Recent changes to tax law have created the potential for significant sources of government tax credits that previously was not available to startups lacking corporate profits. Entrepreneurs should be aware of these new tax law changes regarding the Research and Development tax credit and their applicability for startups not yet profitable. These changes provide substantial competitive advantages and growth opportunities, via tax savings and cash flow. Previously these options were utilized almost exclusively by Fortune 500 firms. These larger firms have received billions in credits annually over the last thirty plus years and now startups can access those same credits.
This piece is specifically aimed at assisting and educating technological firms who are cash sensitive. The knowledge within is derived from the depth of our work and experience assisting startups and understanding their financial needs. The change allows firms with $5MM and under in annualized gross receipts, including those with no declarable income as yet, to claim an R&D credit up to $250,000 annually. We will discuss the history and latest change as well as the steps for qualifying to meet the criteria. Also covered are the caveats to consider in utilizing this credit.
What is the R&D Tax credit?
The R&D tax credit is both a federal and a state tax credit (not all states have a credit) for businesses under Internal Revenue Code section 41 (state to state the credit will vary). Originally it was introduced under the Economic Recovery Tax act of 1981 by U.S. Representative Jack Kemp. Expiring initially in 1985 it has been extended and renewed numerous times by Congress.
It was initiated due to concern over U.S. economic performance and intended to provide stimulus towards productivity gains and competitiveness by increasing support for research and development within the private sector. At the time of its introduction there had been a decline in domestic private spending on research.
In order to define what ‘qualified research’ is eligible for the credit, a four-part test has been developed. Within each part extensive regulations apply and require fact intensive documentation and evaluation of the activities and endeavors for which the credit is sought.
New developments broadening usage
One of the limitations of the tax credit has been its non-permanence. While it has been extended and renewed frequently, those responsible for the management of funds for research and development within companies have not had the ability to plan multi-year projects with the assurance that the cost to benefits ratio would not be drastically different beyond the current tax year window. That has changed as it was extended into permanence under the PATH (Protecting Americans from tax Hikes) Act of 2015. Another recent enhancement to the R&D tax credit, that we believe has the most significant effect for startups, is the ability to utilize it to offset payroll taxes. Beginning with 2016 tax year filings companies will be able to apply their R&D tax credit towards their payroll tax obligations. This benefit has been sought for a long time and is especially needed by early stage companies who had been unable to get the full benefit of the credit due to lack of corporate profits.
Who can benefit
Many fields can take advantage of this benefit. We see tremendous possibility for those involved in:
- App development
- Platform design
- VR hardware and software
This is just a small sample of the type of companies that can use this opportunity for innovation and receive the credit. Any startup that is closely monitoring cash burn and looking to expand their worker base can easily recognize 10’s of thousands in savings.
The ceiling on the benefit an eligible company can claim against payroll taxes annually is $250,000. As a credit rather than a deduction there is incredible impact on a dollar for dollar basis. By being able to apply it to payroll taxes even a small scale startup with 4 or 5 typical engineer salaries could see value in documenting research efforts.
What are the qualifications to be eligible?
In order for a company to take full advantage of the newly declared payroll tax offset there are several guidelines. Companies are eligible if:
- There is five or less years of gross receipts
- Those gross receipts are less than $5 million for each elected year
- Qualifying research and development activity can be documented.
Things to keep in mind:
- Companies in existence before 2012 can still qualify if they did not generate any gross receipts. This is especially useful for any highly research intensive firms that may have existed in an extended non-receipt generating stage, such as in life sciences or new platforms.
- This offset will apply for qualified expenses incurred in 2016. These must be documented on the 2016 federal income tax return. Furthermore the amount of credit that is applied towards offsetting of the payroll tax burden must be identified and elected on the tax return.
- The earliest qualified applicants will need to file by March 30, 2017 to utilize the offset towards second quarter payroll filings. As such the soonest a cash benefit will occur is July 2017.
- Taxpayers cannot receive this credit utilizing amended returns, those seeking to receive it as soon as possible are urged to consult financial and tax professionals and begin the documentation process of specifying, electing and filing immediately.
To substantiate and define what undertakings and activities count towards credit eligibility there is an established four-part test.
Activities being claimed needs to address:
- Technical uncertainty How is it developing or improving a product or method? What elements that were unknown are now being charted? This applies towards apps, workflows, new product lines, etc.
- A process of experimentation What evaluations were conducted? What alternates were explored? Modeling, trials and error, and simulated runs need to be shown.
- Be Technological in Nature quantitative hard sciences such as physics, computer science, engineering need to be utilized in the process.
- Qualified Purpose The end goal should be to bring about improvements in process or product that allows for enhanced performance, ability, function, dependability or quality.
Exclusions to be aware of:
- The activities need to be in the U.S.
- Software and other developments cannot be for internal use only; it must benefit the public.
Categories of eligible expenditures
Multiple expenditures that can be claimed include but are not limited to:
- Wages Both direct supporting candidate’s taxable wages, as well as any first-level supervisor wages are claimable. Supervisors who have other duties in addition will need documentation of the time spent on R&D activities.
- Supplies This applies to not only the supplies utilized in the research but “extraordinary” utility usage.
- Contract Researchers Independent research workers are claimable so long as their payment is not based upon results and additionally they retain substantial rights in the results jointly or independently.
Summary of Benefits
With a maximum cap of $250,000 annually companies could realize up to a total of $1.25 million of credits within the five-year window allowed against their payroll taxes. On average the credit will equal 6-10 percent of a company’s R&D costs, depending on the scale of the quarterly payroll tax filings.
In the event the credit exceeds a company’s OASDI (social security tax) in any of the quarterly filings and hits the annual limit the excess credit will be usable towards the following calendar quarter.
With such great promise also comes the need for caution. Utilizing this credit engages a much higher occurrence of an audit. The IRS has technical specialist teams, within an industry by industry range, already assembled to review documentation submitted and chosen for closer scrutiny. While many endeavors will be eligible an audit is a possibility at some point in the future.
All activities being considered should be reviewed and overseen by a tax advisor experienced with the R&D tax credit in anticipation of this likelihood. The individual nature of research means that a standard documentation software package will not sufficiently track and prepare records that will properly support the credit claimed in the event of an audit. Penalties for rejected claims are also considerable. The IRS can impose in excess of 20 percent of the rejected amount claimed. In the case of a company that has claimed the full $250,000 credit, and found themselves lacking proper paperwork, that would risk the possibility of over $50,000 in penalties. An internally generated audit initiated as soon in the process as possible is highly recommended as part of pursuing this credit.
Even with factoring in any potential risk we maintain a strong positive outlook on the total gains to be had. Firms who think they have eligible activity, or want to develop activity as a result of the incentive, should move soon to best fully capture the returns possible.
In addition to the cap of $250,000 annually there is also the ability to carry forward the credit. Overall this is a sizable tax benefit if fully and well utilized with a knowledgeable financial guide. As always if you have questions and are ready to explore applying this contact our well informed staff to find out how we can support you.