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The R&D tax credit is sizable: it’s worth up to $250,000 per year. Over time that can add up to millions of dollars in savings – which you can then reinvest in your business to extend your runway or accelerate growth.
Yet, despite its size, the credit continues to go unclaimed by thousands of small- and medium-sized businesses who don’t realize they qualify. For instance, many don’t know that engineer wages, contractor payments, and payments to cloud service providers commonly count towards the tax credit.
In fact, we estimate that hundreds of our own customers at Pilot aren’t claiming the credit when they could (that’s one reason we launched Pilot R&D Credit ). Many companies are leaving money—and lots of it—on the table. Are you?
While the best way to see if you qualify is to talk to an expert, we created this brief guide to help you understand the basics about the credit. We’ll answer all your top questions including:
- Which businesses and expenses qualify for the R&D tax credit
- How to claim it and how much money to expect back
- What to look for in a service provider to help you get it and protect your business
- Why robust documentation is crucial to your claim
Let’s dive in.
Does your company qualify for the R&D tax credit?
The R&D tax credit isn’t just for tech startups. Businesses from many industries can qualify, including hardware, life sciences, ecommerce, agriculture, financial services, and more. Started in 2016, the goal of the R&D tax credit is to encourage innovation through designated research and development activities.
For pre-revenue businesses, the credit is typically applied by offsetting payroll liabilities—specifically Social Security and Medicare taxes (FICA).
For businesses that already have revenue, the credit is applied against income tax liabilities instead.
Which of your expenses qualify for the R&D tax credit?
There are many R&D activities and costs that count towards the credit. If you think you’re on the fence, start by asking yourself the following questions about the nature of your product development:
- Is your business involved in engineering, design, data collection or testing?
- Have you designed or developed new software or products?
- Do you develop proprietary technology?
- Do you often improve the technology used to power your products and services?
- Do you take on risky or challenging technical projects in the course of product development?
- Do you have patents, either now or possibly in the future?
- Have you designed or developed new software or products?
- Have you made improvements or added new features to an existing product?
- Have you built a prototype?
- Have you incurred costs relating to a process, project, or prototype that is incomplete because of unresolved technical problems?
Did you answer is “yes” to any of the above questions? Then there’s a good chance some of your expenses could be claimed.
More specifically, the IRS allows four main categories of R&D costs to count as expenses. Some may even surprise you, including:
- W-2 taxable wages for employees offering direct support and first-level research supervision.
- Supplies used in research, including so-called extraordinary utilities but not capital items or general administrative supplies.
- Contract research, including certain subcontractor expenses. These can include labor, services, or research. In addition, you need to retain substantial rights in the results, whether exclusive or shared.
- Rental or lease costs of computers, including payments made to cloud service providers for the cost of renting server space, as long as payments are related to hosting software under development versus payments for hosting a stable software release.
Though these may seem exhaustive, there are many expenses that are explicitly excluded from the credit. Those include research conducted outside of the US, reverse engineering, surveys and market research, studies that relate to social sciences or humanities, and research funded by grants or contracts. Get in touch if you want a full list.
How you apply for the R&D tax credit
Applying for and getting the credit can be a long, tedious process. It requires detailed documentation, filing the right paperwork, and working with your payroll provider to apply it against your FICA taxes.
Here are three main steps to claim your credit:
- Conduct an R&D study: In order to identify the qualifying R&D activities and costs, you’ll need to review internal documents and bookkeeping to understand the nature of your R&D efforts, process, and costs.
- Build your case and submit it to the IRS: Your case needs to be air-tight with the right documentation in order to get the credit. The next step is to file the appropriate forms that list the total amount of expenses you’d like to claim, along with the proof.
- Apply the credit: Once approved, the credit is likely applied through your payroll tax liabilities. You or the partner that helped you claim the credit will work with your payroll provider to deduct the credit from each payroll run.
With many moving pieces, make sure to periodically monitor your payroll taxes to ensure your credit is being applied correctly throughout the year.
Why you need a tax and technical expert to claim your R&D tax credit
Choosing the right partner to help you get the credit is crucial: They should have expertise in both tax law and technical businesses who rely on R&D practices.
Your partner needs to build documentation that protects you in an audit. In fact, the R&D tax program is on the “Dirty Dozen list,” which means the IRS frequently audits companies who claim the credit—and they can do so for up to seven years. If you can’t produce sufficient technical evidence in an audit, you will need to return the money and even worse—potentially pay a hefty penalty.
Here’s what you should look for in a partner to help you claim the credit:
Expertise in tech, engineering, and R&D. The key to building a sound claim is understanding, documenting, and communicating your company’s R&D processes and practices. You want a partner that gets technology and engineering companies—from engineering salaries to patent costs. They also need to ensure your qualifying R&D expenses each pass the IRS’s rigorous four-part test.
Meticulous documentation. The right records protect you during an audit—saving you time, money, and headaches in the long run. Your partner should prepare the following documentation, which include:
- Identifying and listing qualifying work per the IRS’s four-part test
- Substantiating the claim, including the breakdown of how each of your projects meets the IRS’s four-part test in full.
- Time-tracking of the employees whose wages are part of the claim
- Preparing and filing the R&D tax form
- Preparing the payroll offset forms and tracking it every quarter
- Defending the credit in the event of an audit
Finance partnership and best practices. Your partner should also guide your R&D and internal finance team—if you have one—on how to build ongoing documentation practices for future claims and audits.
End-to-end service. You don’t have time to comb through your books or coordinate with your payroll provider; you have a business to run. Your partner should take the lead and handle the whole process for you—pulling you and your R&D team in only when it’s mission critical.
Many accountants and tax preparers who provide R&D tax claiming services only provide part of the puzzle: They ask you a couple of questions around your expenses, and then file the forms based on the calculations. However, without the engineering expertise, it’s difficult for them to understand, document, and defend your R&D practices to the IRS.
To ensure you get the maximum amount you’re owed and protect you from audits, it’s best to partner with the right types of experts.
How much money can you expect from the R&D tax credit?
The R&D tax credit is designed to offset a portion of your R&D costs, not eliminate all of them. How much money can you expect? In general, the IRS tends to credit back 5% to 15% of your total qualifying expenses, which include: wages, contractor payments, and equipment that can be counted towards that tally.
Whether you’re a tech startup, ecommerce, or agtech company, it’s time to claim what’s yours. The claiming process can be tedious with a ton of paperwork; Find a partner who gets your business, has meticulous documentation, and has the area expertise to get the maximum amount you deserve. If you’re doing all this great R&D, at least you want the credit!