Voted by Forbes as the Best Small Place for Business and Careers, it's no surprise that Sioux Falls is home to a bustling startup community. With resources such as the Zeal Center for Entrepreneurship, Startup Sioux Falls, the Greater Sioux Falls Chamber of Commerce and over 30 organizations that support startups, Sioux Falls paves the way for startups to find success.
As startup companies begin the journey to a successful, established business, the dollars spent on research and development (R&D) can consume most of the budget. Fortunately, the Protecting Americans from Tax Hikes (PATH) Act of 2015, established a means for startup companies to recoup some of their R&D investment prior to being a profitable and income tax paying business. The benefit is a cash infusion to the startup at a time when every dollar counts. The process begins by computing the R&D tax credit for the business.
The R&D Tax Credit
The R&D tax credit has been around since 1981 and was made permanent as part of the PATH Act. The credit has served to keep jobs in the U.S. and certain states, as well as encouraged businesses to push the envelope when it comes to innovation. Unfortunately, the R&D tax credit is not a refundable tax credit, meaning only businesses paying federal income tax could utilize the credit, and many startups were originally left out despite the heavy investment in R&D until recently.
In addition, many businesses overlook the R&D tax credit thinking their daily activities are simply necessary to stay competitive in a global marketplace. However, when a business spends time developing new or improving existing products, processes, software or formulas, those activities can qualify for the credit. Businesses in many different industries can claim the R&D credit. The law provides a four-part test that serves to qualify activities as R&D.
Activities that meet the following requirements are potentially eligible for the R&D tax credit:
- Permitted Purpose: Develop a new or improve an existing product, process, formula or software, which may include improving the function, reliability, quality or performance.
- Eliminate Uncertainty: Discover information to eliminate uncertainty concerning capability (can we do it), methodology (do we know how to do it), or appropriateness of design (what is the optimal design).
- Process of Experimentation: Substantially all the activity constitutes a process of experimentation evaluating alternatives (prototyping, modeling, systematic trial and error).
- Technological in Nature: Fundamentally rely on principles of hard science, which can include physical science, biological science, computer science, engineering, etc.
Costs eligible for the R&D tax credit include:
- Wages for individuals performing, supervising or supporting the R&D.
- Supplies used in the research, which may include prototypes, but does not include capital expenditures.
- Contract research or costs incurred for a third party to perform research on the business's behalf. The business must be at risk for the research performed and must retain substantial rights. Rights do not need to be exclusive.
- Rental/lease of computer costs, including payments made to service providers for cloud server space for development environments.
The benefit associated with the federal R&D tax credit ranges from 5% to 8% of total qualified costs. For startups, the benefit can exceed 8%. The R&D tax credit calculation can be complicated depending on the business's fact pattern, and a licensed CPA or R&D tax credit specialist is a great resource to help you get started.
Opportunity for startups to put cash back in the business with the R&D credit
A tax credit provides a dollar-for-dollar reduction of tax liability, which makes it so valuable. Unfortunately, many startups are not in a position where they owe any–or at least not much–in federal income tax. That significantly limits the utilization of the R&D tax credit for startup businesses.
However, the PATH Act provides an election for startups to offset their payroll tax liability with the R&D tax credit. Using the R&D tax credit in lieu of precious cash each quarter for payroll taxes keeps money in the business to invest in other assets. To use the R&D tax credit to offset payroll taxes, the startup must meet certain criteria. To learn more about the specific criteria, visit EideBailly.com.
How startups can benefit from R&D
There is real potential value in R&D for startups. For example, a software company began operations in 2016. By 2018, the company had nine U.S.-based developers and others that supported the software development. The company received a federal R&D tax credit of over $18,000 and utilized the benefit to reduce payroll tax liability. The state R&D tax credit was over $10,000.
The R&D tax credit provides opportunities like this and more for startup businesses to reduce their tax liability and keep cash in their business through the federal payroll tax offset.