R&D Tax Credits for Small Businesses & Startups
Find out how small businesses and startups can benefit from tax credits and deductions.
Research and development tax credits help qualified companies offset innovation and research expenses against taxable income. This incentive is available to businesses of all sizes, whether they are profitable or not. In other words, it is meant for more than just large organizations with in-house research facilities. However, many companies are not aware that their day-to-day activity can qualify for R&D tax credits.
But aware or not, small companies can use this incentive to deduct the FICA portion of payroll taxes. More precisely, your company may be able to apply up to $250,000 of your R&D tax credit to lower your payroll tax obligation. Read more details about this incentive, the filing procedure, and whether your business qualifies.
Why You Need an R&D Tax Credit for a Small Business
Growing a company typically involves capital expenditure to develop new services, products, systems, or technologies. In this way, the success of start ups, and the entire economy, relies on innovation and growth.
In short, innovation requires research that is expensive, and usually accounts for a large portion of start up costs. In addition, such activities generally take place before a company becomes profitable. That’s why the government and different states established the R&D tax credit to encourage firms to maintain their innovative efforts.
R&D Tax Credit Program Explained
The R&D tax credit, also known as the research and experimentation tax credit, is a part of the United States tax code. It stimulates economic growth by incentivizing companies to invest in innovation, research, and technologies.
It was originally presented in 1981 and, for the next 35 years, was only a temporary addition to the American tax code. However, in 2015, the R&D tax credit became a permanent benefit under the Protecting Americans from Tax Hikes (PATH) Act. The Act also allowed qualified small businesses to use up to $250,000 of research credits to reduce payroll tax obligations.
Before this legislation, businesses could use the R&D tax credit only to offset regular tax. As a result, small and mid-sized companies had limited options for claiming the incentive if they were subject to AMT (alternative minimum tax). That was especially debilitating to pass-through entities.
But thanks to the change, eligible small firms can now offset their AMT liability with the R&D tax credit. The incentive underwent further corrections in 2022 under the Tax Cuts and Jobs Act (TCJA).
In general, the Research and development tax credit allows taxpayers to decrease the tax liability on their firm by the amount of the credit. However, the IRS highlights that the credit is meant only for expenses incurred or paid for qualifying research.
What Advantages Does the R&D Tax Credit Offer?
Before 2015, startups that weren’t yet profitable could only take advantage of the R&D tax credit once they started to generate profit and income tax. Also, the unused credits could only be carried back one year or carried forward for up to 20 years until they were used or expired (because businesses with losses do not owe income taxes).
However, the PATH Act of 2015 changed that. The law permanently improved the R&D credit for companies and shareholders. That included enabling unprofitable firms to offset up to $250,000 of their payroll tax payments annually.
Generally speaking, it is thought that giving businesses R&D tax credits boosts innovation and benefits the entire economy. For example, companies claiming the incentive gain the advantage of lower tax liability. Some of the benefits of using an R&D tax credit include the following:
Reducing state and federal tax obligations for the current year and future years;
Increasing your business’s cash flow and market value;
Reducing your company’s effective tax rate;
Enabling you to retain more of your earnings.
From 2022 onward, the TCJA mandates that companies must spread out their U.S.-based R&D expenses over a five-year period as opposed to immediately deducting them. In response, the Tax Foundation, an independent group researching tax policy, has determined that eliminating these amortization restrictions could increase economic output and earnings while adding an estimated 19,500 jobs. In other words, both firms and employees could benefit from reducing the amortization rules.
Do Small Businesses Qualify for the Research and Development Tax Credit?
Most businesses can claim the R&D tax credit for their day-to-day development activity. We are able to qualify activity that uses data science and data analysis, requires hiring engineers, outsourcing product research, or testing products. That said, your firm should be able to verify that the R&D included hard science to be eligible for credit. For instance, if you are an accountant or run a restaurant, you won’t be able to apply for the R&D tax credit, even if you test new products or conduct research. Furthermore, if a business is in the “humanities” and tries to apply for this incentive, it will likely not qualify for credits.
What About Small Businesses and Startups?
The IRS defines qualified small businesses as companies with gross receipts of $5 million or less for the claiming tax year. Moreover, a small business can only have gross receipts for the previous five tax years ending with the current tax year. Sole proprietorships also qualify if the individual passes the gross receipts test for all trades or companies. However, the definition from the IRS excludes exempt organizations.
All in all, startups should consider applying for R&D tax credits on the first days of the new business and before tax time. To determine if your business is eligible for this incentive, the IRS has developed a four-point qualification test:
Purpose. Your research and development project must set out to develop a brand-new or enhanced product offering by seeking to improve the quality, performance, or reliability of that offering.
