Posted by Jeffrey Feingold on 05.20.24

Each year, the US government provides substantial funding to innovative businesses for advancing new or enhancing existing technologies, products, materials, and processes through the US Research & Experimentation Tax Credit (R&D Tax Credit) program. Startups are eligible for R&D tax credits, enabling them to offset payroll taxes by up to $500,000 for each fiscal year. The recent Inflation Reduction Act effectively doubled the previous limit of $250,000. This new law applies to tax years starting January 1, 2023. To make the most of R&D tax credits, startups need to first understand which work qualifies for the tax credit and then gather the relevant documentation.

The R&D Tax Credit Explained

The R&D tax credit is a tax incentive for businesses engaging in research and development activities in the US. The US R&D tax credit has been a part of the tax landscape since 1981. Historically, the R&D tax credit was an income tax credit, making it challenging for startups or unprofitable businesses to benefit from the credits. However, with the changes introduced in the Protecting Americans from Tax Hikes (PATH) Act of 2015, startups could apply the R&D tax credit against the employer portion of Social Security taxes each fiscal year.

The Tax Cuts and Jobs Act that went into effect for tax year 2018, also indirectly increased the R&D tax credit’s after-tax benefit when it reduced the corporate tax rate to 21%. Additionally, the tax law’s removal of the corporate alternative minimum tax (AMT) has given more companies the opportunity to take advantage of the R&D tax credit.

R&D tax credits can immediately benefit you in several ways:

• A source of cash for reinvestment or other needs within the company

• Significant reduction to current and future tax liabilities

• Credits can carry forward up to 20 years

• Offset payroll tax liability

• Determine Which Activities that Qualify for the R&D Tax Credit

Qualification Criteria

Startups must meet the following criteria to qualify for the federal R&D tax credit program:

1. The business must have gross receipts of $5 million or less for the tax year.

2. The business must have gross receipts for five years or less. It must not have had gross receipts before the 5-tax-year period ending with the tax year they are applying for.

Eligible Work for the R&D Tax Credit

The R&D tax credit eligibility largely depends on whether the work you are conducting meets the criteria established by the IRS in its four-part test:

1. Qualified Purpose - The purpose of the research must be to create a new or improved product, process, or formulation, resulting in increased performance, function, reliability or quality.

2. Technological in Nature – The research must rely on principles of the hard sciences, such as engineering, physics, chemistry, biology or computer science.

3. Elimination of Uncertainty – Activities must overcome some unknowns, such as uncertainty as to capability, optimal design, or optimal methodology.

4. Process of Experimentation – Experimentation can be demonstrated through test batches, simulations, systematic trial and error, or other methods of evaluating alternatives to achieve a desired result.

Utilizing R&D Tax Credits to Offset Payroll Tax Liability

The payroll tax credit election allows a qualified small business to specify the amount of research credit, not to exceed $500,000 per year, to be used against the employer portion of Social Security and Medicare payroll tax liability.

Find Out if Your Activities Qualify

The R&D tax credit can be a lucrative incentive for businesses. And given the new permanent nature of the federal tax credit, now is the time to consider whether activities performed by your company qualify for major cash-saving federal and state tax credit opportunities.

Request a free assessment to determine qualifying R&D tax credit eligibility.

Tax Point Advisors, a firm with expertise in working with small and midsize companies, works with businesses that may qualify for R&D tax benefits. For more information, read our e-book: The Business Owner's Guide to R&D Tax Credits.

You may also contact us at (800) 260-4138, or please leave us a message below.