Startup R&D Tax Credits: What You Need to Know

Updated for 2024

Startups across the U.S. are all prepping to file their 2023 taxes. If you’re getting a headstart on tax prep, hear us out…don’t file yet!

Why? Well, if your startup had less than $5M in gross receipts (total sales, net of returns, and allowances) during the 2022 tax year, you definitely don’t want to file your tax return until you’ve considered if you qualify for an R&D tax credit. Otherwise, you‘ll miss out on a ton of free money from the IRS. 

The R&D tax credit allows startups to cut down payroll tax liabilities by up to $500,000 (yes, you read that right). That’s a substantial amount that can serve as a lifeline for growing startups navigating cash flow challenges. 

If you send in your tax returns without submitting your R&D tax credit paperwork, there’s no going back. We’re here to help you avoid this misstep by showing you how to take advantage of R&D tax credits this tax season.

What is the Startup R&D Tax Credit?

A startup R&D tax credit is a government-sponsored “cashback” benefit given to startups to encourage continued research and development expenditures.

In its early days, the R&D tax credit was tilted towards large, profitable corporations. After several updates over the years, the R&D tax credit has become more accessible to startups. Yet, many eligible startups are missing out on what’s basically free money from the IRS.

If your startup is actively involved in the research and development of new products and processes that lead to new or improved functionalities, then you can get some of your business investments back in the form of tax credits.

You can use the tax credit to offset your company’s employer-paid portion of Social Security (6.2%) and Medicare (1.45%) payroll taxes annually.

Key Facts About the Startup R&D Tax Credit

There’s a lot you need to know about the R&D tax credit. For now, let’s focus on some of the most important bits to help you quickly grasp the concept.

• The R&D tax credit only applies to “qualified“ research and development expenditures within the United States. Defining a qualified R&D process can be pretty complicated—always consult a reputable accounting firm to ensure you don’t miss important steps. 
• You do not need to be profitable to access the R&D tax credit. In fact, most unprofitable startups leverage this scheme to slow down their burn. 
• In most cases, the tax credit is around 5-10% of a company’s total R&D expenditure. Use our free R&D tax credit calculator to find the amount you may qualify for. 
• For the 2022 tax season, companies are allowed a maximum tax “cashback” of $500,000. 
• Exciting update! For the 2023 tax season, the Inflation Reduction Act of 2022 has seen this limit increase to $500,000.

What Qualifies for R&D Tax Credits?

To qualify for R&D tax credits, your startup should have less than $5 million in gross receipts for the year in which you are claiming the credit. 

Additionally, you must have no gross receipts for any tax year preceding the five-tax-year period ending with the credit year. So, for the 2022 tax year, you want to have no gross receipts prior to 2018.

The IRS is super specific about what activities count as R&D. To qualify for the startup R&D tax credit, your activities must pass the Four-Part Test:

1. Qualified Purpose

The R&D activity must be geared toward improving the functionality, performance, reliability, or quality of a product, process, software, technique, invention, or formula that is intended to be used by your business or held for sale, lease, or license (component).

2. Technological Uncertainty

You identified uncertainty in relation to the development or improvement of the business component.

3. Process of Experimentation

You evaluated alternatives through modeling, simulation, systematic trial and error, or other methods to eliminate uncertainty.

4. Technological in Nature

The principles of engineering, physics, chemistry, biology, computer science, or similar natural or “hard” science determine the success or failure of the evaluative process.

IRS Tightens Requirements for the Startup R&D Tax Credit

The IRS now has updated documentation requirements for startups seeking to claim credits for research and development tax. This will mainly apply to taxpayers seeking to file amended returns.

According to the IRS, thousands of R&D credit claims flood into their offices every year, and sorting through these takes significant resources. To make the process more efficient and prevent tax fraud, the IRS has shifted the bulk of the work to taxpayers, requiring much in-depth documentation for those filing amended R&D tax credit claims.

If your submission is deemed deficient, the IRS currently allows up to 45 days to send in the required additional documentation.

 To have your claims processed successfully, your documentation needs to be on point. (Need help here? Graphite can help you run your analysis to get all of your documentation together.) 

Your documents need to do the following:

• Identify all business components related to the R&D tax credit claim for the tax year. Identifying these components makes it possible for the IRS to conduct the four-part test. 
• Highlight all research activities performed by/under each component identified above. 
• Identify the individuals (in-house staff or contractors) involved in each research activity. 
• Provide details of the insights each individual tried to uncover. 
• Provide the total qualified supply, employee wage, and contract research expenses for the claim year.

What does this really imply?

If you were eligible for R&D tax credits in prior years but didn’t claim them in your tax returns, you may file amended returns to try and claim the credits. However, the documentation requirements have gotten very tight, making it harder for startups to claim unused credits.

You need to do your best to file your 1120 on time with your R&D tax credits form adequately filled and attached. That way, you won’t have to file amended returns down the line and put up with the rigorous documentation involved.

How Much R&D Credit Can I Get?

The R&D tax credit allows startups to get back approximately 10% of their annual R&D expenditures. This credit can be used to clear the company’s payroll taxes—up to $500,000 per year for the 2022 tax season.

And next year for the 2023 tax season—thanks to the new Inflation Reduction Act of 2022—startups and qualified small businesses can get additional credits (up to $500,000) which can be used to clear the employer-paid portion of the Medicare payroll tax.

This effectively doubles the maximum startup R&D tax credit amount you could be eligible for in 2023 and beyond.

Take the First Step in Getting Your Startup R&D Tax Credit

Okay…that was a ton of information to digest. Now what?

We know it can be difficult to get started with this whole process, so we built an R&D tax credit calculator to help you find out if your organization qualifies for a credit. Just answer four quick questions and we’ll provide a basic estimate of the credit you’ll receive on payroll taxes.

And if you need a firm to handle your tax filings and R&D credit, feel free to reach out to us at Graphite!