Starting a new business is tough. Most entrepreneurs begin with a dream to build something amazing and unique. Most of these dreams begin in losses as the business begins to acquire customers, incur startup expenses and payroll.
Typically, these businesses have a few options to secure capital to grow the business. The business can use founder’s capital, a bank loan (secured by a personal residence or asset), or investment capital from friends and family. In some cases, government grants or loans may also be available. In all cases, however, every entrepreneur will but in their fair share of sweat equity.
The new federal R&D tax credit brings yet another way to help startup companies that are otherwise qualifying for the research tax credit.
Let’s take a look.
Supporting startups through lower payroll taxes
In 2015, the PATH Act (“Protecting Americans from Tax Hikes”) was enacted making the federal
research tax credit permanent. As importantly, it provided for two significant provisions that will reward the sweat equity US taxpayers put into building their businesses in developing innovative solutions.
Real savings through the Research Tax Credit
For the startup business, the R&D tax credit has always been available. However, if the business is in startup mode (i.e. operating but not yet generating revenue or perhaps profit), it would not have income tax due and while it could qualify and generate a research tax credit, the credit would not be used as there was no tax to offset. The entity would simply carry forward the tax credit to use in future years.
Today, with the changes to the research tax credit, a qualified small business can elect to claim a portion (or all) of its research tax credit as a payroll tax credit against its employer OASDI liability.
What is a qualified small business?
A qualified small business is defined as a corporation (including S corporations) or partnership with:
- Gross receipts of less than $5,000,000 for the tax year AND
- No gross receipts in any of the prior 5 years (ending with the tax year).
The qualified small business (startup) can use the amount they specify that does not exceed $250,000, or the research tax credit determined.
In simple terms, a company developing a new product that has yet to generate revenue may calculate a research and development tax credit that may be used to offset payroll taxes incurred.
R&D tax credits taken in the tax year may be used quarterly in the following year to offset payroll taxes. Once the credit has been determined and filed (assuming the company elects to use a portion or the entire amount of R&D tax credits calculated), the company may begin offsetting their payroll taxes each quarter.
Controlled Groups-The Fine Print:
A Controlled Group (as defined in the tax world) referred to a group of tax entities (corporations, partnerships, etc. where there exists common ownership of greater than 80% (tax geeks see IRC Regulations Section 1.1563-1 (a)). For the purposes of the research tax credit, however, a Controlled Group is defined as a group of entities where there is greater than 50% common ownership. I’m oversimplifying the definition but in the event a taxpayer owns or controls multiple entities, the entire group must meet the definition of a qualified small business.
With these changes comes a word or warning. While the credit is more valuable, the IRS is still challenging taxpayers use and calculation of the R&D tax credit. If audited and not sustained, a taxpayer could be subject to penalties if the credit is disallowed or reduced substantially.
Having an expert in your corner for the research tax credit is like having a heart surgeon on hand when needed. Many times, we have been asked to assist a taxpayer with an audit where they have completed a very rough calculation with little documentation. These audits can be difficult and result in a reduced credit, interest and in some cases penalties.
We recommend utilizing the services of an expert (shameless self-promotion below) in this area in order to mitigate potential mistakes, maximize your research tax credit and develop the proper documentation.
At Acena Consulting, we recognize that you, the small business owner, have a lot more on your plate than worrying about a tax credit. Our role is to bring strong tax technical knowledge, ability to build efficient processes, answer the questions you may not know to ask. We take this concern off your list so you can focus on your core business.
Want to learn more about the magic of our approach? Join us for our Free CPE Session on the Research Tax Credit. You can get more information and a link to registration below.
Let’s get started!