Companies of all sizes can benefit from the Research and Experimentation tax credit (R&D Credit) which has been around since 1981. This credit aims to reward businesses for increasing the amount of investment it puts toward research expenditures during the current tax year. In a 2012 study, it was found that one-fourth of businesses claiming the credit had assets of less than $1 million.
The most popular form of the credit is applied against income taxes. If a company can’t use all of the credits in the current year, the unused portion can be carried back one year and carried forward 20 years. However, for most startup/emerging companies – who are using substantial angel and venture capital-backed funds to develop their product/service – the thought of taxable income to be able to utilize these credits against is off in the distance. Up until 2016, most of these companies had a tough time justifying the effort, cost, and additional risk of IRS scrutiny that are involved with claiming the credit when it was unclear if/when they would eventually benefit from the credit.
Enter the Protecting Americans From Tax Hikes (PATH) Act of 2015. This was a game changer for startup/emerging companies in the United States, as it allowed “qualified small businesses” to elect to apply their R&D Credits against the employer portion of its Social Security payroll tax beginning in 2016.
To be considered a qualified small business, a company must be in its first five years of collecting receipts and have receipts of less than $5 million in the year the credit is being elected. Additionally, the credit against payroll taxes is limited to $250,000 each year.
Some of the activities that indicate your business may qualify for the credit include:
- Continually developing or improving new products or processes
- Employing degreed engineers, scientists, or programmers
- Subcontracting engineering or testing functions
- Incurring raw material costs during the product development/improvement process
- Building prototypes, jigs, molds or dies
Most startup/emerging companies eligible for the credit will typically see a credit that is equal to about 10% of their qualified research expenses. For example, a company with $500,000 of qualified research expenses could see a credit of $50,000 to be applied to the employer portion of its payroll taxes. A credit of $50,000 would be enough to completely eliminate the employer portion of social security taxes on a little over $806,000 in wages.
With the ability to receive a dollar for dollar payroll tax credit now rather than waiting on taxable income, we recommend all startup/emerging companies investigate whether or not the R&D credit against payroll taxes makes sense for them. Contact us today to discuss how your company may benefit.