As startup companies begin the journey to a successful, established business, the dollars spent on research and development (R&D) can consume most of the budget. Fortunately, the Protecting Americans from Tax Hikes (PATH) Act of 2015, established a means for startup companies to recoup some of their R&D investment prior to being a profitable and income tax paying business.

The benefit is a cash infusion to the startup at a time when every dollar counts. The process begins by computing the R&D tax credit for the business.

The R&D Tax Credit

The R&D tax credit has been around since 1981 and was made permanent as part of the PATH Act. The credit has served to keep jobs in the U.S. and certain states, as well as encouraged businesses to push the envelope when it comes to innovation. Unfortunately, the R&D tax credit is not a refundable tax credit, meaning only businesses paying federal income tax could utilize the credit, and many startups were originally left out despite the heavy investment in R&D until recently.

In addition, many businesses overlook the R&D tax credit thinking their daily activities are simply necessary to stay competitive in a global marketplace. However, when a business spends time developing new or improving existing products, processes, software or formulas, those activities can qualify for the credit. Businesses in many different industries can claim the R&D credit. The law provides a four-part test that serves to qualify activities as R&D.

Activities that meet the following requirements are potentially eligible for the R&D tax credit:

• Permitted Purpose: Develop a new or improve an existing product, process, formula or software, which may include improving the function, reliability, quality or performance.
• Eliminate Uncertainty: Discover information to eliminate uncertainty concerning capability (can we do it), methodology (do we know how to do it), or appropriateness of design (what is the optimal design).
• Process of Experimentation: Substantially all the activity constitutes a process of experimentation evaluating alternatives (prototyping, modeling, systematic trial and error).
• Technological in Nature: Fundamentally rely on principles of hard science, which can include physical science, biological science, computer science, engineering, etc.

Costs eligible for the R&D tax credit include:

• Wages for individuals performing, supervising or supporting the R&D.
• Supplies used in the research, which may include prototypes, but does not include capital expenditures.
• Contract research or costs incurred for a third-party to perform research on the business’s behalf. The business must be at risk for the research performed and must retain substantial rights. Rights do not need to be exclusive.
• Rental/lease of computer costs, including payments made to service providers for cloud server space for development environments.

The benefit associated with the federal R&D tax credit ranges from 5% to 8% of total qualified costs. For startups, the benefit can exceed 8%. The R&D tax credit calculation can be complicated depending on the business’s fact pattern, and a licensed CPA or R&D tax credit specialist is a great resource to help you get started.

Startup Opportunities with the R&D Credit

A tax credit provides a dollar-for-dollar reduction of tax liability, which makes it so valuable. Unfortunately, many startups are not in a position where they owe any—or at least not much—in federal income tax. That significantly limits the utilization of the R&D tax credit for startup businesses.

However, the PATH Act provides an election for startups to offset their payroll tax liability with the R&D tax credit. Using the R&D tax credit in lieu of precious cash each quarter for payroll taxes keeps money in the business to invest in other assets. To use the R&D tax credit to offset payroll taxes, the startup must meet certain criteria.

Gross Receipts

To elect to offset payroll tax liability in 2024 with the startup’s 2023 R&D tax credit, the startup must be a “qualified small business.” A qualified small business has less than $5 million in gross receipts for the tax year. Furthermore, the business would not be eligible if it generated gross receipts for any taxable year before the five taxable year period ending with the taxable year.

For a 2023 calendar year taxpayer with no short tax years, this would mean no gross receipts prior to 2019. The definition of gross receipts is inclusive—even interest income counts as gross receipts, along with sales (net of returns and allowances), all amounts received for services and income from investments. In addition, gross receipts must be aggregated for a controlled group of corporations, or for trades or businesses under common control when determining whether either of the gross receipts tests are met.

Payroll Offset Election and Limitation

Assuming the startup has less than $5 million in gross receipts for 2023 and didn’t have any receipts before 2019, the R&D tax credit is claimed on federal Form 6765, Credit for Increasing Research Activities, and Section D is completed electing to offset payroll tax. The tax return must be timely filed, including extensions. The credit can be used to offset payroll tax liability in the quarter following the filing of the federal tax return. Federal Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must accompany the payroll tax filing, Form 941. Any excess R&D credit not utilized is carried forward to succeeding quarters.

The credit is specifically applied against the business’ portion of Social Security tax. Social Security tax is part of the payroll tax employers owe. Thus, if a startup had five employees with a salary of $55,000, up to $17,050 of tax liability can be offset by the R&D tax credit. A business is limited to a maximum annual election amount of $250,000-$500,000 to apply against future payroll tax liability. 

How Startups Can Benefit From R&D

The R&D tax credit provides opportunities for startup businesses to reduce their tax liability and keep cash in their business through the federal payroll tax offset.