Any effort to reduce the amount of income tax owed is always welcomed by businesses. This is especially true for startups, which usually need every dollar to put toward growing and developing their business. Any savings can go a long way toward keeping a startup moving forward.

Tax credits, or dollar-for-dollar amounts that taxpayers – or in this case, startups – can use to reduce their taxable income is one way to achieve this. Among the tax credits that startups may qualify for include research and development, or R&D, tax credits.

What’s the R&D Tax Credit? Simply put, it’s a tax credit that startups can claim for costs related to developing, designing or improving products, processes, formulas or software.

The good news with calculating R&D tax credits is that it’s easy to do. There are many R&D tax credit calculators available to help startups determine if they qualify for the credit and how much of it they may qualify for. Accurate calculation is especially important for startups to maximize the financial impact of this tax credit.

Understanding R&D Tax Credits

The R&D Tax Credit is a federal benefit that was passed back in 1981 to help stimulate innovation and encourage product development in the United States. It’s also intended to help provide startups with funds to hire employees, invest in the expansion of facilities, and the various tools and technologies to streamline innovation. Since its inception in 1981, many states have followed suit and passed incentives of their own.

What is the R&D Tax Credit and How Does it Work?

The R&D Tax Credit is only available for those who are developing new or improved business components. It can be used in one of two ways: to either reduce a startup’s income tax owed or to offset a startup’s social security tax within its payroll taxes. If startups wish to apply it toward the latter, they’re potentially able to receive up to $1.25 million – or $500,000 a year for up to five years. If your startup doesn’t qualify to use it in one way, it will likely qualify to use it in the other way.

There are also eligibility requirements that startups have to meet to qualify for the business payroll tax credit. For instance, your startup must have no more than $5 million in gross receipts in the year you intend to claim the credit. Your startup must also not have any gross receipts in the tax year preceding the five years ending with the tax year of the election.

Benefits of the R&D Tax Credit

There are plenty of benefits that your business can realize by qualifying for – and claiming – the R&D Tax Credit. There are both financial benefits and benefits for the long-term viability of your business. Here’s a look at some of them:

• Reduce taxable income: Your startup can create a dollar-for-dollar reduction in what it owes in taxes. This can be both in federal taxes and state taxes.
• Reduced payroll costs: It can be used to offset your startup’s social security expenses.
• Competitive advantages: The whole point of the R&D Tax Credit is to help businesses foster innovation and reduce the financial burden of doing so. It was the goal when it was established at the federal level in 1981 and why some 40 U.S. states have also passed it within their jurisdictions. Long-term benefits of qualifying for and claiming the R&D Tax Credit include continuing to foster innovation, enhancing competitiveness and supporting sustainable business growth.

How the R&D Tax Credit Benefits Startups

Reducing taxable income, fostering continued innovation and putting money back into the pocket of qualifying startups so they can continue to grow their business, improve competitive advantage and increase their market share are all key benefits of how significantly the R&D Tax Credit can help startups.

In any business model, let alone a startup, businesses have to continue to produce new products or services to stay competitive. This is especially true for startups looking to make a name for themselves and continue to gain market share. That’s where the R&D Tax Credit can help. By reducing taxable income or offsetting payroll taxes, the credit is literally putting money back into the pockets of startup businesses, allowing them to invest in themselves by limiting the financial burden of doing so. This can affect the startups financial projections.

Receiving the credit could be the difference between introducing a new product in the first year of a startup or in the third year of a startup just based on the available funds. This can all have a trickle-down effect on the future of the business, luring in new investors and propelling the business forward on a path of growth. One unique thing about R&D tax credits is that they can be carried forward for up to 20 years.

Another nice thing to note about the R&D Tax Credit is that startups in a wide range of industries can benefit from it. In other words, it’s not just for tech startups. From aerospace to tool & die to oil and gas to metal fabrication – literally any industry that improves processes or products is eligible to receive the R&D Tax Credit.

Important Considerations for Startups Applying for the R&D Tax Credit

Like any tax credit, you can’t just apply for it and expect it to be approved. There are various considerations you need to weigh, from your startup’s qualifications to providing documentation. The IRS has recently updated its necessary document requirements to claim these credits as a means of making the approval process more efficient and helping ensure that only those who qualify for it are receiving it. Documentation requirements include:

• Identifying all business components related to applicability from the past tax year.
• Highlighting all research activities and components and identifying the people involved in each of the activities.
• Providing in-depth details of the activities and what employees aimed to uncover by participating in them.
• Proving other factors such as employee wages and contract research expenses for the year in which your startup is claiming the tax credit.

If any submission is not accepted, the IRS will give startups 45 days to gather and submit any additional documentation.

