Pre-revenue technology companies often overlook the Research and Development (R&D) Tax Credit. In doing so, they bypass the powerful benefits the credit can provide during a company’s earliest stages (and beyond).
Provisions within legislation allow companies to apply some or all of their research tax credit against payroll taxes—instead of income taxes. This can free up valuable cash as the company works to establish its marketplace and financial foundations.
Understanding the R&D Tax Credit
The federal Research and Experimentation (R&E) tax credit, often called the R&D Tax Credit, is designed to incentivize U.S. private-sector innovation by providing cash savings that, in turn, enable investment or reinvestment and growth.
Four-Part Qualification Test
Companies can receive credits for up to approximately 10% of project-qualifying expenditures that satisfy a four-part test embedded in the legislation:
- Research must be undertaken for a permitted purpose, such as a new or improved product or process function, performance, reliability, or quality.
- The project or activity must be technological in nature, relying on a hard science such as engineering, physical or biological sciences, or computer science.
- There must be technological uncertainty related to the capability, methodology, or design of the project (known as a “business component” in the tax credit regulations).
- A process of experimentation must be used to resolve uncertainty, and the company must be able to demonstrate how the project progresses from its initial concept through design, testing, and validation to commercialization.
Eligible Expenses
Wages, typically the major driver of R&D credits, include the eligible portion of all taxable compensation. Qualified wages include the portion of an employee’s compensation corresponding to the percentage of working time engaged in one of several designations.
Direct conduct wages (engineers, scientists, and programmers performing the basic work required to complete an R&D project) typically represent the largest eligible wage expense category, though the credit also includes direct support (production personnel, testers, drafters) and first-line supervisors.
Other eligible expenses include:
- Project supplies, such as materials used to create and evaluate prototypes and engineering software licenses.
- Contract research performed on behalf of the company in the United States.
Note that under Section 174 of the Tax Code, domestic research or experimental expenditures must be capitalized and amortized over five years (expenses attributable to foreign research must be amortized over 15 years).
The Payroll Tax Election for Tech Ventures
During the startup phase, most technology companies make significant investments long before their products and services begin to generate revenue, let alone profit. For these companies, the payroll tax election offers an opportunity to get immediate use from the organization’s research credits. Because every dollar of credit-eligible expenditure can result in as much as a 10-cent tax credit, that’s a big help in a company’s earliest stages.
To qualify for the election, a company must have gross receipts for the election year of less than $5 million and no more than five years (or tax periods in the case of short years) past the period for which it had no receipts (the start-up period).
Starting with the 2023 tax year, the amount of research credit a company can elect to use the payroll tax offset doubled to $500,000. The company can allocate the payroll tax offset in any value up to the amount of total credits generated or the statutory maximum.
Another change in 2023 is that the payroll tax election can be applied to the employer side of Social Security and Medicare, not just the Social Security portion of FICA taxes.
Stricter R&D Tax Credit Documentation
Reporting and documentation changes starting with the 2024 tax year are increasing the complexity of filing for the R&D credit by mandating more detailed disclosures of business component details and expenses.
A new Business Component Information section on the proposed new Federal Form 6765 requires taxpayers to identify specific projects included in the credit and to break out qualified research expenses by project. Direct wages are further allocated to the conduct, supervision, and support of qualified research.
Time tracking and project-level accounting, often set aside during the long days and nights that define startups with leaders performing multiple roles, can provide valuable information for claiming the R&D credit on a company’s return. Companies should take time to ensure expenses are coded to the relevant project.
Absent time-tracking tools and processes, startups should conduct quarterly surveys to capture lists of ongoing projects and the time allocated to them.
The R&D tax credit is an active area, with legislative changes under discussion at the federal and state levels. For more details, explore the webinar video and the accompanying slides on this page. To understand the latest developments and how they may affect your technology company, contact us.
