How R&D tax credits can fund your startup in 2024?

What is the R&D Tax Credit?

The government has been encouraging startups and small businesses to invest in research and development (R&D) to keep up with global competition for a while. 

This R&D credit isn't just for groundbreaking inventions but for making new things happen within your company. So, you don't have to change the world to benefit from this tax credit. Therefore, companies need to work on making new or better products, processes, or software to get this credit. 

R&D tax credits can make a big difference for new startups that are tight on resources. Here, we'll guide you through everything you need about the R&D credits. You'll determine if you qualify and learn how to make the most of them to help your startup grow.

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How does one qualify?

Regardless of size or industry, almost any startup or small business can be eligible for this tax credit. It's not limited to specific sectors – companies in software, life sciences, engineering, and even those creating unique products can qualify. 

However, in the U.S., not all activities automatically qualify for R&D tax credits. The rules are outlined in the Internal Revenue Code (IRC) section 41, but here's a more straightforward explanation: Typically, your investments should lead to making new or better products, processes, or software. 

Now, this includes:

• Resolving technological uncertainties
• Designing and testing prototypes or models
• Creating new algorithms or software components
• Finding new materials or researching methods to improve product performance

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Eligibility Criteria: The Purpose of R&D

The purpose should focus on enhancing a business component's quality, performance, dependability, or functionality, which must be the research goal. Enhancing appearance alone won't be sufficient.

Technological in nature: The research activity must be based on the concepts of engineering, computer science, physical science, or biological science.

Elimination of uncertainty: The actions must gather data to remove technical uncertainty about the creation or enhancement of a product.

Experimentation: The research should include trying out different approaches to see what works best. It's like experimenting with different hypotheses and adjusting them based on what happens during the tests.

Here's the thing to remember: the four-part test is something you do for only some of your business. Instead, you apply it to each project individually. The applicability of R&D tax credits also depends on the business size, profitability, and ownership structure.

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How can R&D credit be of use to you?

This part discusses how these credits help a startup financially and encourage trying out new things and standing out from the competition.

Cash Flow

For startups, every penny matters. R&D tax credits can make a big difference by lowering the amount a startup owes in federal taxes. This leaves more money for startups to put back into their business, speeding up their growth and progress. Sometimes, startups can get cash back for their R&D expenses, giving them instant financial relief.

Experimentation

R&D tax credits are meant to encourage businesses to be bold and creative. Thanks to these credits, small businesses can try out new ideas, technologies, and solutions without worrying about running out of money. This creates an environment where startups feel inspired to think outside the box and explore new industry possibilities.

Competition

R&D tax credits give startups the money they need to invest in advanced research and development. This means they can introduce new and creative products and services more quickly. Doing this helps your business grab a more significant piece of the market and show that you're leading the way with new ideas. By using R&D tax credits, your startup can stand out from competitors and find its unique niche in the market.

Further reading: IRS Form 7004 for business tax deadline extension. 

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What expenses qualify for the credit?

The IRS lists specific categories that qualify for the credit. However, it's worth mentioning that some of these categories have specific nuances that you should talk about with your company's tax advisor.

Wages

Wages paid to employees who are actively working on R&D projects, as well as those who supervise or support them, can count towards the credit. Here's a tip: If 80% of an employee's time is spent on research and development, you can include 100% of their wages for the tax credit. Many tax advisors need to pay attention to this detail, so it's worth paying attention to and could mean more money for your business.

Supplies

Items like materials for making prototypes, testing supplies, and things used during experiments count towards the credit. But remember, fixed assets don't count.

Contract Research Expenses

Money paid to a third party to do research for your company can qualify, but there are some essential details. You can claim 65% of these payments if they go to U.S.-based companies or individuals. Plus, your company has to take on the risk in the contract.

Computing Expenses

Expenses related to handling and storing data for research will be included in the credit.

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How to report the tax credit?

In 1981, the U.S. launched its first R&D tax credit under the Economic Recovery Tax Act. It aimed to boost innovation within the country and reverse the downward trend in American research and development. The government has improved and broadened these credits over the past few decades to include a broader range of applications and eligibility.

To claim your R&D tax credits, fill out IRS Form 6765. Depending on your business type and research spending, you might also need to complete other forms, such as IRS Form 8932 for wage payments and IRS Form 3800 for general business credit.

Small businesses also need to submit Form 8975 for the Qualified Small Business Payroll Tax Credit for Increasing Research Activities. However, you will fill this out once the IRS gives the green light for your credit.

Figuring out the R&D tax credit involves detailed analysis, documentation, and math, but they are highly beneficial for filing your 1120s. If you need assistance calculating your credits or completing IRS Form 6765, it's best to seek guidance from an accountant who knows their way around this credit.

To get your R&D tax credits, keep thorough records of all your research activities and costs. This shows the IRS that your work meets the tax credit eligibility. Essential documents to hang onto include Timesheets for everyone working on R&D, Detailed notes on your projects, any changes to your software, Lab notebooks, Iterations of prototypes, and a list of all the supplies and materials you've used.

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Final thoughts

The R&D tax credit is a strong incentive for business owners, yet many need to realize its potential. It's available across numerous industries, and there are innovative ways to ensure you're getting the most out of it every tax season.

With the assistance of our Inkle Tax software, you may file for R&D tax credits and retain more of your hard-earned money to continue pushing the boundaries, disrupting industries, and creating a brighter tomorrow. 

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