Maximizing R&D Tax Credits for Tech Startups and Software Developers
Josh Leider - Head of Growth
December 20, 2024
From startups to matured entities, any type of business should be looking for ways to reduce their tax liability and improve their overall bottom line. However, this is especially important for startups that are still in growth mode and looking to gain market share. The good news is that some startups, notably tech and software companies, have a variety of ways to help reduce their tax liability while still fueling innovation.
One such example is Research & Development tax credits. Yet, while available for the startups that qualify, many tech and software startups overlook them due to misconceptions or simply a lack of awareness. Overlooking these credits is a major missed opportunity. We’ll explain more about how to take advantage of them and how Graphite Financial can help in this post.
Understanding R&D Tax Credits
R&D tax credits are dollar-for-dollar credits that startups can qualify for by performing activities related to development and design, or improvements to existing processes or products. In the case of a software startup, it may qualify for a development tax credit by improving software.
Tax credits help directly reduce taxable liabilities, which can either help increase refunds or decrease the amount that you owe. R&D tax credits can affect both federal and state tax liabilities. Even startups that have yet to earn a profit can take advantage of R&D credits, notably when it comes to offsetting payroll tax.
Eligibility Criteria for R&D Tax Credits
How can startups and software development companies qualify for R&D tax credits? The Internal Revenue Service (IRS) uses a four-part test to determine eligibility—something that you should also use with your startup. Here’s a look at how to assess your eligibility:
- Does what you’re doing lead to the development of a new product, process or software or the improvement of an existing product, process or software?
- Can what you’re doing be described as technological?
- Was there ever any uncertainty about the method or outcome?
- Was the development process experimental?
Many software and tech developments tend to meet this criteria and qualify for such credits.
Qualified Research Activities in Software Development
Beyond what the IRS assesses, some specific activities in software development qualify for R&D tax credits. This includes:
- Developing new software or enhancing existing software.
- Prototyping and testing new functionalities.
- Improving algorithms, coding and software architecture.
- Custom integration and solving technical challenges.
Maximizing Your R&D Tax Credits
Qualifying for R&D tax credits is one thing—making sure that you’re maximizing them is another. Here’s a look at some tips to maximize the credit amount that you qualify for to reduce your taxable liability:
Thorough Documentation Practices
Documentation is everything when it comes to managing your financial portfolio. Tax documentation is a natural extension of this, both in terms of ensuring compliance and maximizing your opportunity to earn credits. Good documentation practices include:
- Keeping detailed project descriptions, time logs and financial records related to qualified research expenses.
- Using project management tools to keep track of R&D activities.
- Working with a professional if necessary to help maintain proper documentation.
Leveraging the Startup Payroll Tax Offset
If you’re a startup in a net operating loss (NOL) position, you can likely monetize R&D credits through payroll tax offsets. Startups less than five years old with less than $5 million in gross receipts may qualify for up to $500,000 worth of payroll taxes to be offset. This can provide immediate cash flow benefits for startups that have not turned a profit.
Understanding Internal Use Software (IUS) vs. External Use Software
In order to qualify for the R&D tax credit, it’s important to know the different rules and regulations as it pertains to internal use software and external use software. As the name implies, internal use software, or IUS, is mainly developed for internal use processes and it must meet additional criteria to qualify for R&D tax credits. For instance, IUS software must pass a three-part High Threshold of Innovation test to qualify.
Conversely, external use software (EUS) is developed and sold or licensed. EUS generally qualifies for R&D tax credits under the IRS’ four-part test.
Another consideration is dual-use software. Dual-use software is a form of IUS that is able to qualify for R&D tax credits thanks to updated regulations that were released in 2016.
Navigating Section 174 and Amortization Rules
Section 174 requires startups to amortize any R&D expenditures, which can be complex and confusing. Introduced with the Tax Cuts & Jobs Act in 2017, the section requires the amortization of R&D expenditures over five years for domestic companies and over 15 years for foreign companies. This can have an impact on cash flow and deductions. Before the Tax Cuts & Jobs Act, R&D expenditures were listed as expenses in that respective taxable year.
There are some exclusions to Section 174, including marketing and research expenses, quality control testing, research by a third party and research conducted outside of the United States.
Common Misconceptions About R&D Tax Credits
Can only profitable startups claim R&D tax credits? Does only scientific research qualify? Is the application process complex?
The answer to these questions is “no.” In fact, these are some of the most common misconceptions about R&D tax credits.
