R&D Tax Credit for Startups — A CFO Review
If your startup or small business spends money on R&D activities, there is new legislation that can significantly impact your cash flow. The Protecting Americans from Tax Hikes Act (PATH Act) has significantly enhanced the R&D Tax Credit Program. This new program is available starting in 2016 to Startup and small companies with less than $5M in total gross revenues, and with less than five years of revenue. Credits derived from 2016 spending can be applied starting in April 2017.
Your company can claim up to $250,000 per year in credits against Federal payroll tax. Once your taxes have been filed, you simply notify your payroll provider. The credit is applied against your federal payroll tax at each payroll run, saving you potentially thousands in real cash each month. Using a twenty employee firm as a benchmark, your estimated savings is roughly $12k per month.
Note: A similar program is available for small businesses that have $50M or less in gross sales, but the claim is against AMT (not payroll tax).
How the R&D Credit is Computed
There are essentially three main R&D “buckets” (see IRS form 6765 Section B) that help define “Qualified Research Expenses” (QRE’s).
The first bucket includes employee wages (from Box 1 on a W-2 form) only for R&D specific activity (see line #24). Employees that spend part of their time on R&D efforts will be calculated by using a percentage (i.e. 50%). Next is another segment of human capital, where only 65% of the total R&D contractor spend is included (line #27). The last bucket includes any supplies that were “fully consumed” during the R&D process (line #25).
Next, the prior 3 years of QRE’s (if applicable) are added (line #29), divided by 6, and then subtracted from the current year spend (line #30). The remainder (line #31) is multiplied by 14%, which equals your total allowable credit of $210,000 (line #32).
It’s critical to set up your books and financial statements upfront so you can easily capture and report on these specific QRE’s. It will save you time and money both internally and also for the firm performing the analysis.
Other Benefits — State Taxes
A similar calculation using the same QRE’s is performed for state taxes. The amount of tax credits allowable will vary by state. The difference is that you can’t apply the credit against payroll. You can only increase your NOL (net operating loss) carryforward for state taxes (or apply them against your current taxes if you are profitable). You can also include the last three years to your NOL carryforward (Note: you will also have to refile those tax years). For a company with $2M in QRE’s you can probably expect $50K or more annually in state taxes (again this can vary widely by state, but you grasp the magnitude).
The Trade-off — and Section 280C Election
There is a trade-off to taking the total allowable credit. If your company is carrying NOL forward, then any credit taken will reduce your NOL by the amount of the credit. For example, if your loss for the year is $1M but you take a $200K R&D credit, your NOL carryforward is then reduced to $800K (the $200K is treated as income). For companies that are pre-revenue, operating at a loss, or are cash flow challenged, it makes sense to take the total credit.
The alternative is to elect Section 280C, which reduces your credit to 65% of the total allowable credit. This reduction allows you to take the credit, but it does not count as revenue (or against NOL). In this example below, the total allowable credit was $200K, but the company elected to take the reduced credit. In this case, they still have $130K to apply against future Federal payroll taxes, but without any penalty. Companies that elect section 382 are likely profitable or have some other tax advantage to do so.
Risk — What Else You Need to Know
Finding out after the fact that your company may not be eligible for any tax credit can be exasperating, and will likely get you replaced as CFO. Who wants to pay $20K or more for a service you ultimately can’t use?
IRS Code Section 382 has limitations on companies with NOL carryovers. The reason for the code was to limit tax benefits for acquiring companies scooping up NOL companies, looking to reduce their tax base. Unfortunately, Section 382 can have unintended consequences to individual companies, where there could be a “382 limitation” on the amount of credits available.
The trigger for Section 382 is a 50% change in ownership (in value, not shares), over the past three years. This is a fairly complex analysis that should be performed by a CPA firm. If you have had a significant change in equity (purchase, sale, or re-issue) over the past three years, you may want to check with a CPA before starting the R&D process. Note that this full analysis is not inexpensive, so ask for a reasonableness check first.
The R&D Tax credit is not a new concept, however, this new program has not been widely used. My recommendation is to utilize a boutique tax firm that specializes in the payroll tax credit. They understand the nuances of the new legislation, and have templates in place to gather all relevant backup to support the findings (and also to stand up under audit). There are stories of firms simply providing an excel spreadsheet as the only backup, and failing their audit. The firm should also schedule an onsite visit to your location, to interview your team leads and other pertinent R&D personnel. Make sure the firm you are working with has solid references and provides you with an estimate of your savings upfront. A conservative benchmark is to take 10% of your total QRE’s for 2016 (where $2M in QRE times 10% = $200K in Federal R&D Tax Credit).
The cost of the R&D Tax Credit analysis can be high. Some firms will charge you an hourly rate, while others will take a percentage of the savings (upwards of 25%). Depending on the amount, business complexity, and other factors, you are looking at generally $20K to $30K+ for the process. If your cash flow is already a challenge, ask the firm to work with you on terms (like spreading payments over a few months as the credit is applied).
Is It Worth The Effort?
The short answer is yes, as long as the credit is greater than the cost of the analysis. Assuming you are eligible for the credit, the only downside is figuring out how and when to pay the fees.
Step 1 is no ensure there has not been a 50% or greater change in ownership over the past three years. If ownership change has occurred, then your CPA can determine how much of a credit is still available if any. Your next step is to calculate your QRE’s and multiply by 10% to estimate your credit. The final step is selecting the right vendor.
Note you still have time to file 2016 taxes (or refile), in order to be eligible for the credit in 2017. The next deadline is June 30th, to start receiving credit on July 1st. We’ve helped a number of clients through this process and can recommend trusted vendors. Feel free to reach out to us at www.bostonstartupcfo.com with questions.