Calculating Your R&D Tax Credit

How do you calculate your R&D Tax Credit? While there are plenty of calculators out there to use to come up with an accurate figure, there are also a lot of details that firms must gather to use the calculators and come up with the right figure. Some of these figures include:

• Qualifying research expenses
• Wages
• Supplies
• Contract research costs

Factors to Consider When Calculating the R&D Tax Credit

Some of the key factors to consider when calculating the R&D Tax Credit include knowing just what constitutes research expenses. Specifically, these are divided into two categories: in-house research, which includes wages or payments made to workers for services performed, and contract research expenses, which are the same thing except contracted out to a third-party provider.

There are also different calculation methodologies when determining the tax credit that you’ll want to weigh. There’s the Regular Research Credit and the Alternative Simplified Credit. Reference IRS Form 6765 for more information on these two general methods.

Step-by-Step Guide to Using an R&D Tax Credit Calculator

Once you have this information, you can use the calculator to determine your prospective credit. Here’s a step-by-step guide on how to use it:

• Start by noting whether you currently claim the credit.
• You’ll then move on to verify that your startup qualifies for it by acknowledging that it improves the functionality or performance of a product, process, software or other component.
• Next, you’ll enter the number of R&D staff that your startup employs, their average annual salary, and an estimation of the percentage of these employees’ time spent on R&D tasks.
• Graphite’s calculator also takes into account any R&D consultant expenses for the year, which could affect the amount of tax credit you could receive.

In the end, based on the data you entered and answers to the posed questions, you’ll receive the prospective high and low end credit estimates that you’re eligible for.

How Much is the R&D Tax Credit?

How much can you expect from the R&D Tax Credit? It depends on the factors that you used to calculate your anticipated refund and the status of your startup. Other than a dollar-for-dollar match, your startup may be eligible for up to $1.25 million – or $500,000 a year for up to five years. Use the calculator to determine how much your startup can receive.

Qualifying Industries and Activities

The R&D Tax Credit isn’t just available for tech startups, but for businesses in any industry that meet the criteria – from aerospace to metals to oil and gas. Qualified R&D activities are as follows:

• Expenditures connected to the business or trade.
• Passage of the discovery of technological information, business component and process of experimentation test.
• Proof that activities are dedicated to improving an existing business component or developing a new one.

Industries Eligible for the R&D Tax Credit

Just about every industry is eligible for the R&D Tax Credit should they meet the criteria. Some common industries include:

• Aerospace
• Tool and die
• Metals
• Consumer products
• AEC
• Food and beverage
• Software development
• Oil and gas
• Pharmaceuticals
• Chemicals

Activities that Qualify for the R&D Tax Credit

Activities that qualify for the R&D Tax Credit include:

• Activities dedicated to improving an existing business component or developing a new one.
• Development of new products or processes.
• Wages, as long as they don’t involve work out of qualifying R&D activities.

Activities that do not qualify for the credit include market research and data collection.

Tips for Maximizing Your R&D Tax Credit

You don’t want to leave any money sitting on the table, so it’s important to make sure all your “i’s” are dotted and “t’s” are crossed when filing for it. There are various strategies for maximizing the credit and some best practices to avoid mistakes:

Strategies for Maximizing Your R&D Tax Credit Benefits

• Ensure thorough documentation.
• Keep a detailed record of all business activities that could qualify.
• Utilize a professional service provider to ensure everything is filed correctly and you can maximize your return.

Common Mistakes to Avoid When Claiming the R&D Tax Credit

• Filing errors
• Misclassification of business expenses
• Failure to document activities properly

Regular audits and using reliable accounting systems can help mitigate some of these errors.

Frequently Asked Questions About the R&D Tax Credit

What expenses qualify for the R&D Tax Credit?

Expenses include:

• Money is spent on activities dedicated to improving an existing business component or developing a new one.
• Money spent on the development of new products or processes.
• Wages, as long as they don’t involve work out of qualifying R&D activities.

Can startups that are not yet profitable still benefit from the R&D Tax Credit?

Absolutely, and doing so can help them develop new products, establish competitive advantages and grow.

How is the R&D Tax Credit calculated for startups?

Use the R&D calculator to determine what amount you’re eligible for or consider working with a professional service provider for assistance.

What documentation is required to claim the R&D Tax Credit?

Requirements include:

• Identifying all business components related to applicability from the past tax year.
• Highlighting all research activities and components and identifying the people involved in each of the activities.
• Providing in-depth details of the activities and what employees aimed to uncover by participating in them.
• Proving other factors such as employee wages and contract research expenses for the year in which your startup is claiming the tax credit.

Ready to Maximize Your R&D Tax Credits?

Contact Graphite Financial today for personalized assistance when claiming the R&D Tax Credit that are available to your startup. Graphite’s R&D calculator can make it easy for you to accurately estimate the amount you’re eligible for, and save your startup time and money along the way. Contact us today for more information and to get started.