we’ll give you the bad news first startups can no longer deduct (aka subtract) r&d expenses from revenue.
for software or product development costs, you now have to capitalize (aka spread them out)
over 5 years if they’re domestic, and over 15 years if they’re foreign (aka offshore).
because of something called...
we’ll give you the bad news first
startups can no longer deduct (aka subtract) r&d expenses from revenue. for software or product development costs, you now have to capitalize (aka spread them out) over 5 years if they’re domestic, and over 15 years if they’re foreign (aka offshore). because of something called the ‘mid-year convention’, year 1 counts as only half of a year. so functionally, you can only deduct 10% (not 20%) of domestic r&d expenses — and only 3.33% (not 6.66%) of foreign expenses — in the first year, 2022. this creates a substantially larger “computed” taxable income → an actual tax liability.
you may be thinking “whatever i’ve got NOLs” — but even those have been neutered: you can now only use NOLs to offset up to 80% of your “computed” taxable income. “hey you have a big tax liability now — and oh you can’t really use your NOLs to wipe it out.” all the while, this added tax burden means it’ll become harder to stockpile NOLs like before. it’s a combo fucking judo move if i’ve ever seen one.
now the good news: you can solve this with e2e tax strategy
all of a sudden, you can no longer separate NOLs and R&D in your thinking. your startup’s revenues and expenses, NOLs, and the new tax code need to be baked together. even future headcount planning and revenue projections roll into your complete tax strategy.
the semi-good news is that your startup likely already has a very healthy reserve of NOLs, so you'd only really have to worry about covering the remaining 20% with r&d credits. aka optimize the allocation of r&d expenses such that whatever is capitalized — ironically the same (ish) type of expense used to generate an r&d credit — creates a taxable income just big enough to have 80% of it wiped out by NOLs. the remainder will get taken care of by the income tax r&d credits.
plus, if you model out + expect future years to have computed taxable income, you can be sure to build up a healthy enough reserve of deferred tax assets. you'd only need 1/5 the tax credits since they'd offset the tax burden itself, as opposed to the NOLs which only offset computed taxable income.
why startups can’t just do r&d credits anymore
apart from often being inaccurate, this method presents a new problem under the new rules: the well-known strategy of ‘throwing in the kitchen sink’ to maximize your r&d credit will create a larger tax bill in its wake than the credit it alleges to claim for startups.
instead, startups need to start planning and optimizing their tax strategy, while optimizing — not maximizing — their r&d tax credit along the way.
By Neo.Tax Team So you’re a startup and believe the best way to get the help you need to build your company is with independent contractors... hmmm, interesting. It’s your company, so we’re not here to tell you how to run it, just that you’re missing out on up...
By Neo.Tax Team
So you’re a startup and believe the best way to get the help you need to build your company is with independent contractors... hmmm, interesting.
It’s your company, so we’re not here to tell you how to run it, just that you’re missing out on up to $250,000 in research and development tax credits by not setting up payroll.
Yup, you heard that right. You could miss out on hundreds of thousands of dollars because you either haven’t set up payroll or you've set it up incorrectly.
Imagine what you could do with that money. Maybe:
Extend your runway
Help continue necessary R&D
Have no fear, Neo. Tax is here!
Check out our guide to setting up your payroll taxes as a startup or new business.
Why not Independent Contractors?
Let’s be clear: you can report independent contractors on your R&D tax credit claim.
The credit is a percentage of your QREs, also known as qualified research expenditures. These expenditures include in-house research expenses and contracted research expenses. Contract research expenses are handled a bit differently than in-house research. Only 65% of contractor research can be claimed–here’s an example of what that means:
Say I want to research sneaker materials as I’m developing an innovative new style of lifestyle shoe with posture support. I need to get some research from an outside firm; the cost is $100k. When reporting this expense for your R&D credit, only 65% of that independent contractor’s payment will count toward your credit claim. Essentially, $65k of this firm’s bill.
Now, let’s say you realize your needs exceed just research on materials and you contract the same firm to conduct an analysis of the sneaker market and who the target audience for the shoes will be at the same time. The cost is $250k; $100k for research on materials and $150k for the marketing analysis. Typically, marketing expenses are not qualified expenses for the R&D tax credit. This means you can only claim 65% of what you paid to the firm for R&D only–which, in this case, amounts to $100k of the $250k final bill.
The same calculation applies to percentages of time as well. Let’s say the firm bills hourly and states they dedicated 200 hours to R&D at $500/hour, which is one part of the final $250k bill from the firm. It’s then up to you to calculate 65% of those 200 hours that go toward your claim. Again, in this case, you could claim $65k of the firm's bill toward your R&D tax credit.
Remember: as a company that is not yet profitable, your R&D credit comes as a payroll deduction. This means that even if you’re employing independent contractors, you must set up payroll in order to receive your credit.
Where To Start?
If you’re already working with an accountant or accounting firm, then they can handle all your payroll needs.
If not, think about getting a payroll provider like Gusto, or learning the ins and outs of payroll yourself.
After you’ve set it all up, find trustworthy R&D tax credit software to help you seamlessly integrate your payroll and accounting information to claim your R&D credit.
Want to learn more about R&D software? Check out our post about what to look for.
More often than not, setting up payroll boils down to these steps:
Gather necessary documents like your company’s EIN, state or local Business ID, and your employee’s onboarding information, as well as their employee classification–if they’re part-time or full-time, etc.;
Choose your payment schedule or pay period;
And decide on a payroll system or provider.
