R&D Tax Credits to the Rescue
Are You Leaving Money on the Table?
This week, we spoke with Brian Goodwin about R&D tax credits and what they mean for startups. Goodwin is the Director of Sales and Partnerships at Incentax, a tax credit consulting firm focused on these tax credits for businesses. Quibi has pulled the plugged
What is the R&D tax credit and how does it apply to my company?
The Research and Experimentation (R&D) Tax Credit has been around for over 30 years and aims to promote innovation and jobs within the United States. Traditionally, this credit has been used by larger profitable companies looking to eliminate their overall tax burden, since it is applied dollar for dollar against income tax liabilities. A great example of this is Amazon, who reduced their federal tax bill to nearly zero.
Startups innovate at a very high level, but until the recent PATH Act, they were unable to take advantage of the program. Now early-stage businesses with qualifying expenses can put the credits toward the employer share of Social Security payroll taxes, thereby freeing up cash flow.
What makes a startup eligible for the early-stage R&D tax credit?
Companies just need qualifying R&D activities and expenses. These can differ by industry, but here are a few quick items we look for at a high level:
- Does the company create or improve a new product process or technology?
- Do employees have scientific-based roles (e.g. engineer, mathematician, developer, etc.)?
- Was there a level of uncertainty in the process?
Startups are eligible for up to $250k per year in credits on R&D-related payroll taxes (~6.2% of wages) if they:
- Have a total of less than 5 years total of revenue (or gross receipts)
- Have less than $5 million in revenue in the current open year (greater revenue in prior years is allowed)
One thing to note: income tax credits (if available) must be applied before payroll tax credits. For instance, if a company gets $100k in R&D credits while having an income tax liability of $25k, the credit would be applied to eliminate that first. The remaining $75k would be applied to payroll taxes in the early-stage provision.
Why don’t more companies know about this? Is this different from other typical business deductions?
Companies often focus on deductions rather than credits in order to reduce the amount paid on taxes. With a deduction, you are reducing taxable income, which decreases the amount owed in taxes, whereas a credit is a dollar-for-dollar cancellation of tax liability. Credits tend to provide more bang for the buck.
Example: A person with an income of $200,000 is taxed at 32% and pays $64,000 in taxes.
- DEDUCTION: A deduction of $60,000 leaves $140,000 of income. Potentially taxed at a lower rate of 24%, the tax bill would be $33,600.
- TAX CREDIT: If instead the person received a tax credit of $60,000, they still have a tax bill of $64,000 on the $200,000 of income. With the dollar for dollar tax credit, the final tax bill would be $4,000.
The R&D tax credit is mainly underutilized because businesses, particularly early-stage ones, think they won’t qualify for it. Unfortunately, very few conversations are being had to change that, because tax firms tend to focus on larger business. That leaves a big knowledge gap in which early-stage companies and their advisors aren’t given enough resources to understand the potential of this credit. They are missing out on cash flow that can be reinvested in the business, all generated from expenses they’ve already incurred.
What are some examples of companies using the credits?
On the early-stage side, we’re working with a biotech company with 25 employees (including 5 engineers involved in R&D) and roughly $125K in annual revenue. They qualified for $105K in Social Security tax credits. Another small startup developing a mental health app just did the same, freeing up additional capital to reinvest into clinical trials key to their development.
On the income tax credit side, we currently are working with a 45-employee company that manufacturers packaging equipment. They’ve been in business for over 20 years but have never taken the credit. With a multi-year study, they’re eligible to apply over $600K in credits towards current and future tax liabilities.
Can these credits ever be applied retroactively?
The payroll tax application of the R&D credit is only good for the open year/current year. However, the income tax application of the credit can be claimed retroactively, up to three years back for the federal credit. Most states also have a state R&D tax credit, with the rules and lookback periods varying by state. (California, for example, has a lookback of four years.)
Outside of that window, income tax credits can be carried forward up to 20 years and applied to income taxes at a future date, as seen in the manufacturing company example earlier.
Are there any risks in using R&D tax credits?
The main risk is working with someone who either doesn’t have your best interest in mind (they may over-inflate the credit) or doesn’t specialize in the R&D tax credit (they may not get the calculations correct).
If I think my company may qualify, what do I do next?
Speak with either a CPA or a tax credit consulting firm, like Incentax, and learn more about your individual situation.
Any recommendations for finding a qualified CPA with R&D tax credit experience?
Smaller CPA firms are not likely to offer R&D tax credit services because it is very specialized. Ask your firm if they offer it all, and then whether it’s in-house or through a third party. Incentax works with CPA firms in these exact cases, providing expertise and advice on an as-needed basis.
What startup do you find most interesting at the moment?
StartEngine - their platform helps startups with crowdfunding, and they are creating a secondary market for startup investors to trade their shares.
What have you been reading lately?
Talking to Strangers by Malcolm Gladwell; another thought-provoking book on the way we perceive and interact with others.
What’s a great piece of advice you've received?
One from Ryan Holiday’s The Obstacle Is the Way stands out. A challenge that looks insurmountable is, in fact, the way through. Obstacles are only obstacles because we perceive them to be. See it in a different way and you can, and will, overcome it.
To connect with Brian about tax credits and more, email him here.
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