Founders are driven to create the future, to disrupt a broken system, or to make something new out of whole cloth. It’s not surprising then that for most of them, tax season — with its archaic rules and tedious paperwork — is the worst part of the year. Luckily, we at neo.tax are tax guys through and through; we’ve spent decades obsessing over the minutia. And so, we’re here to help make tax season simple, streamlined, and even advantageous for your startup.
Our Co-Founder and Head of Tax Stephen Yarbrough has been a corporate tax CPA for over 20 years. He spent most of the 2000s working at PwC, followed by 6 years as a Senior IRS Auditor, before serving as Head of Tax at a startup-focused CPA firm. In 2020, he joined forces with Ahmad Ibrahim to help found neo.tax. These are his six essential tax tips for your tech startup.
Incorporate in Delaware: If you’re expecting to raise money from venture capital firms or major investors, a Delaware C-Corp Structure is almost always a condition of funding. If you don’t expect to raise money for a long time, there may be other tax-advantageous structures (such as a partnership or LLC). However, be aware: conversion from an LLC/Partnership is more complex than you’d think and can trigger tax for the founders if executed incorrectly.
Get your R&D Payroll Tax Credit: For tech startups (software, hardware, biomedical, SaaS), the R&D Payroll Tax Credit is the closest thing to “free money” that a company will ever get from the government. Startups with less than 5 years of revenue (or no sales at all!) can earn up to 10% of their R&D spend back in payroll tax credits. R&D spend includes wages to engineers, payments to U.S. contractors and cloud computing (AWS) costs used towards R&D. This payroll benefit (up to a max of $250k/yr) is eligible for startups for a max of 5 years and only eligible on originally filed tax returns (you can’t amend to get this payroll benefit retroactively), so don’t miss out! The credit can extend your runway by dropping your total payroll costs by 6+% each pay period until the credit is used up. With the help of neo.tax, you can file for your R&D Payroll Tax Credit in just 15 minutes.
Get Compliant with Payroll Taxes: Big problems can pop up if founders draw funds as “loans” and neglect setting up and paying payroll taxes. Getting compliant doesn’t need to be a painful process; automated services like Gusto make this a breeze.
Collect Forms W-9 and Issue Forms 1099: Make it a point to collect W-9s BEFORE making a single payment to an outside contractor and to issue Forms 1099 each January. If you fail to receive a vendor’s taxpayer ID, or SSN, with a Form W-9 (or a foreign tax exemption declaration with form W-8 BEN), your company may be liable for up to 24% backup withholding tax with respect to those payments. On top of that, the failure to file Forms 1099 has become costly — over the past few years, penalties have skyrocketed from $25 to $1000 for each Form 1099 you fail to file!
Hire an Accountant with Tech Startup Experience: Startups are “small businesses,” but they often have multinational corporate tax challenges due to the nature of their work. This means a small-business accountant may not be the right choice for the complicated work: we can help with the R&D tax credits, but these accountants may not be familiar with forms related to foreign investments or investors. Startups are often penny wise and pound foolish when it comes to tax compliance. Saving a few hundred dollars on an accountant upfront isn’t worth the backend cost, especially if you have any business or owners outside the United States. Failure to file some international information returns can result in mandatory $25,000 penalties for EACH form missed! Also, small business accountants will likely keep your books on a “cash basis”, when future investors will want to see “Accrual basis” books. It’s easier to set it up right from the start than have to change this in a couple years.
Don’t Make Tax an Afterthought: This is the hardest piece of advice, but it’s the one that will extend your runway and keep you safe from costly fines down the road. It also can prove essential when you’re negotiating an acquisition down the road. So, invest in an accountant or automated service that you trust. If you’re making a major R&D equipment purchase, your accountant can get you a 50% sales tax exemption in CA. If you’re hiring employees, you’ll need to make sure you’re registered in the state. If you start making sales, you should be verifying that you’re compliant with sales tax collection and remittance. Sales taxes are complicated, but services such as Avalara or TaxJar can link into your current systems and automate the process — thinking about taxes with each major transaction can save you money in the future by avoiding penalties and interest. Fine-avoidance often isn’t enough incentive for a funded startup to get compliant, but this fact should: tax compliance is often a MAJOR area of due diligence when a larger company is negotiating an acquisition. I’ve seen founders lose money or have long delays during an acquisition as they scramble to correct the tax issues they ignored. Believe me: it’s not worth the risk.
