The U.S. government supports innovative businesses by providing tax incentives each year through the R&D Tax Credit program to help businesses develop new technologies, products, or methods, and improve existing technologies, products, or methods.
Now, startups can benefit too: a new law coming into force in 2023 will allow startups to save employees up to $500,000 a year in taxes, which is great for companies involved in research and innovation.
The program is designed to reward companies that try new ideas. It’s not just for big tech companies; small businesses working on cool projects can also get help. This funding can make a big difference for small startups.
Providing these credits is the government’s way of investing in American creativity and problem-solving spirit and encouraging innovation across all industries.
How startups can make the most of the R&D Tax Credit in 2024
These tax incentives will be further strengthened from 2023 onwards. Here are steps to understand the R&D tax and use it effectively to get the maximum benefit.
1. Know what’s important
Make sure your work fits into what the IRS calls research, which usually means trying to make something new or better in a way that’s not easily understood.
2. Take good notes
Write down everything you did for your research. Also keep a record of what you spent your money on. This will help you prove that you qualify for tax breaks.
3. File it the right way
When claiming your tax credit, make sure you use the correct IRS form and file on time.
4. Check the status
Some states offer additional tax incentives for research, so find out if your state does and apply for them too.
5. Ask for help if you need it
Consider hiring someone who is knowledgeable about these tax credits, as they can help you get the maximum amount back.
Startup eligibility: Who is eligible for these R&D tax credits?
The rules are pretty simple: if your company makes less than $5 million a year in profits, you’re on the right track. And if you’ve been profitable for less than five years, that’s another good sign. Just make sure you’re not a tax-exempt organization.
The interesting thing is that you may be able to qualify even if your company doesn’t make a profit right away. For example, if you started your business in 2018 but didn’t make a profit until much later, you could still take the deduction for 2022. This is great for new companies that take a while to make a profit.
Federal and State Research and Development Credits
The federal government has stepped up support for startups, allowing them to save employees up to $500,000 in taxes each year, double the previous limit. The change is part of the Inflation Control Act of 2023.
States also offer incentives: Arizona, for example, gives back 24% of research expenses up to $2.5 million, and 15% above that; California offers a 15% credit that can be used to reduce future taxes; and New York offers a simple 6% credit on research expenses.
Minnesota has a unique approach. It offers income or franchise tax relief to companies that conduct qualified research in the state. For expenses up to $2 million, Minnesota offers a 10% deduction. Above that, it’s 4%. This deduction isn’t just for this year, it can be carried forward for up to 15 years.
Interestingly, Minnesota allows businesses to claim refunds within the statute of limitations, so even if you missed out on a deduction in the past, you may be able to benefit by filing an amended return.
Texas has taken a different approach, offering a franchise tax credit and exempting sales tax on certain research-related purchases.
Qualifying Research and Development Activities
The IRS has a four-part test to determine what qualifies as R&D: First, it must be experimental and related to the business. They’re trying to clarify something that’s not clear.
Second, you need to use science or technology: it could be physics, biology, engineering, computer science, etc. Third, you need to work on something that the business can leverage: a new product, a better way of doing things, new software, etc.
Finally, you need to try different ways to solve a problem: test and evaluate different options rather than just picking the first idea that comes to mind.
What counts as R&D?
Developing new products and materials, or improving existing products, also counts. Researching new manufacturing techniques also counts. Working to make products more sustainable also counts.
Keep in mind that each state has its own rules. For example, Minnesota offers a 10% tax credit on the first $2 million of R&D expenditures, and a 4% tax credit thereafter, but the research must be conducted in Minnesota. Other states, such as Arizona and California, have different rates and rules.
The key is to keep good records. Track the expenses you spend on R&D: salaries, supplies, contract work, etc. Even if the project doesn’t work out, you may be eligible for a credit for the effort you put into it.
Excluded Activities
However, not everything counts as R&D. If you work on something after you’ve started selling it usually doesn’t count.
Also, if you only change something a little bit for one customer, that’s not R&D. Copying something that already exists doesn’t count either.
Each state has its own rules, so it’s wise to check what your state offers. You may find some additional assistance that could make a big difference for your company.
If you’re unsure about anything, it’s always a good idea to ask a professional, who can help you make the most of these credits.
Making the most of the R&D Tax Credit
The R&D Tax Credit can be a game changer for your startup. It offers a way to cut costs while propelling your business forward. Here’s how to make the most of the R&D Tax Credit.
First, understand how these deductions work. The deductions can be used to offset up to $500,000 in annual payroll taxes. This applies to the amount you pay for Social Security and Medicare. To claim the deductions, you will need to file several forms with the IRS. The main forms are Form 6765, Form 8974, and Form 941.
Timing is also important: If you’re a C corporation with a December fiscal year, you have until April 15 to file. For S corporations, it’s March 15. Other fiscal years have different deadlines, so keep that in mind.
These deductions can also be used to offset your income taxes. Look back at your tax returns from the past three years and you may be able to amend them and get some tax back.
How much can the R&D Tax Credit save you?
The federal tax credit is about 10% of eligible R&D expenses. States also offer tax credits, the amount of which varies by state. You can claim up to $2.5 million on your quarterly payroll tax return. Don’t worry if you don’t use all of your tax credit; you can carry it forward for up to 20 years.
The benefits go beyond just saving money: These deductions reduce your tax bill by up to 20% on eligible research expenses, meaning more cash in your pocket, which is crucial for a growing business.
But it’s not just about the money. These credits encourage innovation. They help you attract talented employees who want to work on cutting-edge projects. Investors also like to see companies taking advantage of these credits, because it shows you’re serious about growth.
To make the most of these credits, consider using a purpose-built tool. Software is available that is designed to help you track R&D spending. Some companies even hire R&D accountants to manage this for them. It may seem like extra work, but it can quickly reap benefits.
Conclusion
The R&D tax credit can be a powerful tool for startup growth. It provides financial savings and encourages innovation. Startups should consider both federal and state tax credits to get the most benefit.
Remember, even failed studies can qualify. It’s the effort that counts, not just the result. This encourages companies to take risks and try new things.
FAQ
What qualifies for the R&D Tax Credit?
Qualified JobsThe activity of developing new or improved products, processes, or technologies.
Eligible expenses:
staff: Includes salary, employer’s national insurance contributions, pension contributions and reimbursed expenses.
Subcontractors and freelancers: Payments to outside employees involved in research and development.
Materials and Consumables: The cost of heat, light and electricity consumed or changed during research and development.
Does Minnesota have research and development credits?
Minnesota was the first state to create an R&D tax credit in 1981. Many states that impose corporate taxes now offer similar deductions for research expenses. These deductions may vary from state to state, but Minnesota’s deduction is similar to the federal deduction.
What are the R&D credit rules?
The Research and Development (R&D) Tax Credit provides federal tax relief on approved research expenses in the U.S. The credit is applied dollar for dollar, so you save $1 for every dollar you spend, and you get back approximately 13 cents for every dollar you spend on eligible research activities.
