How to Claim R&D Tax Credits for Startups in 2024

Startups are often at the forefront of innovation, making them ideal candidates for the R&D tax credit. The credit has no size requirement, and the scope of eligible activities is quite broad.

That’s why the research and development tax credit for startups is worth investigating in most cases, even for those who are unsure if they qualify.

The following article explains how to claim the R&D tax credit for startups, including:

1. Which startups qualify.
2. How to understand the eligibility requirements.
3. And practical steps for claiming the credit.

What is the R&D Tax Credit?

The research and development tax credit encourages businesses to innovate and think ahead. It credits an average of 6.5-10% of QREs (Qualified Research Expenditures) including wages, supply costs, and contracted research expenses.

The R&D tax credit applies mainly to small and medium-sized businesses. It provides tax incentives for:

• Developing new products or services
• Improvements in old products or services
• The creation or testing of new prototypes 

How Does the Research & Development Tax Credit Work?

The R&D tax credit provides tax breaks to companies that conduct research and develop new products, improvements, and other innovations.

If the firm has been in business for less than 5 years and has less than 5 million in gross receipts, the R&D tax credit can be applied to payroll taxes. This allows firms that have yet to profit to benefit.  

Can Startups Claim The R&D Tax Credit?

Yes, startups are eligible for the R&D tax credit.

One common misunderstanding of credit is that the R&D tax credit is limited only to traditional research sectors.

However, the R&D tax credit can be applied to a wide variety of new and improved products and services as long as the effort towards them uses the hard sciences.

Another misconception is that the R&D tax credit is only for the “big players” – not true! Startups, even those that have yet to profit, can also claim the credit.

In addition, the IRS's R&D criteria are quite broad. Startups contribute to societal innovation just as much as the big guys do and can similarly qualify under the IRS criteria.

How to Claim R&D Tax Credits for Startups

Follow the steps below to claim the R&D tax credit:

Check Your Eligibility

First, you should check which of your startup’s activities qualify for the R&D tax credit. The IRS outlines specific activities that are eligible, including:

• Developing new products or processes: This can range from creating novel technologies to devising new or more efficient manufacturing processes that increase efficiency.
• Improving existing products or processes: This includes significant improvements to existing products or processes that result in enhanced performance, efficiency, or cost-effectiveness.
• Creating or Improving Software Solutions: Software development efforts aimed at introducing new functionalities, improving performance, or overcoming technical hurdles.

These are just a few examples. The main claim to the R&D credit comes from qualifying research expenses (QREs).

The Four-Part Test

To qualify for the R&D Tax Credit, your projects must be engaged in activities that pass the four-part test that was created by the precedent set by the 2023 IRS case:

1. Permitted Purpose – The project aims to create or improve the functionality, performance, reliability, or quality of a business component.
2. Elimination of Uncertainty – The project begins with uncertainty about how to achieve the project goal and involves work to eliminate this uncertainty.
3. Process of Experimentation – The project involves a systematic process of experimentation by evaluating one or more alternatives.
4. Technological in Nature – The experimentation relies on the hard sciences, such as engineering or computer science.

Although still somewhat subjective, using previous examples to show that one’s efforts fall within the four parts is the most straightforward way to claim your case.

Speak to a Tax Planning Team

Figuring out the R&D Tax Credit's intricacies on your own can be daunting, given the nuances of tax law and the laundry list of documentation required.

That’s why we recommend speaking with a tax planning team with solid knowledge of the R&D tax incentives for startup firms. The experts at RevenueSafe bring a wealth of experience in this area, including the ability to:

• Reliably identify eligible R&D activities.
• Calculate potential credits accurately.
• Ensure your claim adheres to all relevant laws and regulations.

This can set a solid foundation for fast and efficient tax returns as a startup grows and evolves.

Examples of R&D for Startups

Startups can cover almost any industry, but here are 3 specific examples from different industries to help give you an idea of what they’re looking for:

A tech startup developing a new mobile app

Imagine a startup creating an app that can translate spoken language in real time. 

