Does My Startup Qualify for Research and Development Tax Credit?

Of all the tax credits to be aware of, the Research and Development Tax Credit (R&D Tax Credit) may be the most important for startups; it is governed under the Internal Revenue Code Section 41, as the credit for increasing research activities. To encourage research activities, the federal government provides a reward for business entities that invest in research and development in the U.S., by returning a percentage of qualifying expenses as a nonrefundable credit. But before you get too excited, there are a few crucial requirements you should be aware of. Thankfully, we have provided a general overview of the tax credit and the requirements companies must meet to benefit from it.

What is the R&D Tax Credit?

The R&D Tax Credit is nonrefundable which means that taxpayers cannot utilize the credit to create or increase their tax refund. Put another way, the taxpayer can only utilize the credit to the extent of their tax liability. Qualified startup businesses (those that have less than $5 million in gross receipts and have gross receipts for less than 5 years) may offset up to $500,000 of the R&D Tax Credit against their payroll taxes.

How Do I Qualify for the R&D Tax Credit?

While companies from various industries can qualify, they must first identify their business components and determine whether the activities and expenses involved qualify. A business component is defined as any product, process, computer software, technique, formula, or invention that the taxpayer wishes to profit from or use in their business. Each business component must be analyzed separately as to whether the activity and the resulting expenses meet the following tests.

Qualifying Activities For The R&D Tax Credit: The Four-Part Test

1. Permitted Purpose. The purpose of the activity must be to improve business function, performance, reliability, or quality. A common example is the development of new products or parts for the company and/or customers. Although more subtle improvements, such as the improvement of a process or reorganization to increase efficiency, may also qualify.
   
2. Technological in Nature. The activity must depend upon principles of “hard sciences”. A hard science is any of the natural or physical sciences that use hypotheses and experiments. Examples include biological science, computer science, chemistry, or engineering. Soft science, on the other hand (psychology, sociology, or anthropology) may use hypotheses and experiments but they do not qualify under this prong. A common example of an activity that qualifies is experimenting with new techniques to improve the manufacturing process.
   
3. Technical Uncertainty. The activity must aim to make a discovery or eliminate uncertainty pertaining to capability, methodology, or design. The uncertainty could be as complicated as redesigning all components of a process to utilize high-speed manufacturing techniques, or as simple as reducing the time and complexity of an assembly process. As long as technical uncertainty is involved, the activity will pass this prong of the test.
4. Process of Experimentation. Substantially all of the activities must be elements of a process of experimentation.  “Substantially all” is defined as at least 80%. Thankfully accompanying such a quantitative threshold is a favorable provision known as the “shrink-back” rule. The Shrink-Back Rule allows this prong of the test to be applied first at the level of the overall business component. If the requirements are not met at that level, the qualification requirements are subsequently applied to the next significant subset of elements of the business component. An example of when this rule would be beneficial could be as follows:

A manufacturing company decides to manufacture a new version of a product and utilizes a design that is known and proven. Overall, this new product will not qualify for the credit and fail the Four-Part Test. However, if a component of the product requires substantial R&D to develop, the company may be able to utilize the Shrink-Back rule and apply the fourth prong of the test to this newly designed component of the product.

Specific Exclusions

While the relevant tax code sections do not elaborate on which activities would qualify, the IRS has carved out a list of activities that do not:

• Research conducted after commercial production of the business component has begun;
• Research related to adapting an existing business component to a particular customer’s request or need;
• Research related to the reproduction of an existing business component;
• Efficiency surveys;
• Activity related to management function, market research, testing, routine data collection, or any ordinary or routine inspection for quality control;
• Research related to the development of computer software with internal use being the primary use (there are a few exceptions to this);.
• Research conducted outside of the U.S; and
• Funded research.

Qualifying Expenses: Qualified Research Expenses (QREs)

The second determination is whether the expenses are qualified. Qualified Research Expenses (QREs)  are direct expenses accrued in pursuit of research and development.

There are two categories of QREs: In-House Research Expenses and Contract Research Expenses. In-House Research Expenses are those incurred by the company or their employees when carrying on a trade or business. These expenses also include the supplies that are utilized by either the company or employee in doing so. Contract Research Expenses, however, are the expenses paid to and/or incurred by someone other than an employee (most likely an independent contractor) in carrying on a trade or business for the benefit of the company and such expenses are limited to 65% of the expense paid.

If the company, however, is performing research for the benefit of another, the expenses will only be considered for the R&D tax credit if the company retains substantial rights to the research. If the company does not, the expenses will be excluded.

How Do I Calculate and Claim The R&D Tax Credit?

Now that you know how to qualify for this tax credit, you may be wondering how much you will receive and how you can claim it.

There are two methods to choose from to calculate the credit amount you claim: the Traditional and the Alternative Simplified Credit (ASC). Due to the data required to calculate the credit under the Traditional Method, most modern companies prefer the ASC method.

Traditional Method

The Traditional Method appears easy because it is simply 20% of the total amount of QRE’s over the base amount. The calculation for the base amount, however, is where the method gets complicated. The base is the product of the average annual gross receipts for the company for the four previous tax years and a fixed base percentage. For startups and companies that lack such data or are unable to easily retrieve it, the ASC method is preferred.

ACS Method

The ACS Method is a four-step process that is much simpler in comparison to the Traditional Method. The credit is 14% of the current year QRE’s in excess of the 50% of the average QRE’s for the last three tax years. If the company does not have QRE’s in any of the past three tax years, the rate is reduced from 14% to 6%. The four-step process is as follows:

• Calculate the average of the company’s QRE’s from the three preceding tax years;
• Multiply that average by 50%;
• Subtract that amount from the company’s current year QRE; and
• Multiply the result by 14% to determine your credit.

Below is the modified version if you are a startup and do not have QRE’s for each of the three preceding tax years:

• Calculate your total QRE’s from the current year; and
• Multiply the result by 6%.

As the modified version of the ACS method shows, if you are a startup, the calculation of the credit is quite easy under this method.

Five Items of Information

So what information do you need to claim the credit? The Chief Counsel memorandum released in October of 2021, identified the items of information that are required to claim the R&D Tax Credit on an amended return. The items of information are as follows:

1. Identify all the business components to which the claim relates to for the tax year;
2. For each business component, identify all research activities performed;
3. For each business component, identify all individuals who performed each research activity;
4. For each business component, identify all the information each individual sought to discover; and
5. Provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (Form 6765).

Next Steps for the R&D Credit for Startups

As a new company, startups should focus on taking advantage of all credits and deductions available to them to limit their tax liability. The R&D Tax Credit is one of these credits and can be easy to claim if the company understands the eligibility requirements and maintains records sufficient to establish the amount of credits. This job will be made even easier if you work with a robust tax software that helps you with this calculation. If you want to see how our Corvee Tax Planning software helps calculate the R&D Tax Credit, reach out to us today for a demo.