Successful startups tend to strike a balance between stability and innovation. However, maintaining this ideal equilibrium is often more of a pipe dream than a standard practice. Couple this with advancing tech and fluctuations in the market, and the path to building a thriving startup can feel insurmountable. Without a steady stream of funding to fall back on, it can be hard for companies to swing big for fear of overinvesting and underdelivering. Luckily, there are programs designed to reward companies for improving products and developing new ones.
Research and Development, or “R&D” Tax Credits offer businesses the opportunity to cash in on the innovative work they’re already doing, regardless of the outcome. These government credits offer additional funding to companies who prove their commitment – and investment – to new and improved ideas. Businesses that claim these credits aren’t reinventing the wheel. They’re simply investing in making their products better and stimulating the economy along the way.
Programs like R&D tax credits are often overlooked. Whether this apprehension is due to the complex qualification processes, skepticism around a government check, or simply lack of understanding, most companies aren’t taking advantage of this essential program. Instead, they’re leaving this money on the table – to the tune of billions of dollars a year.
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Understanding R&D Credit Eligibility
One of the biggest misconceptions about R&D Tax Credit eligibility is that only large companies are eligible. That’s far from the truth. In fact, this tax incentive is open to companies in all sectors and of all sizes.
Roughly 50% of the companies that claim the R&D tax credit qualify as small and middle-sized businesses. So, regardless of whether you’re in manufacturing, energy, food and beverage production, or engineering, your business is likely eligible.
Eligibility is mainly based on whether your company actively invests in developing new products and improving existing ones. However, there are additional steps required to ensure that you meet IRS requirements for qualified research expenses (“QREs”).
How to Determine Eligibility
To avoid misuse of the tax credit, the IRS put in place a four-part qualification test. Under IRS Section 41, your activities must satisfy the following requirements to be considered QREs:
- Technological in nature – To qualify, your experimentation process should be dependent on hard sciences such as computer science, biology, chemistry, physics, engineering, etc. The good news is that you don’t really have to refine, expand, or exceed the existing principles.
- Elimination of uncertainty – You should show that you have tried to eliminate uncertainties regarding the improvement or development of business components.
- Experimentation process – You should demonstrate that you have evaluated one or multiple methods of achieving your desired results either through systematic trial and error, simulation, modeling, etc.
- Qualified purpose – Your main aim of conducting research should be to create improved or new performances, functions, quality, or reliable products.
For any expense to be treated as a qualified research expense, you must be able to provide proof of the above requirements.
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Qualified Research Activities
R&D tax credits are not limited to successful research and experiments. So long as activities meet the four-part test, it doesn’t matter whether they contributed to your ROI. The following are considered qualifying activities:
- Projects that involve developing proprietary innovations
- Engineering processes that involve the design, analysis, testing, and data collection
- Building of product prototypes
- Improvement of technologies that facilitate your business, such as software
- Developing patents
Additionally, the IRS has four main categories of R&D costs that it considers legitimate expenses. These include:
- Supplies – Any supplies that you use for R&D aside from general administrative supplies necessary for ordinary operations can be included.
- Wages – You can include all taxable wages for employees who participate in research and development processes.
- Outsourcing – You can include expenses you incur for outsourcing R&D processes, but they will be considered at a lower rate than if the activities were performed in-house.
- Computer services – Include expenses you incur for renting computers or cloud storage to host and support the research process or software.
The ambiguity of this qualification can be a double-edged sword. Without explicit guidelines, more companies are able to qualify and redeem tax credits. However, it can also be challenging to interpret which of your expenses actually qualify for the R&D credits. Many companies rely on a third-party professional to confirm their qualification and to avoid making mistakes upon filing.
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Calculating the R&D Credit
If your company is eligible for the R&D credit, you may be eager to know just how much it can benefit you. For this, there are two standard methods for calculation.
1. The Regular Research Credit Method
If you use the standard method, you’ll receive a tax credit of 20% of all qualifying expenditures for the current year. Such expenses must exceed a set base amount, which is the product of average annual gross receipts from the four previous years and a fixed-base percentage.
2. The Alternative Simplified Credit Method
With this method, the tax incentives equate to 14% of your research and development expenses for the present year and half of the average qualifying expenditure for the previous three years. If you do not have Qualified Research Expenses (QRE) for previous years, R&D credit will be 6% of the current year’s QREs.
Which Option Should You Choose?
The methods for calculating R&D tax credits use varying criteria, so expect them to yield different results. Luckily, you can calculate your tax incentives using both methods and apply using the method that yields better results.
On the surface, it may seem an obvious choice to file using the method that allows for a larger tax credit. However, you also have the option of choosing a reduced tax credit. While it may seem counterintuitive, there are two reasons why you should consider this. First, a smaller credit will make it easier to file state tax returns. Second, there will be no need to adjust your taxable income, which may have unfavorable results. Either way, you have the flexibility to decide which route offers the best result for your business needs.
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How to Apply for R&D Tax Credits
The application process can be tricky for some companies, especially those with limited resources to devote to tax credit processing. Before you consider applying, remember that proper documentation is the best way to set your company up for success and maximize your benefits.
Such documents include:
- Tax and payroll records
- Reports that track the expenses, time, and other key metrics during R&D
- R&D documentation such as lab notes, project records, prototypes, design drawings, and patent applications
As a startup, you should prioritize a comprehensive documentation system from the jump. Otherwise, filing taxes and claiming such benefits could end up being more trouble than their worth.
Once everything is in place, you can take the following steps to a seamless R&D credit application:
- Develop a clear picture of your processes – Have your team review your R&D processes from start to finish. By reviewing bookkeeping and other related documents, you’ll identify all your activities and their costs.
- Prepare your case – As with all other forms of tax credit, the burden of proof is upon you. Gather all the necessary documentation that the IRS can accept as proof and the relevant filing forms on which you’ll outline all the costs.
- Apply for R&D tax credit – With everything in place, you can proceed to make your claim. For this, you’ll need to fill Form 6765 and file it together with your business’s federal income tax return.
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The Benefits of R&D Tax Credits
For growing companies, R&D tax credits come with a wide range of benefits. To begin with, you’ll enjoy a lower dollar-to-dollar federal and state income tax liability. In turn, this will unlock benefits like:
- Increased market value
- Improved cashflow
- Higher profits
With reduced liability from R&D, it’ll also be much easier to increase funding for the same products that helped you qualify. This expedites product development and improvement, allowing you to increase your market share and profits.
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Save Money While You Scale
When scaling your company, it can be tough to focus on anything beyond increased revenue. But growth for growth’s sake is meaningless if you don’t manage costs along the way. That’s why it’s crucial for growing companies to capitalize on opportunities for additional capital, like R&D tax credits.
At MainStreet, we’re on a mission to help create jobs and opportunities by supporting startups and small businesses through R&D tax credits. We review more than 200+ credits, find the ones that apply to your business, and pass the savings onto you.