used to offset income taxes, if your startup owes them. That’s not too likely in a startup’s early days. If you’re not profitable, the credit can be used to offset your payroll taxes.
For the 2021 tax year, which you will file in 2022, you’ll want to begin working on calculating the amount as soon as your 2021 books are closed. When your CPA has calculated what the amount will be, they will add it to your 2021 annual corporate form 1120 and file the return. 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. The cap doubles to half a million for the tax year 2023. However, early-stage companies likely do not spend enough on qualified research and development - our clients, on average, get about $50,000 to $60,000 per year.
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.
The best research and development tax firms are CPAs - Certified Public Accountants who are trained in the tax code and who are legally allowed to perform tax services on behalf of their clients. CPAs who know startup taxation are best, as these credits do raise the risk of an audit by the IRS. And CPAs like Kruze Consulting know how to help guide tax due diligence if a startup is getting acquired by a major public technology company.
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