Successful Strategies for Startups
Internal. Immediate. In perpetuity. The research and development tax credit for small business startups just changed in some important ways—acknowledging development of internal software, making tax incentives more immediate, and transforming the status of these credits to permanent. The changes come with some caveats as well—one that will be easier to navigate with the expertise of your tax consultant.
To help you understand the changes, I’ve addressed some of the most important nuances to help small startups determine if they qualify to take advantage of research credits.
Q: How can a small business or startup determine if it is eligible to claim the R&D tax credit? Do they need to develop a new product and/or have a patent?
A: The R&D tax credit is now more attractive than ever. With recent changes in regulations, small businesses and startups can derive immediate value from a credit they historically shied away from. A company with no more than $5 million in gross receipts in 2016 and no gross receipts prior to 2012 no longer needs to save the credits for future federal taxes. Instead, the R&D tax credit can now offset some of their payroll tax.
Fortunately, a very wide range of projects can qualify for the credit. Essentially, if you develop new products, manufacturing processes, techniques or software, or improve the functionality, performance, quality or reliability of existing ones, you can potentially qualify. These developments must, however, meet a host of eligibility requirements. An experienced tax advisor can help startups navigate the complex requirements and claim the credit.
Q: What about software used internally? Are the new, final regulations issued in October 2016 favorable to the development of internal use software?
A: Yes, they are. These new regulations will put to rest decades of uncertainty regarding what is considered internal use software (IUS) for R&D tax purposes. The new regulations clarify that internal use software is limited to software developed for use in general and administrative functions. This is great news for a lot of small businesses developing their own tools to conduct their core operations and provide services.
Regardless of industry, the regulations provide that IUS is generally limited to software used in the back-office functions of a company, mainly financial management, human resources management and daily support functions. This clarification of which software qualifies for the tax credit should enable more businesses to claim the R&D tax credit for their investments in developing their own software.
Q: In their early inception, startups can go years without owing any federal tax. Why should they care about a tax credit?
A: Certain small businesses are now permitted to apply the research credit against the payroll tax imposed on wages paid to employees. This change means a qualifying small business that does not yet pay a federal income tax can apply the credit against a portion (roughly 6.2%) of its payroll tax, up to a maximum of $250,000 per year. This is the equivalent of a refundable credit, and it can provide immediate value for qualifying businesses. Small businesses and startups that did not consider claiming the research credit before should reconsider and explore this new opportunity with their CPA or tax specialist.
Historically, when there was no income tax liability to offset, startups capturing the R&D tax credit would carry it forward and hope to use it in future years when they turn profitable and have a tax liability. Although they had 20 years to use the credit, the idea of not knowing if this credit will ever be needed was discouraging many of early-stage businesses from claiming it. Those days are over.
Q: What are some key strategies for maximizing these benefits to gain the most return?
A: Documenting and keeping track of the resources allocated to development/improvement projects that might qualify for the credit can help companies to maximize the gains by accelerating the process of preparing the credit at the end of the year. Keeping project logs and contemporaneous documentation helps a lot when it is time to substantiate the credit and determine the expenditures associated with each project. It’s important to document and track all steps of the development to show that you went through a systematic process to develop or improve your software.
One of the key challenges in preparing a credit claim is that employees don’t always remember projects undertaken several months earlier, and so expenditures that should have been included are forgotten. Qualifying for the R&D tax credit is fact-intensive. Documented credit claims are more robust and exhaustive than those prepared based on memory and fact recollection.
It is also important to cast a wide net when evaluating what projects should be included in the R&D credit claim. Do not discard projects or initiatives simply because they don’t “sound” like “R&D.” Confer with your R&D tax specialist and let him or her ask the right questions to help determine eligibility for specific projects. In general, companies working on development or improvement projects tend to initially underestimate the amount of effort and the complexity inherent to their projects.
Q: How should small businesses and startups get started to capture the 2016 R&D tax credit? Is it too late?
A: It is not too late, in fact, the credit is captured through a company’s annual tax return, so now is the time to look at 2016 retrospectively and identify the potential projects and initiatives that could qualify. Then you should sit with your tax specialist to evaluate their eligibility and identify the expenditures that will be included in the credit calculation and how to support their eligibility. This is also a perfect time to look ahead, plan for next year, and put in place the appropriate documentation and tracking mechanisms to qualify for the 2017 credit.
Louis Guay is a manager in the tax department of Kaufman Rossin. Louis is an industrial engineer specializing in research and development and other engineering-based tax incentives. He focuses on providing R&D credit analysis and assisting companies qualify and capture research credits. Over the past few years, he has managed R&D studies for large multinational, medium, and start-up companies in various industries, helping them capture tax credits for expenses incurred in the conduct of R&D activities and projects regarding the development or the improvement of products and processes.