How Startups Can Benefit from 250K R&D Tax Credits and Deductions

If you are a startup with annual gross receipts of less than $5 million, you can apply up to $250,000 of your research and development (R&D) credit to offset against your payroll tax liability.   

2016 is shaping up to be a banner year for startups. Believe it or not, founders and investors of innovative software and technology companies have to thank the Congress.

When it comes to paying Uncle Sam no one wants to pay more than they legally have to. The new legislation makes the section 41 tax credit for research & development available to many small and mid-sized companies that had been effectively barred from using it.  Many small startups operate at a loss. Until recently, these businesses were unable to get a current cash benefit from the federal research credit because the credit could only be used to offset federal income tax liability.

Companies in losses have no income tax liability, so the unused credits could only be carried back one year, or forward for up to 20 years until they were used or expired.

For the past 35 years, the R&D credit was just a temporary part of the U.S. tax code. The Protecting Americans from Tax Hikes Act of 2015 - PATH Act - made the research credit a permanent benefit, enabling qualified small businesses to use up to $250,000 of research credits to offset payroll tax liabilities.  Below is a chart that goes into the criteria for qualifying for it.  

Qualified Small Businesses With Less Than $5 Million in Gross Receipts

The PATH Act allows qualified small businesses to elect use of the research credit to offset the employer’s FICA payroll taxes. The total benefit is limited to $250,000 per year for up to five years. Taxpayers can make the election with the payroll tax filing for the first quarter that begins after an annual income tax return. This is filed for tax years beginning after December 31, 2015, and on which a research credit is claimed.

Eligible taxpayers may specify the amount of credit up to $250,000 to be utilized for the quarter. Excess credits that do not exceed the annual limit will carry forward for use against subsequent quarterly payroll tax liabilities.

Qualified small businesses are defined as corporations with gross receipts of less than $5 million for the current tax year and no history of gross receipts that extends beyond the 5 year tax years ending with the current tax year.

Sole proprietorships can qualify if the individual meets the gross receipts test with respect to all trades or businesses. The definition excludes exempt organizations.

“One sign of potential eligibility for the R&D tax credit is having engineers, scientists, or product development personnel on your payroll," says Huckabee CPA Thomas Huckabee.  

Startups that can claim the credit come from a variety of industries, all of which are making incremental improvements to their products. These industries include the on-demand economy, big data, chemistry, agriculture, technology, software, manufacturing, wine, oil & gas, aerospace subcontracting, pharmaceutical, and biotech. Basically, any company that is designing new products could take advantage of this.   

Founders: What Else Can You Deduct From Your Taxes?

It's never been a more exciting time to start a new business. Advances in technology are virtually disrupting nearly every industry, but before you find your product market fit or raise a round of funding, you generally have to spend a lot of money and time.

You have to hire engineers, train employees, pay overhead costs such as rent, utilities, and for sales and marketing to help acquire customers. If your startup has not hired a controller or CPA firm yet, than many founders may not be aware that many incurred expenses cannot be immediately deducted.   

How Expenses are Handled on Your Tax Return

When planning a new business, it’s important to be aware of these 4 key points:

  • Business startup costs include those incurred or paid while creating an active trade or business or investigating the creation or acquisition of one. Organizational costs include the costs of creating a corporation or partnership.

  • Under the federal tax code, taxpayers can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs. The $5,000 deduction is reduced dollar-for-dollar by the amount by which your total start-up or organizational costs exceed $50,000. Any remaining costs must be amortized over 180 months on a straight-line basis.

  • No deductions or amortization write-offs are allowed until the year when “active conduct” of your new business commences. That usually means the year when the enterprise has all the pieces in place to begin earning revenue. To determine if a taxpayer meets this test, the IRS and courts will generally ask: Did the taxpayer undertake the activity intending to earn a profit? Was the taxpayer regularly and actively involved? Has the activity actually begun?

The Conclusion

The timing is everything with claiming tax deductions related to your startup business. Sometimes taking the deduction in the first year doesn't always make financial sense.

The R&D Tax Credit helps companies remain competitive in the marketplace by allowing a dollar-for-dollar reduction of federal and state income taxes owed for qualified expenditures incident to the development or improvement of a product, process, software, formula or invention.

The PATH Act of 2015 created important opportunities for taxpayers claiming the federal research credit. A permanent credit means that all businesses can engage in meaningful long-term planning for tax benefits. The expansion of the research credit to offset payroll tax liabilities means that many small businesses will now share in these benefits.

Businesses conducting research and development with gross receipts under $5 million, should take a second look at the federal research credit and the many state credits that follow the federal rules. Put in a quick call to your CPA to determine if your company is eligible for this new provision. The research credit services team at Thomas Huckabee CPA can also help you determine if your business can benefit from the new rules, and add value to your business for years to come.