At Neo.Tax, we’ve been preparing for months for the eventuality that Congress wouldn't strike a deal to end R&D Capitalization. We view it as our duty to make taxes work for innovative companies, so we’re proud to say that Neo.Tax has the only software solution that can cover all aspects of R&D tax strategy: from credits to amortization, and everything in between.
This whole year, founders, CFOs, and accountants have been staring down a new tax paradigm. When former President Donald Trump passed his Tax Cuts and Jobs Act in 2017, it included a five-year ticking time bomb that would completely change the way R&D expenses could be deducted. In earlier posts, we’ve outlined how changing R&D from a deductible expense to a capitalized one would cost companies of all sizes dearly on Tax Day.
There was hope that legislators could overturn this costly tax law before the 2023 tax year (and even pass a law that would undo the effect on the 2022 tax year), but the lame-duck Congress was unable to strike a deal. So, for the foreseeable future, R&D Capitalization is here to stay.
As we explained in our post “R&D Capitalization Has Arrived (For Now)—Here's What You Need To Know,” the new law changes the way R&D spend can be deducted, which completely changes the calculus for pre-revenue startups. Up until 2023, R&D spend could be deducted all at once, which allowed companies in the red to stack NOLs. Now, R&D spend must be amortized fractionally over the course of 5 or 15 years, depending on whether the expenses are domestic or international. That means, tax bills will rise and NOLs will become harder to compile; it’s bad news for innovative companies.
At Neo.Tax, we’ve been preparing for this eventuality. We view it as our duty to make taxes work for innovative companies, so we’re proud to say that Neo.Tax has the only software solution that can cover all aspects of R&D tax strategy: from credits to amortization, and everything in between.
How Does the U.S. R&D Policy Stack Up With The World?
During the rollout of his signature corporate tax cut, the Tax Cut and Jobs Act of 2017, President Donald Trump argued that his plan would stop U.S. companies from offshoring their work overseas. But according to Reuters, it failed to curtail the flow of American jobs abroad…
During the rollout of his signature corporate tax cut, the Tax Cut and Jobs Act of 2017, President Donald Trump argued that his plan would stop U.S. companies from offshoring their work overseas. But according to Reuters, it failed to curtail the flow of American jobs abroad:
“During the four years of the Trump administration, [the Labor Department] program certified 2,095 petitions covering 202,151 workers who lost jobs that moved overseas. That’s only slightly less than the 2,170 petitions approved during the last four years of the Obama administration, which covered 209,735 workers.”
Additionally, the TCJA included a provision that changed how R&D deductions can be taken by American companies—rather than being deducted all at once, R&D costs must be amortized over 5 years for domestic spending and 15 years for foreign expenditures. The change threatens to disincentivize American companies to invest in innovation. “In a letter dated Nov. 4, 178 chief financial officers, primarily from large U.S. companies, including Ford Motor Co., Raytheon Technologies Corp., Lockheed Martin Corp. and Boeing Co., said the new rules create a competitive disadvantage for American companies and will lead to job losses and thwart innovation,” an article in the Wall Street Journal explained. “They are asking Congress to move back to immediate deductibility before the end of the year.”
The CFOs argue that the R&D capitalization change will threaten American business and foreign policy interests; they argue that a country that stops prioritizing innovation will fall behind on the global playing field. “On a level playing field, the U.S. can compete for R&D investment with any country in the world,” they wrote. “Unfortunately, the current playing field is tilted against the U.S., and every day this policy continues to be in place makes it harder for the U.S. to remain a global leader in innovation.”
Since World War II, the United States has functioned as the world’s economic superpower. Prior to that, Great Britain held that mantle, and many believe that China may soon surpass the U.S. and claim that title in the future. It turns out that both the UK and China have committed to a much more robust R&D investment than the current American plan—the two countries have “super deductions” for R&D expenditures, allowing companies there to deduct more than 100% of R&D costs from their taxes. According to EY’s Worldwide R&D Incentives Guide, mainland China-based companies can deduct 175% of qualified R&D expenses for purposes; manufacturing enterprises began deducting up to 200% of qualified R&D expenses starting in 2021!
