Josh Leider, Head of Growth at Graphite
When you’re leading a lean, high-growth startup, it’s critical to take advantage of every tax credit available to you. These tax credits are basically a bonus for your organization that you can reallocate into building up your team and your business.
One of these credits that we always tell our startup clients to keep an eye out for is the R&D tax credit. It’s too valuable to ignore.
We’re going to break down exactly what is taken into account for the R&D tax credit calculation to help you understand whether or not you qualify. After that, you can use our R&D tax credit calculator.
Who Qualifies for the R&D Tax Credit?
In order to qualify for the R&D tax credit, your organization needs to participate in qualified research activities (QRAs). This is easier than you might think—if you develop new products or improve on existing ones, chances are you qualify.
There are four main criteria your R&D process needs to meet in order to qualify for this tax credit:
- Qualified business purpose: Your R&D work needs to be done with the intent of improving the quality, functionality, performance, or reliability of a product, process, software, technique, invention, or formula.
- Elimination of technological uncertainty: In your R&D work, there needs to be some uncertainty regarding whether the product is possible to develop or how to develop it.
- Process of experimentation: Your work needs to go through a process of experimentation, including simulation, modeling, systematic trial and error, or your organization’s own experimentation methods.
- Technological in nature: Your research and development needs to be technological in nature, meaning that it uses engineering, computer science, physics, chemistry, biology, or other “hard” sciences.
The exact amount you’ll get back after applying for an R&D tax credit depends on the scope of your operations and your business model. Most startups should expect to receive between 5 and 10 percent of their total R&D expenditures.
4 Questions to Determine Your R&D Tax Credit Amount
If the thought of doing your R&D tax credit calculation manually has your head swimming, don’t worry—it’s not as complicated as it seems. We’ve identified four key considerations that are taken into account to determine how substantial your R&D tax credit will be.
You can use our R&D tax credit calculator to plug in these numbers and estimate your company’s tax credit. Before you start calculating, be sure to read through the sections below to wrap your head around the answers you should provide.
1. How Many US-Based R&D-Related W2 Employees Do You Have?
One of the biggest qualifying expenses for the R&D tax credit is employee wages. In order for these wages to be eligible, your employees must directly perform or support qualified research activities.
There are many different types of employees that fall under this classification, depending on your industry and the specific projects you’re working on. Engineers, software developers, and lab technicians are common examples of W2 employees who qualify.
Employees who support your research and development efforts will also qualify. For example, a manager supervising a team of engineers would meet the requirements.
2. What Is the Average Salary of a W2 R&D-Related Employee at Your Company?
Once you’ve identified how many of your employees’ salaries will qualify for the tax credit, the next step is to determine their average salary.
The easiest way to do this is by referencing existing payroll documents. This number doesn’t have to be exact—an approximate average is enough to make the initial estimate.
3. What Is Your Total Annual Spend on US-Based 1099 R&D Consultants?
In addition to deducting full-time employee wages, the R&D tax credit also allows you to deduct the amount you spend on US-based consultants. Your consultants will also need to conduct R&D activities or support them directly.
This is a crucial financial consideration for early-stage startups. Your budget for full-time employees might be limited, making contractors your primary source of labor. The R&D tax credit will allow you to offset these contractor expenses and invest in top talent.
4. How Much Time Does the Team Specified Above Spend on Qualifying R&D Activities?
The amount of time your team spends on R&D will also affect your total tax credit amount.
Your team doesn’t need to focus entirely on research in order to qualify, though. For example, if your team of employees and contractors spends roughly half their time on these research activities, half of their salaries or contracts would be eligible for the tax credit.
Tracking your team’s time will help you get an accurate breakdown of your team’s activities. When possible, use time-tracking software or employee time questionnaires for R&D projects. Having these documents is essential for potential IRS audits in the future, and they’ll also ensure you don’t miss out on any potential tax savings.
Use Graphite’s R&D Tax Credit Calculator to Get Started
Now that you’ve answered these four key questions, it’s time to perform your R&D tax credit calculation below. We’ve created a straightforward R&D tax credit calculator that does the math for you—just plug in the answers to get your estimated tax credit range.
After you use our R&D tax calculator, the Graphite team is here to help you file your R&D tax credit. We only charge if we determine you are entitled to a tax credit.
Need CFO or Accounting Help?
Born out of a VC fund, Graphite fully understands the strategic and financial needs of high growth companies. If you need accounting support or simply have a question about accounting at your company, feel free to connect with us!