Let’s say its niche is in its unique features, such as regional dialect recognition and integration with smart home devices. 

This project would involve extensive research into language processing algorithms, user interface design, and connections to different smart home devices. 

This counts as R&D activities, meaning all the wages, supplies, and third-party support used for it can be accounted for in an R&D credit claim.

An engineering firm working on a more efficient water filtration system

Now, consider an engineering startup focused on designing a compact, energy-efficient water filtration system suitable for use in remote areas. 

This project might involve experimenting with different filtration materials, developing low-energy pump designs, and conducting field testing.

While not fundamental research, each of these counts under the eligibility requirements for the R&D credit.

A health tech company creating new software to improve patient care management

This startup is working on an AI-powered platform that aggregates patient data.

The platform aims to provide personalized care plans, predict potential health issues, and facilitate remote monitoring.

Research might involve data privacy compliance, machine learning algorithms, and user experience design.

While this startup is focused on software, it still counts as R&D under the eligibility requirements, as the IRS considers software design a hard science. 

As long as a startup’s activities fall under qualifying research expenses, they can claim their costs under the R&D tax credit.

How The IRS Calculates the R&D Credit

The IRS uses two primary methods for calculating the R&D tax credit: the traditional and the Alternative Simplified Credit (ASC) method.

1. Traditional method – Document and calculate 20% of research expenses over a base amount. The base amount is a fixed-base percentage multiplied by the average annual gross receipts for the last 4 years.
2. Alternative Simplified Credit (ASC) method – This method calculates the credit based on 14% of the qualified research expenses (QREs) that exceed 50% of the average QREs for the 3 preceding tax years. If the company had no research expenses in any of the previous three years, the credit is 6% of the QREs for the current year​​.

The approach you should choose depends on the calculation method that best suits a company’s financial situation and R&D spending patterns.

How Much Can Startups Earn from the R&D Tax Credit?

The potential tax savings from the R&D tax credit for startups can be substantial.

For new businesses, how a startup’s claim is calculated depends on a variety of factors, including the amount of QREs and the startup's age.

The credit can also offset up to $500,000 of payroll taxes for startups operating for less than five years with less than $5 million in revenue.

Qualifying expenses can be broadly categorized into 3 main areas:

• Wages: This includes salaries for all employees directly involved in conducting the R&D work. For startups, a significant portion of their team is often engaged in R&D, meaning the credit often applies to a majority of their payroll.
• Supplies: The credit applies to costs incurred for supplies used exclusively in R&D activities, such as materials for prototypes, software used in development, and consumables necessary for testing.
• Third-Party Contracts: Payments to third parties related to your R&D tasks can also qualify. This allows startups to leverage external expertise and facilities to advance their R&D objectives.

Under these parameters, startups can often reclaim quite a meaningful percentage of their R&D expenditures through the tax credit.

Frequently Asked Questions

How Far Back Can You Claim R&D Tax Credits?

You can claim R&D Tax Credits for the last 3 tax years. If your company has missed out, you still have a chance to amend past returns and get the credit. This could lead to significant savings on already completed research and development initiatives.

How Should Startups Document R&D Expenses?

Keeping rigorous records is key to getting the most out of your R&D tax credit for startup companies.

Here are some of the types of activities you should document:

• Everything related to each of your R&D projects: This includes which technical challenges you addressed and how desired outcomes were achieved. 
• All related company expenses include all itemized payroll records, invoices and receipts, and contracts with third-party services. 

What Doesn’t Qualify for the Credit as a Startup?

While startups can qualify for the R&D tax credit with a broad range of activities, some startup activities are specifically excluded:

1. Research conducted outside the United States.
2. Research funded by another entity.
3. Social sciences or humanities research.
4. Routine data collection. 
5. Market research.
6. Simple adaptation of existing technology.

Start Your R&D Claim - Do You Qualify?

At RevenueSafe, we explore a business’s R&D methods and expenses to ensure a compliant claim of maximum value. Our process is simple, straightforward, and easy to use. So don’t wait, take the opportunity now to save money for your business.