No, profitable startups aren’t the only ones who can benefit. Startups who aren’t profitable can benefit and they may even be able to take advantage of the payroll tax offset for up to $500,000.
No, scientific research isn’t the only thing that qualifies for R&D tax credits. Any expenditure related to your startup’s efforts to develop, design and enhance its own product or develop, design and enhance an existing product qualifies for the R&D tax credit.
Finally, no, the application process doesn’t have to be complex. It really comes down to ensuring that there’s proper documentation of all expenditures related to R&D and having general knowledge of the rules and regulations associated with it.
Steps to Claiming R&D Tax Credits
Claiming R&D tax credits involves filing the appropriate forms with your startup’s annual tax returns. However, it can be challenging to navigate the process and identify all the expenditures that qualify. That’s why the first step in claiming R&D tax credits for many startups is engaging with a qualified CPA or tax professional. Such professionals can help perform an R&D tax credit study, identify the expenditures that qualify and file the appropriate forms to maximize the credits your startup can receive.
Additionally, you’ll want to make sure that you coordinate with your startup’s payroll department or payroll providers and use tax credit software to look for payroll tax offsets.
The Importance of Professional Guidance
Overwhelmed by the R&D tax credit process or just want to make sure that you’re maximizing the credit amount that you’re eligible for? Working with a professional can help.
A qualified professional has expertise in identifying qualifying activities and expenses, ensuring compliance with IRS regulations and avoiding audits, and, most importantly, maximizing credit amounts.
Don’t ever hesitate to work with a professional to help with your taxes and determine what tax credits your startup is eligible for.
Leverage R&D Tax Credits for Your Tech or Software Startup
If you’ve spent money to develop your own product or enhance an existing product, chances are that your startup qualifies for R&D tax credits—and R&D tax credits don’t just help offset your tax liability, but they can have a major impact on your cash flow and growth.
The best way to leverage these tax credits is to first be aware of them and what expenditures qualify. Then, you’ll want to make sure that your startup’s tax planning strategy includes R&D tax credits. Working with a professional to help you navigate the process can help.
Partner with Graphite to Maximize Your R&D Tax Credits
If you want to maximize your R&D tax credits, consider working with a professional like Graphite Financial. At Graphite, we’ve helped hundreds of startups with their accounting needs—and our expertise also extends to helping startups navigate R&D tax credits while staying compliant with IRS regulations. We even offer personalized service to ensure we meet any unique startup needs. Contact us today for more information and to schedule a free consultation.
FAQs
What types of software development activities qualify for R&D tax credits?
Startups can qualify for R&D tax credits by performing activities related to development and design, or improvements to existing products. In the case of a software startup, it may qualify for R&D tax credits by improving software.
Can unprofitable startups benefit from R&D tax credits?
Yes, one of the biggest misconceptions is that startups that aren’t turning a profit cannot capitalize on R&D tax credits. Startups that aren’t profitable can benefit and they may even be able to take advantage of the payroll tax offset for up to $500,000.
What is the difference between internal use software and external use software regarding tax credits?
IUS is mainly developed for internal use processes and must meet additional criteria to qualify for R&D tax credits. Specifically, IUS software must pass a three-part High Threshold of Innovation test to qualify. Conversely, EUS is developed and sold or licensed. EUS generally qualifies for R&D tax credits under the IRS’ four-part test.
How does Section 174 impact my ability to deduct R&D expenses?
The section requires the amortization of R&D expenditures over five years for domestic companies and over 15 years for foreign companies. This can have an impact on cash flow and deductions.
What documentation is required to support an R&D tax credit claim?
Good documentation is imperative. It’s important to keep detailed project descriptions, time logs and financial records to be able to verify expenditures that qualify for R&D credits. Project management tools and professional accounting partners can help keep track of R&D activities.
How do I know if my startup qualifies for the payroll tax offset?
If your startup is in a net operating loss (NOL) position, you can likely monetize R&D credits through payroll tax offsets. Startups less than five years old with less than $5 million in gross receipts may qualify for up to $500,000 worth of payroll taxes.
Why should I work with a tax professional to claim R&D tax credits?
Working with an experienced professional to claim R&D tax credits can be beneficial for several reasons. One, you can ensure that you’re going through the right processes and meeting IRS rules and regulations. Two, you can ensure that you’re maximizing the R&D tax credits. Lastly, you can have peace of mind that your taxes were handled correctly and have one less task on your plate during tax season so you can focus more on growing your startup.