What Are R&D Tax Credits?
As incentive tax credits, R&D tax credit programs encourage technological innovation and design improvement by paying companies who develop innovative processes, products, or innovations. By utilizing the tax credit, businesses can save on taxes, boost cash flow, and stay competitive in the market.
Per the IRS, your R&D activities must meet this 4 part test. R&D tax credits aren’t just for successful projects. They can also be used for projects that end up in failure. The process or product you design doesn’t have to be completely new to your field but should be new to your company.
$250,000 in Payroll Offset
In the wake of the PATH Act of 2015, which made the federal tax credit for R&D permanent, startup companies are now able to use the credit, even when they don’t pay federal income tax, to reduce up to $250,000 of the FICA taxes on the payroll for the first five years of tax-free.
However, they must show gross receipts of less than $5 million during this tax year and no gross receipts in any tax year before the five-taxable year, ending in the year of tax credits.
Business Tax Credit Limitation Rules
How much you earn in R&D tax credit depends on your Qualified Research Expensing (QRE) total, comprising contractor costs, wages, and supplies costs. The wage QREs make up the majority of taxpayers who have QREs.
As per Section 38 of the IRS tax code, the tax credit you receive can only be used for the total of your tax liabilities above $25,000. Suppose a startup is not earning any income or tax obligations for the current year and is not a tax-paying entity. In that case, it might not get immediate benefits of the tax credit for research and development. In this situation, the company has unused tax credit carryforwards. Still, they can only be used when the company is profitable, and there is less of a financial requirement for the tax credit for R&D
Fixed-Base Percentage Rules
The IRS fixed-base percentage rules could be an aid or hindrance for entrepreneurs. Fixed-base percentages measure the expenditure of the taxpayer. Companies that are older or have a long history calculate it by multiplying the total of their gross revenues from the preceding four tax years by their average QREs for the same years. However, startups are given a fixed base of 3% for the first five years. They also get an amount of the gross receipts and QREs allocated for the following tax year.
Suppose your client’s fixed-base percentage is the maximum fixed-base percentage greater than 16%. In that case, their chances of getting an R&D tax credit are challenging, as a fixed-base rate of less than 1% is usually the result of the taxpayer gaining the tax credit. A fixed base of 3% can be accepted or denied. In the end, if a company can meet the percent fixed base, this could aid them in obtaining the tax credit.
Sometimes, the IRS base amount limitation rules can get into the way of new businesses. The rules for base amount limitation limit the amount of QREs for the current tax year, which are deemed to be the lower of these two criteria.
(1) the taxpayer’s total QREs for the year in question with the base amount reduced from it.
(2) half of the QREs of the taxpayer’s total for that current year.
The credit is almost guaranteed to be greater under the first circumstance instead of the second. Because the low fixed-base percentage statutory for startups applies to the first choice instead of the other. Due to the base amount restriction, startups must calculate taxes using the more appealing alternative. This will significantly decrease the number of tax credits available for startups. It could make it impossible for startups to be eligible to receive the credit.
Alternative Simplified Credit Rules
Alternative simplified credit (ASC) rules are an option that’s feasible by offering an easy method to calculate the tax credit for R&D by comparison of the taxpayer’s QREs in the current tax year with the QREs they had for the prior three tax years. The prior three years are their base tax year, instead of the historical or startup company base period tax years previously mentioned.
Additionally further, in addition, the IRS Code has instituted a base period limit on the ASC. If the taxpayer does not have QREs for one of the previous three tax years, the IRS will assess their ASC at the equivalent of 6% of their tax year’s QREs. This limits how much ASC can be accessed by startup businesses that haven’t been operating for longer than three years.
Other Considerations for Startup Companies
Startups must be aware of the rules governing contract expenses, which limit QREs for the amount given to contractors to up to 65% of the amount spent, compared to 100 percent for full-time employees. This is intended to encourage taxpayers to utilize their staff for research.
It’s also important to consider the limitations on stock options. Since many startups do not have the capital they require immediately, they instead resort to stock options to reward employees and attract and retain them. Startups do not count the options as QREs to calculate tax purposes. R&D credit until employees exercise their options, which could be several years or even decades in advance. Because of the delay in incorporating stock options as QREs, startups could face a huge restriction on the benefits of the tax credit.
Your Tax Credit Could Help Fund Your Startup
R&D tax credits could serve as a major financial boost for startups of all kinds; however, as was previously mentioned, only one-third of eligible businesses are even aware of their eligibility to receive tax credits for an R&D tax deduction. Don’t Put Money on the table! A firm specializing in R&D tax credit such as Bourkehood can help. R&D will be critical to your organization if you fully embrace it. With our help, your business will learn how a well-thought-out strategy can make a huge impact.
If you’d like to learn more about the R&D tax credit, or if you have a proposal, please send us an email.