How R&D Tax Credits Can Benefit Your Small Business
Let's unpack how research and development (R&D) tax credits can mean thousands of dollars for your startup.
R&D tax credits are intended to incentivize companies for innovation. For most Fortune 500 companies, taking advantage of these billion-dollar programs is a no-brainer. These companies have the resources to navigate complex government processes and the internal know-how to apply and claim their savings. But large companies aren’t the only ones who qualify for these incentives.
Any business that conducts research and development likely qualifies for certain federal tax credits. “Qualified research” is broadly defined by the IRS as any development or functional improvement of any product, process, or technique. These credits provide a reduction in federal income taxes, and in some states, an additional reduction is also available.
For growing small businesses, these credits are equal parts appealing and unattainable. On the one hand, they can help bring a product to market faster, reduce research and development costs, and even lower R&D tax liabilities. But on the other hand, most small businesses assume they don’t qualify. Luckily, this is a common misconception.
Qualifying for R&D Tax Credits
Introduced in 1981, the R&D tax credit is one of the most valuable credits provided to innovators and entrepreneurs alike. Though originally intended as a two-year incentive, the credit was so successful that it was baked into the tax code long term. As opportunities for research and development have broadened over time, this credit has become increasingly valuable across almost every industry.
Recent amendments and new laws, including the 2015 Protecting Americans From Tax Hikes (PATH) Act, expanded this program to include additional benefits specifically aimed at small businesses and startups. For example, if you own a startup company with less than $5 million gross receipts for the current tax year, and no gross receipts prior to five years ago, you can apply for up to $250,000 credit against payroll tax liability.
Many activities qualify under the R&D umbrella: developing new products, conducting research or applying it, designing and evaluating alternatives, and modifying the concept and design of an existing project. The list goes on (though it does exclude market research, routine data collection, quality control, etc.). Essentially, if you’re trying to provide a better product for your customers or improve the process by which your product is created, it’s considered R&D.
To determine eligibility, businesses must pass the IRS’s four-part test. Simply put, the project(s) in question must:
- Aim to design or improve a new or existing product or process.
- Have some technical uncertainty, meaning you’re not sure whether it works until you try it.
- Involve some experimentation, such as prototypes or A/B tests.
- Rely on hard sciences, like (but not limited to) chemistry, physics, computer science, or engineering.
A lot of companies don't realize how much R&D they’re actually doing. Improvements are a standard part of any product lifecycle, so many companies qualify just by going about their day-to-day. Small businesses can even claim tax credits on R&D-adjacent expenses, like:
- Wages of employees working on, supporting, or supervising R&D.
- Supplies used during the development process.
- Outside vendors and contractors assisting with R&D.
- Research payments made to partnering educational institutions or scientific research organizations.
It’s important to note that any business looking to claim R&D tax credits should keep detailed records to ensure that qualified expenses are properly documented. In the event of an IRS audit, you’ll want to avoid paying back taxes and/or penalties if you inadvertently claim an expense that is not related.
While qualification for these credits has gotten easier over time, claiming them is still a complicated process.
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R&D Tax Credit Benefits for Small Businesses
The benefits of R&D tax credits are tremendous. While specifics vary by business need, some of the most significant benefits are:
- An immediate source of cash. By claiming this credit on payroll taxes, rather than income taxes, eligible startups and small businesses can take advantage of this program without turning a profit. This helps support R&D in the early stages when you are almost guaranteed to make a loss. If your company is centered around a new product or idea, R&D tax credits can make the difference between success and failure.
- A dollar-for-dollar reduction in federal and state income tax liability. This reduces tax liability substantially for current and future years. This is not a deduction, but rather a reduction in your tax burden that passes forward through the years.
- Increased earnings-per-share. Reducing your tax liability helps increase your earnings and those of your shareholders. It’s also an effective way to continue funding the innovation that qualifies you in the first place.
- Retroactive claims from past years. You can perform look-back studies, within the past three or four years, and recognize unclaimed tax credits for open tax years, resulting in another influx of cash. For many companies, this allows them to claim credits on activities they might not have recognized at the time were, in fact, R&D.
These benefits make it well worth the effort of determining whether you can claim these tax credits for your company. But once you’re confident that your business qualifies, a new question emerges: how do you find the time and expertise to properly claim them?
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Claiming R&D Tax Credits
For many growing companies, conducting an independent R&D study to establish credit eligibility is extremely difficult and time-consuming. Your CPA or tax professional can help, but they don’t always have the in-depth knowledge and expertise to work with these particular credits.
That’s where MainStreet comes in. At MainStreet, we’re on a mission to uncomplicate government tax credits and pass real savings (time, money, headaches, you name it) onto small businesses. We plug directly into your payroll provider to determine exactly how much you can save now, providing you with an educated assessment of how this program can benefit your business. From there, the rest is up to you. It’s completely free to see what you’re owed and we only make money when you save.
The average venture-backed startup unlocks an average of $51,040 on their first 20-minute call. We’ve helped 2000+ startups and small businesses claim over $100,000,000 so far. Let us take the guesswork out of government credits so you can get back to innovating.