Many startup founders might be surprised to learn that qualifying for the R&D Tax credit doesn’t require a dedicated R&D department.
It’s not necessary to be on the cutting edge of the latest technologies, reinventing the wheel, or building a spaceship, either. All that’s necessary is to engage in activities intended to solve a technical uncertainty.
Of course, claiming the credit isn’t quite as simple as telling the IRS you did some research. The research activity must pass the IRS’s 4-part test and not be part of an excluded activity.
But many startups and software companies are indeed actively (and unknowingly) engaging in qualified research and development activities. In other words, they’re leaving tax credits on the table, a missed opportunity.
If your startup builds new products or creates new software tools, the R&D Tax Credit is worth researching.
But first, let’s take a step back. What is the R&D tax credit anyway?
Originally introduced in 1981 as the Research and Experimentation tax credit, the R&D tax credit was intended to incentivize companies engaging in R&D activities. The federal government could promote innovation and create high-paying technical jobs on US soil by encouraging companies to perform research.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act made the temporary measure permanent.
Unlike deductions, which reduce a company’s taxable income, the R&D tax credit improves cash flow by directly reducing tax liability for companies applying resources to solve technological uncertainty.
The credit applies to these three types of business tax liabilities:
R&D tax credits aren’t limited to companies doing certain types of research in specific fields. When it comes to the industry, there is no exclusivity. It’s not a tax credit for specific kinds of technologies.
While there are certain exclusions, any company and activity could qualify: farming, software, manufacturing, you name it.
To determine whether or not a specific activity qualifies, the IRS has a 4-part test.
However, certain activities are excluded from qualifying for the R&D tax credit, even if they pass the 4-part test.
It’s difficult for:
Expenses for software development can be a complicated topic. If you’d like to claim the credit for software development, make sure to get expert advice.
Software developed as a commercial product might qualify.
But when developed for internal day-to-day use, the expenses typically don’t qualify for the R&D tax credit.
However, software developed for internal use, but as part of qualifying, wider-reaching research may also qualify for the credit, complicating the matter.
Because the credits are intended to promote hiring on US soil, expenses paid to internal employees living in the US and its territories return the highest credit.
As with any tax topic, the IRS has the right to audit you to confirm that the expenses you claimed are indeed eligible.
Many founders start their companies in order to solve a problem for their customers. By bringing their products to market, many startups naturally engage in activities that qualify for the R&D tax credit.
Not looking into the credit means leaving money on the table. The credits can have a significant impact on your business’s taxable income and cash flow.
But handling the credit on your own can be complicated, especially if you’re in the software space. You’re much better off with an experienced partner who can help navigate which activities qualify and how to claim them. If you’re building a startup that might have qualifying activities, contact us for a free consultation with one of our startup experts.