Act Fast – State deadline is July 1st!
Tax credits are a great way to increase cash flow for your business, and it may come as a surprise to many that millions of dollars go unclaimed each year.
If you’re a high growth start-up or early stage business engaging in research and development (R&D), you’re likely leaving State and Federal money on the table. Continue reading to see if you qualify for tax credits to help you propel your business.
THE FEDERAL R&D TAX CREDIT
Companies that qualify according to the below criteria may file for the Federal R&D Tax Credit (26 U.S. Code § 41) when they file their annual tax return.
Does My Company Qualify?
A company conducting Qualified Research and incurring Qualifying Expenses related to such Qualified Research is eligible for the Federal R&D Tax Credit.
What Is Qualified Research (R&D)?
Qualified Research is research in any industry, business, or sector, that is “undertaken for the purpose of discovering information—(i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of [a Company],” and for which substantially all of its activities are related to the eligibility criteria, below. [**There are limited exceptions in 26 U.S. Code § 41(d)(4).]
- The R&D is technological in nature. That is--the process of experimentation relies on the hard sciences, such as engineering, physics, chemistry, biology, or computer science.
- The R&D is undertaken for a qualified purpose. A purpose is “qualified” is it involves he creating a a new or improved product or process (computer software included) that results in increased performance, functionality, reliability, or quality.
- The R&D is performed to eliminate technical uncertainty about the development or improvement of a product or process, which includes computer software, techniques, formulas, and inventions.
- The R&D includes some process of experimentation undertaken to eliminate or resolve a technical uncertainty. This process involves an evaluation of alternative solutions or approaches and is performed through modeling, simulation, systematic trial and error, or other methods.
What are “Qualifying Expenses”?
If your start-up or early stage company is conducting Qualified Research, amounts paid for the following expenses related to such Qualified Research can be characterized as Qualifying Expenses:
- Wages or earned income paid to employees for whom “substantially all” of his or her job includes performing or directly supporting or supervising Qualified Research activities.
- Supplies used for Qualified Research that are (a) tangible, (b) not subject to depreciation, and (c) not land or improvements to land.
- “Contract Research”. In general, this means a percentage (based on the entity conducting the research) of any amount paid or incurred to any independent contractor for Qualified Research.
- Computer Leasing for the purposes on conducting Qualified Research.
- Server Leasing for hosting software under development related to Qualified Research.
Exclusions. If the activities meet any of the below criteria, they’re not Qualified Research activities for the purpose of the Tax Credit:
- Survey studies, market research, or routine data collection
- Foreign research performed outside the United States (including US possessions)
- Funded research
- Research in the social sciences, arts, or humanities
How Can This Financially Help My Start-up or High Growth Company?
Eligible companies may receive up to 13.5 cents for every qualified dollar, which can take the form of a dollar-for-dollar reduction in federal and state income tax liability or a payroll offset. The Federal R&D tax credit can improve cash flow and reduce a company’s effective tax rate, among other positive effects. In addition, companies can claim credits for up to 4 years of prior expenditures and they can carry the credit forward up to 20 years.
Offset to Payroll Tax
Companies that qualify as “small businesses” with less than $5 million in revenue can make an election that will allow them to offset up to $250,000 in payroll taxes for the first five years they have gross receipts (instead of receiving an income tax credit). Therefore, most Start-ups can take advantage of the R&D credit for qualifying expenses regardless of whether they’ve yet become profitable.
If you choose not to use the payroll tax offset, and you don’t currently have a tax liability but your activities qualify, you can alternatively choose to carry the credit forward to offset future liabilities, for up to 20 years.
If you are just now learning about this opportunity, but your R&D expenses were incurred in prior years, you can STILL take advantage of the Federal R&D tax credit. You can claim this credit retroactively by filing amended returns for the prior three tax years (or more if your company endured losses during that time). [**There are limited exceptions in 26 U.S. Code § 41(d)(4).]
THE VIRGINIA R&D TAX CREDIT
In Virginia, Start-ups may qualify for one of two available R&D tax credits, depending on your R&D expenditures. Virginia uses the same criteria to categorize qualified research and qualifying expenses. However, Virginia’s deadline for applying for the tax credit is July 1. If this applies to you, it’s vital you ACT FAST!
Companies that spend less than $5 million per year in R&D (Va. Code § 58.1-439.12:08)
This tax credit makes businesses eligible for an income tax credit of (a) 15% of the first $300,000 qualifying expenses; or (b) 20% of the first $300,000 qualifying expenses ONLY IF the research was conducted in conjunction with a Virginia public or private college or university, to the extent the expenses exceed a base amount. That means that your business could be eligible for up to $45,000 in state credits. If your company’s tax liability is less than the amount of credit for which you are eligible, the credit is refundable, so the company would receive a cash refund of the difference. Like the Federal R&D credit, this Virginia tax credit has a lookback period. State taxpayers may claim a credit for qualifying expenses incurred as early as 2011.
**Virginia has capped the total amount of these credits at $7 million per fiscal year.
Companies that spend $5 million or more per year in R&D (Va. Code § 58.1-320 or 58.1-400)
This non-refundable tax credit may be used to offset VA State income tax. If a business has qualifying expenses in any of the 3 taxable years prior to the current taxable year, that business may be eligible for an amount equal to 10% of the difference between the their qualifying expenses and 50% of the average qualifying expenses for the prior 3 taxable years If this is the first year the business has qualifying expenses, the business may be eligible for a tax credit in the amount of 5% of its qualifying expenses. However, the credit may not exceed 75% of the total amount of the business’s income tax liability for the taxable year. Any credit not usable for the taxable year for which the credit was first allowed may be carried over for credit against the income taxes of the taxpayer in the next 10 succeeding taxable years or until the total amount of the tax credit has been taken, whichever is sooner. This credit also has a lookback to qualifying expenses incurred as early as 2016.
**Virginia has capped the total amount of these credits at $20 million per fiscal year.
How Do I Get Started?
If you’re interested in how to take advantage of these tax benefits for your business, you need to do two things right away:
- Start gathering all documentation regarding activities that might meet the criteria for “Qualifying Research”
- Contact a finance professional to help you get organized. We suggest our friends at the Sandbox (contact Liz Doerr @ Liz@thesbx.co)!
- If you use outside contractors for any qualifying research, you’ll need to ensure that your contracts are compliant with the Tax Code requirements regarding financial risk and IP ownership (Contact Nixon Law Group @ firstname.lastname@example.org)!
- Get in touch with an accountant that knows how to apply this opportunity to your tax strategy. We recommend BDO (contact Lauren Soles @ email@example.com)!
Special Thanks to Liz Doerr at The Sandbox for her contributions to this post.
The Sandbox is a team of financial, operational, and human capital experts helping emerging companies launch, grow, and monetize their businesses. We're passionate about helping awesome entrepreneurs, founders, small and mid-market business owners and leaders realize their venture dreams.