Research and Development Tax Credit

Can your firm save up to $250,000 per year on payroll taxes?

See If You Qualify Now!

Vanessa Kruze, CPA Kruze Consulting

Vanessa Kruze, CPA
Kruze Consulting

What is the Research and Development Tax Credit?

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 $10 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. 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.

How can unprofitable startups in the US save on taxes?

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. 

Steps to claim the R&D tax credit

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:

  1. 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.
  2. 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.
  3. The company's payroll provider can then be instructed to reduce the company's payroll taxes.
  4. 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.

Ready to see if your startup qualifies? Contact us now.

What startups, and startup expenses, qualify for the research and development credit?

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!

What does the IRS consider qualifying expenses?

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:

  1. Qualified purpose: The project must be specific and defined; no mindless tinkering allowed. 
  2. Elimination of uncertainty: The project must be legitimately advancing the “science” of your business or products, and your team must have attempted to eliminate uncertainty about the development process/project.
  3. Experimental: The company must document that it is using either a scientific method or trial and error process.
  4. Technical: the work must be grounded in the hard sciences like biology or engineering - note that computer science can and does count in many cases, so companies like SaaS startups may likely be eligible.

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:

  1. Research after commercial production
  2. Adaptation of existing business components
  3. Duplication of existing business component
  4. Reverse Engineering
  5. Surveys & studies
  6. Computer software for internal use
  7. Foreign research
  8. Research in the Social Sciences, Arts, Humanities, etc.
  9. Funded research (i.e through government grants)

Is my startup eligible?

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.

State Research and Development Tax Credits

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.

R&D & Credits by State

This is for informational purposes only - state credit data changes often, so check with your CPA for current incentives.

State Offers State R&D Tax Credit? % of Federal
Alabama NO X
Alaska Yes 18%
Arizona Yes 20%
Arkansas Yes 33%
California Yes 10%
Colorado Yes 3%
Connecticut Yes 20%
Delaware Yes 10%
Florida Yes 10%
Georgia Yes 10%
Hawaii Yes 10%
Idaho Yes 5%
Illinois Yes 6.50%
Indiana Yes 15%
Iowa Yes 6.50%
Kansas Yes 6.50%
Kentucky Yes 5%
Louisiana Yes 30%
Maine Yes 5%
Maryland Yes 3%
Massachusetts Yes 15%
Michigan NO X
Minnesota Yes 10%
Mississippi NO X
Missouri NO X
Montana NO X
Nebraska Yes 15%
Nevada NO X
New Hampshire Yes 10%
New Jersey Yes 10%
New Mexico Yes 5%
New York Yes 3%
North Carolina NO X
North Dakota Yes 8%
Ohio Yes 7%
Oklahoma NO X
Oregon NO X
Pennsylvania Yes 10%
Rhode Island Yes 20%
South Carolina Yes 5%
South Dakota NO X
Tennessee NO X
Texas Yes 5%
Utah Yes 7.50%
Vermont Yes 5.50%
Virginia Yes 15%
Washington NO X
Washington DC NO X
West Virginia NO X
Wisconsin Yes 5%
Wyoming NO X

Startup R&D Tax Credits FAQs

Why are Research and Development tax credits now so valuable for startups?

    Research and Development Tax Credit History and Benefits:

  • Usually about 5% to 10% return on engineer salaries and US based contractors that are doing true Research and Development
  • Research and Development Credits have been around for many years
  • Previously: could only use the credits when your company became profitable (note: most state credits still work this way, you need to be profitable)
  • The Government looked for a way to make the Credit a high ROI immediately
  • Now: Non Profitable Companies now can immediately apply R&D Tax Credit against Payroll Taxes
  • Goal was to incentivize startups to do more R&D and it worked
  • Research and Development tax credit startup benefits: It increases the amount startups can spend on R&D. It extends their burn and supplements the VC equity that they can take.
  • Last year Kruze Clients reinvested $4.5M in R&D Credits, this year it will be $6M+.

Why should an early-stage company file for the 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.

Why should an early-stage company file for the Research and Development tax credit?

Section 382

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.

What defines research & development?

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.

What defines research & development?

Are there any R&D activities that don't qualify?

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.
Are there any R&D activities that don't qualify?

What qualifies as a research and development expenses?

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.

What expenses don’t qualify?

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.

How to claim and get a research and development 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.

In 2020, when should I file for the research and development tax credit?

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.

In 2020, when should I file for the research and development tax credit?

How much will my startup really save by implementing the startup R&D tax credit payroll offset?

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!

How much will my startup really save by implementing the startup R&D tax credit payroll offset?

Can unprofitable companies in the US get this credit?

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."

If my company procures patents, IP or venture funding for a project, does this matter for the credit?

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.
If my company procures patents, IP or venture funding for a project, does this matter for the credit?

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