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How to Guide on R&D Tax Credits for Startups

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R&D tax credits can be ideal for clients operating startups—particularly those of a technical nature, such as in the fields of computer science or pharmaceuticals. The credits can deliver a financial windfall to qualifying taxpayers, but the unique circumstances of startups entail challenges you need to help them navigate.

Apr 12th 2022
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What is the current state of research and development (R&D) tax credits and how can you help your startup clients obtain them? 

As federal and state tax incentives, R&D tax credits encourage innovation and technical design improvement by reimbursing companies that develop new products, processes, or inventions. With the credit, companies can gain tax savings, boost their cash flow, and remain competitive.

For many industries, day-to-day operations are considered qualifying activities, yet less than one-third of eligible companies are even aware they qualify for R&D tax credits.

According to the IRS, your client’s R&D activities must meet this four-part test:

1. Permitted Purpose: Research must entail new or improved business components, function, performance, reliability, and quality.

2. Technological in Nature: Research must be based on physical or biological science, engineering, or computer science.

3. Elimination of Uncertainty:  Research must aim to discover information to eliminate uncertainty about the capability, method, or design for developing or upgrading a product or process.

4. Process of Experimentation: Research must evaluate more than one alternative to reach a result; modeling, simulation, or a systematic trial-and-error methodology can be involved.

R&D tax credits aren’t only for successful projects. Your clients can also use them for efforts that result in failure. The product or process you develop doesn’t have to be new to your industry; it only needs to be new to your company.

Payroll Offset

Thanks to the PATH Act of 2015, which made the federal R&D tax credit permanent, startups can now use the credit—even if they’re not paying federal income tax—to offset up to $250,000 of their FICA payroll tax for their first five taxable years.

Stipulations dictate they must have gross receipts less than $5 million in the tax credit year and zero gross receipts for any taxable year preceding the five-taxable-year period ending with the tax credit year.                                      

Startups and Business Tax Credit Limitation Rules

How much your client gets back in R&D tax credit depends on the sum of their Qualified Research Expenses (QRE), which can include wages, contractor costs, and supply costs. Wage QREs represent the vast majority of most taxpayers’ QREs.

According to Section 38 of the IRS tax code, your client’s tax credit is limited to the sum of the their tax liability over $25,000. If a startup has little or no income or current-year tax liability, it may not be able to get an immediate benefit from the R&D tax credit. In this case, the startup will have unused R&D tax credit carryforwards, but it can only use them if the business is profitable, when potentially it will have less of a financial need for an R&D tax credit.

Startups and Fixed-Base Percentage Rules

The IRS’ fixed-base percentage rules can be either be a help or a hindrance for startups. The fixed-base percentage measures the taxpayer’s increase in spending. Older or historic companies calculate it by multiplying the average of their gross receipts for the prior four tax years by the average of its QREs for the same years. But startups are assigned a fixed-base percentage at 3% for the first five years, with a percentage of the gross receipts and QREs for later tax years.

If your client has a maximum fixed-base percentage of 16 percent, their changes of obtaining R&D tax credit are problematic, while a fixed-base percentage of 1 percent or less will usually result in the taxpayer winning the credit; a 3% fixed-base could either be accepted or rejected. As a result, if a startup has the 3% fixed-base percentage, it can help them qualify for the credit.

Sometimes the IRS’ base amount limitation rules get in the way of startups. The base amount limitation rules restrict the amount of the taxpayer’s current tax year QREs that are assessed to the lesser of these two conditions:

  • the taxpayer’s total QREs for the current year, with its base amount subtracted
  • one-half of the taxpayer’s total QREs for that current year

The credit will almost always be bigger under the first condition, rather than the second. This is because the low statutory fixed-base percentage for startups is applied to the first option, and not the second. Because of the base amount limitation, startups are usually forced to compute their tax credits using the less desirable second option. This can meaningfully reduce the amount of credit available to startups; it can even prevent startups from being able to take the credit.

Startups and Alternative Simplified Credit Rules

The alternative simplified credit (ASC) rules offer a viable alternative by providing a simplified method for computing the R&D tax credit by comparing the taxpayer’s QREs for their current tax year to their QREs for their prior three tax years; the prior three years represent the base period tax years, instead of the historic or start-up company base period tax years earlier mentioned.

Further, the IRS Code decrees a base period limitation regarding the ASC. If the taxpayer lacks QREs for any one of the prior three tax years, the IRS assesses their ASC as 6% of their current tax year QREs, which limits the amount of ASC available to start-up companies that have not been in existence for more than three tax years.

Startups and Other Considerations

Startups should be aware of the contract expense rules, which limit QREs for amounts paid to contractors to 65% of the amounts spent, as opposed to 100% for full-time employees. This is designed to encourage taxpayers to use their in-house staff to perform research activities.

It’s also important to note the limitation around stock options. Since many startups lack immediate access to capital, they instead use stock options to compensate employees and attract and retain employees. Startups defer counting the options as QREs for their R&D tax credits until the employees exercise the options, which can be years or even decades ahead. As a result of this delay in including of stock options as QREs, startups can see a major limit to the benefits derived from the credit.

Delivering Value-Added Service to Clients

R&D tax credits can serve as a serious financial boon for startups of all varieties, but as mentioned earlier, less than one-third of eligible companies are even aware they qualify for the R&D tax credit. As a CPA, you can demonstrate your added worth to your valued clients by bringing to their attention a tax strategy that could improve their bottom line dramatically.

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