Resources & Tips
Now that you’re setting up payroll, it’s a good time to pay extra attention to the details of all your records. The IRS can be fickle, so it’s always better to stay ahead of your payroll filings. Here are some resources to help you along your payroll journey.
Form SS-8: If you’re wondering how to classify employees and/or determine worker status for Federal Employment Taxes and Income Tax Withholding, this is the form.
Form I-9: Your go-to form for employment eligibility verification.
Form W-4: You’re probably familiar with this one. It’s your employee’s withholding certificate.
Form W-2: Another familiar one is this–the wage and tax statement.
Form W-9: If you’re working with independent contractors, then you definitely know this one. This is your request for taxpayer identification number and certification.
Form 941: this form is the employer’s quarterly federal tax return.
Form 940: and last, but certainly not least, the employer’s annual Federal Unemployment (FUTA) Tax Return.
Payroll can be one of the more complicated processes, making it extremely important to have a solid Payroll Dream Team that will help ensure your company payroll is done accurately and on time! If the ‘92 Men’s Olympic Basketball Team taught us anything, it’s that the Dream Team exists.
This is who you should have on your Payroll Dream Team:
A trusted accountant or accounting firm,
Accurate accounting software,
Payroll software that integrates seamlessly with your accounting software,
And, if you can swing it, a human resources manager, COO, or business partner.
Here are a few more tips for payroll:
Make sure you pay close attention to your records and fill every form out correctly.
Always, always, always file your payroll taxes on time. This not only ensures that you pay employees on time every time, but also helps avoid overpayments or any other mistakes. Here are some deadlines to mark in your calendar.
Don’t forget to keep your records organized and remember to keep former employees' records for 3 years after separation from the company.
Payroll is a fundamental part of claiming your R&D tax credit as a startup or new business. Set it up and watch the R&D credits flow in.
Founder Series: Stephen Yarbrough is Leading by Example
By Neo.Tax Team 5 min read Stephen Yarbrough is the epitome of a founder who is walking the walk. And if you’re asking, can he talk the talk? Stephen is a veteran of The Big 4 and the IRS… enough said. Despite his resume, what really stands out...
By Neo.Tax Team
5 min read
Stephen Yarbrough is the epitome of a founder who is walking the walk. And if you’re asking, can he talk the talk? Stephen is a veteran of The Big 4 and the IRS… enough said. Despite his resume, what really stands out most about him is his energetic laugh that makes you feel you’re talking to an old college friend–even through the screen during a zoom call.
An openly out and proud gay man, Yarbrough is taking a “lead by example” approach to visibility, representation, and inclusion. As one of three ethnically and racially diverse founders of Neo.Tax, a tax automation software startup, Stephen believes that senior leadership’s responsibility lies in setting an example and following through. “It's much more empowering [to say] during work conversations, ‘hey, I'm gonna be out of the office for pride, or telling stories and being open about when you got married to your husband or same-sex partner.’ I think that level of openness actually has a bigger impact when it comes from senior leadership. It’s important for senior leadership to be open and comfortable.”
By the same token, Yarbrough acknowledges it isn’t always that easy and that the choice of whether to be out at work shows a bigger cultural shift that needs to happen.
The reality of what employees have to go through takes Stephen back to a time when discrimination was all too real for him while working for a Big Four accounting firm–back when it was still called the Big 6.
“I was the only intern from my school that didn't get a full-time hire offer on the last day of our internship and it was very clear it was because I was gay. They said it was because I didn't know my target audience, ‘conservative accountants.’ They kept having events where they would ask us to bring our boyfriends or girlfriends, and I brought my boyfriend. And that was not cool back in 1997.”
Fast forward to 2022 and 40% of LGBTQIA employees stated they had witnessed homophobic harassment working at tech companies. A recent ICA & CalCPA study cited a lack of fair treatment, diversity, and inclusion were key reasons LGBTQIA+ identifying professionals are leaving the accounting profession entirely.
Visibility and cultural shifts go hand in hand. It’s not enough to see an underrepresented person in a position of power and leadership, it’s equally important to see shifts happen within the boots-on-the-ground, day-to-day, watercooler culture that is fundamental to everyday life in a workplace, be it remote or in the office. And for Stephen, affecting positive change in the Fintech space that Neo.Tax occupies is what motivates him. “I think leading by example is important. But I also recognize that organizations have difficulty doing this. You can't just say find the gay partner [at a firm] and push them out there to be open. When you have senior leadership that is open, it makes it easier for everybody else. And that translates into the culture here [at Neo.Tax].”
That ease around company culture and relaxed approach to inclusion are apparent in the interactions between employees, founders, and senior leadership at Neo.Tax. And especially with matters of the heart, love is love. “One of the interesting conversations I had with Ibrahim,” another co-founder of Neo.Tax, “was about a second date I was going on with a Muslim man. I wanted to know which meats to avoid when picking a restaurant. So he gave me some advice. It didn’t matter who I was dating.”
Walking the walking is not always easy. And in Stephen Yarbrough’s case, it has meant moving across the country to find an environment where he could be himself and still work in what many consider a “conservative” profession. But with the power of visibility, inclusion, and respect in the workplace, it can mean that walking the walk, or rather putting action behind the words, makes it less of a singular, individual path and more of a collective journey.
Advice for founders? Take a top-down approach and remember being inclusive doesn’t have to be showy, as long as companies put inclusivity into action.