Eliminate uncertainty. Companies must face a challenge with some form of technical uncertainty and attempt to solve it using their own iterative methods to be eligible for the R&D tax credit. As long as the final design of the project is unknown at the start of the project, and a method of development is used to achieve the final design, the activity can qualify for R&D credits.
The qualifying research must be of a technical nature. But for an activity to be classified as technical, it must be based in hard sciences (computer science counts as a hard science for tax credit purposes).
R&D credit qualification requires that the experimental process must include evaluating alternatives in the form of simulation, systematic trial and error, modeling, refining, or testing.
What Paperwork Do You Need to Submit to Apply for the R&D Tax Credit?
Regardless of the type of business you operate, it is required that you have documentation to prove the adequacy of your R&D activity. This requirement is non-specific, meaning that the IRS does not require a specific type of documentation – they only require that you can show some form of proof for the activities you claim to conduct. For this reason, this requirement is rarely prohibitive of an R&D credit claim. We can use emails and even meeting notes to prove R&D activity. Some of the records you may have on hand are the following:
Schematics, test results, blueprints, status updates, marketing materials, and any other records that demonstrate the course and results of your research;
Timekeeping data for meetings, work schedules, payroll, and other activities to demonstrate they were relevant to R&D;
Copies of all contracts and payments made to any contractors who conduct third-party research for you;
The general ledger reports showing which costs, supplies, and materials relate to research and which do not (including paying for cloud services);
Payroll records for the employees actively involved in R&D as well as for those who supervise them.
That said, the IRS does not define what constitutes “adequate documentation” when applying for the R&D tax credit. However, you must submit IRS Form 6765. Also, depending on the company structure, you might need to complete a few other forms like IRS Form 3800 and IRS Form 8932. Small firms also have to submit Form 8975, but you will only have to file it once the IRS approves your credit.
Can You Increase Your Tax Credit?
The R&D tax credit is available to small companies in a variety of ways. There are several ways of calculating R&D credits, and they are not mutually exclusive of one another. This means that it is critical to have a specialty tax expert determine which of the calculation methodologies is most beneficial to your company in any given tax year.
If your eligible small business has no income tax, you can use the research and development tax credit to deduct the FICA part of the payroll taxes up to $250,000. Again, you can claim this incentive even if your small business isn’t yet profitable.
What Costs are Eligible for this Incentive?
The following R&D-related costs are eligible for the tax credit:
The expense of creating a patent;
Research payments made to an accredited educational institution or a recognized scientific research body for approved R&D activity;
The costs incurred by a third-party contractor to carry out research-related tasks for your company, regardless of the success or outcome of such activity;
Materials used for creating new technologies that aren’t land, improvements to land, or depreciable property;
The wages you pay to personnel who perform qualifying R&D, as well as those who oversee or assist them.
Does your Small Business Qualify for the R&D Tax Credit?
Any taxpayer who incurs qualifying R&D expenses on U.S. soil is eligible to claim this credit. Nevertheless, you must demonstrate that your R&D activities meet certain requirements in order to apply. In other words, they must meet the four-part criteria mentioned above.
That means your efforts must aim to create a new or enhanced product, invention, procedure, or software. Next, they must rely on hard sciences like physics, biology, engineering, computer science, and engineering. Your research activities must also try to eliminate uncertainty and use testing and other forms of scientific experimentation.
It is important to note that for your research to be regarded as “eliminating uncertainty” meaning that the exact path to the end result is unknown at the outset of the project. Additionally, if your innovation revolves around software for internal use, that software:
Can’t be marketed or sold commercially;
Must involve financial risk to develop;
Must lead to a speed or cost reduction that is commercially significant;
Should be innovative.
Is the payroll offset available to all businesses or just startups and small businesses?
The payroll offset is available to all qualifying companies that:
Have R&D tax credits they can use in the claiming year;
Have gross receipts that don’t exceed $5 million in the claiming year;
Don’t have any gross receipts prior to the five tax years leading up to the claiming year.
However, even businesses that were operating long before the five-year limit and have invested millions of dollars in innovation can apply. For example, a life science company may be eligible if it has $0 gross receipts for a certain period of time before it receives FDA approval.
Where can I find out more about the R&D tax credit?
The Internal Revenue Code Section 41 and the related regulations include more detailed guidelines for the R&D tax credit.
This page was last updated by Steven Jefferies
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Common R&D States:
California Research and Development tax credit
Maryland R&D tax credit
Virginia Research and Development tax credit
Ohio Research and Development tax credit
Georgia R&D tax credit
Massachusetts R&D tax credit
Michigan Research and Development tax credit
New Jersey R&D tax credit
Texas R&D tax credit
Pennsylvania Research and Development tax credit
Illinois Research and Development tax credit
Louisiana Research and Development tax credit
Arizona R&D tax credit
New Hampshire Research and Development tax credit
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