Finance Forward Blog
Navigating R&D Tax Credits: What Every Business Owner Should Know
Every business, whether a sprouting startup or an industry giant, is on the lookout for financial wins. The R&D tax credit could be a promising avenue. This isn't just another dry, complex tax concept; it's an exciting opportunity to fuel growth and innovation for your business.
What Are R&D Tax Credits?
The R&D tax credit is a specific provision in the tax code dedicated to providing businesses with a financial incentive for their research and development activities. This tax relief allows companies to claim certain R&D expenses, which then leads to a reduced tax liability.
The primary objective? To stimulate innovation, promote economic growth, and maintain a competitive edge in global markets.
Originating in the early 1980s, this credit was introduced to counterbalance the declining R&D investment in the U.S., offering a financial leg-up to businesses pushing technological boundaries. Its significance was further cemented with the PATH Act, making the R&D tax credit a permanent fixture in the tax landscape.
What Qualifies as R&D?
Research and Development (R&D) encompasses creative and systematic work undertaken with the intent to broaden the spectrum of knowledge and formulate novel applications of pre-existing knowledge. Here’s an example of some of the activities that can qualify under the R&D tax credit:
Developing new processes, patents, formulas, methods, prototypes, or proprietary software.
Improving existing products to enhance functionality or performance.
Hiring experts like scientists, engineers, or designers for R&D work.
Investing in the creation and testing of innovative products.
Developing intellectual property and applying for patents.
What’s more, even if your project fails or gets abandoned, you can still claim it for the R&D tax credit!
Some of the industries that commonly qualify include but are not limited to:
Artificial intelligence
Consumer packaged goods
Cryptocurrency
Software/Software as a Service (SaaS)
Manufacturing
Aerospace
Virtual reality
Textiles
Pharmaceuticals
Life Sciences
How Do R&D Tax Credits Work?
The R&D tax credit operates as an incentive, allowing companies to offset a certain percentage of their qualifying R&D expenditures against a portion of their federal tax liabilities. As a general guideline, you can receive up to 10% back on what you've spent on product development.
For example, if your company paid $700,000 in W-2 salaries to software engineers in 2024, you could get up to $70,000 in relief against your federal tax liabilities. If you spent $1,000,000 in W-2 salaries, you might receive up to $100,000 back.
Additionally, any unused credits can be carried forward for up to 20 years, allowing companies to incorporate these savings into their long-term planning.
It’s also critical to note how the R&D credit can be applied. It can be used in one of two ways:
Depending on specific qualifications, businesses can use the R&D Credit as a dollar for dollar offset against federal income tax liabilities
Companies, especially start-ups can leverage the R&D tax credit to offset their payroll tax liabilities on a dollar for dollar basis
How Do I Apply for the R&D Credit?
Businesses claim the R&D Credit by filing IRS Form 6765. To do this, they must identify qualifying expenses per IRS guidelines. These expenses are made up of four buckets:
W-2 payroll for any employee involved in R&D activities – including supervision, support, or doing the actual work
U.S. based contractors (1099s)
Materials used for prototyping and development throughout the process of working on your product or service
For SaaS companies - cloud costs for your pre-production and staging environment (think Google cloud, AWS, Heroku, etc.)
After you’ve identified the qualifying expenses above, it’s important to provide detailed documentation to prove they meet the requirements. Simply put, you'll need a thorough paper trail.
Some examples of good documentation include:
Technical documents
Emails
Whiteboard or product roadmaps
Timesheets for technical staff
Development/engineering notes
Why the R&D Credit Is so Useful
Consider the R&D tax credit as a financial catalyst. It directly reduces tax liability, effectively freeing up capital that can be reinvested into the business. This is crucial for tech companies where cash flow is often the lifeblood of continued innovation and market competitiveness.
The R&D tax credit can also be a strategic tool in financial planning. It’s not just about short-term savings; it's an investment in the company’s future. This credit can become a part of a company's broader financial strategy, aligning with long-term goals and helping to fuel sustained growth and market differentiation.
Furthermore, utilizing the R&D tax credit effectively can enhance a tech company's appeal to potential investors and stakeholders. It sends a message of fiscal responsibility and forward-thinking management. It shows that the company is not only innovating in technology but is also savvy in leveraging available financial incentives to maximize their resources.
Understanding and leveraging R&D tax credits can provide significant financial benefits and fuel ongoing innovation for your business. If you’re interested in learning more, we refer our clients to TaxTaker, our trusted partner who specializes in R&D tax credit savings. And as always, we’re here to help with any of your tax and accounting needs! Don’t hesitate to reach out.