Until a new R&D policy was announced this month, the UK had a more favorable (or, perhaps, favourable) R&D credit for all businesses, and was especially invested in domestic small-to-medium-sized enterprises (SMEs). SMEs could claim an enhanced deduction of 230% of qualifying R&D spend, as a deduction against taxpayers’ profits. If the deduction was more than the taxes, these SMEs could claim a cash credit at 14.5%, according to EY’s Worldwide R&D Incentives Guide.
The tax code in the UK and China is a demonstration of the way each country works to incentivize R&D, but taxes only tell part of the story. The UK also has a large number of public grants meant to spur innovation. For example, Innovate UK, which gets funding from the Department for Business, Energy & Industrial Strategy (BEIS), works to get academia and industry working towards UK-based patents and products and gives around £1 billion in direct grant funding every year for company-run R&D projects.
The United States has a similar SMB R&D grant called the Small Business Innovation Research program, but most of the R&D spend is done by private industry. As the Wall Street Journal explains: “U.S. companies spent an estimated $532 billion on R&D in 2020, representing the lion’s share of what the U.S. as a country allocates to it, according to the National Center for Science and Engineering Statistics, a statistical government agency. A 2019 report from Big Four accounting firm Ernst & Young forecasts that U.S. R&D spending would be cut by $4.1 billion a year for five years because of the change and then by $10.1 billion annually for the subsequent half-decade.”
The change in R&D capitalization threatens to accelerate that reduction in industrial R&D spending. Without the public grants to buoy American innovation, it could lead America to fall behind in the global race towards innovation.
India as a Case Study
India is a fascinating case study in R&D tax law and its impact. During its rapid push to liberalize and modernize the economy, the Indian government introduced an R&D tax credit to stimulate innovation. From 2001 to 2010, the R&D tax deductions were worth 150% of any capital and revenue R&D spend by firms in qualifying sectors. Starting in 2010, the R&D tax deduction was increased to 200% and became available to every Indian company. That new structure helped make India one of the most tax-friendly countries in the world in regards to R&D. (Note: in 2020-21, the deduction was reduced to 100% of R&D expenditure.) Researchers at three universities looked at the effects and found a substantial rise in R&D spending and patent applications in both India and in the US due to the changes: “We find that the R&D tax credit scheme and its 2010-11 reform spurred firm innovation,” they wrote in their 2021 journal articleR&D tax credit and innovation: Evidence from private firms in India. “In response, such firms became more innovative and more productive.”
The finding is intuitive, but it doesn’t make it any less striking when compared to the US policy toward R&D spending: lowering the cost of R&D through tax credits increases research spending, which leads to more domestic patents.
Learning from our Neighbor to the North
Canada has an interesting R&D policy that could be a valuable model for making R&D reform more politically palatable in the United States. The country offers a 15% federal R&D credit on all qualifying expenses. However, in addition, they offer an enhanced credit rate of 35% for R&D spend by small Canadian-controlled private corporations (CCPC) on their first $3 million of R&D expenditures each year. That 35% credit is 100% refundable.
The policy is specifically crafted to incentivize domestic small-and-medium-sized businesses run by Canadians. For a company to qualify as a CCPC, it must be privately owned and operated in Canada, and must not be controlled directly or indirectly by a nonresident or a public corporation.
The PATH Act, passed in 2015, is an example of an American law with a similar aim. It amended the R&D Credit so that it could count against payroll taxes rather than just income tax for pre-revenue and early-revenue startups. It meant that the credit could be claimed by the companies that were actually sparking much of American innovation over the last decade: technological startups.
The Way Forward
Clearly, as the letter-writing CFOs explained, the change to R&D Capitalization threatens to make America a country that disincentivizes domestic R&D. That could have stark consequences for the next generation of American business and American foreign policy. There seems to be bipartisan support for a change to the law, but it’s unclear if the political climate or economic moment will allow it to be prioritized. According to a recent piece in Marketwatch, the “bipartisan push on R&D tax break looks likely to flop.”
At Neo.Tax, we hope lawmakers will look abroad and realize there is a way to incentivize innovation. Perhaps a “super deduction” is not possible at this moment, but a model that allows SMBs to continue to innovate should be a no-brainer. Either way, we’ll do our part to make sure startups maximize their R&D credits and minimize their R&D tax burden; that’s why we built Neo.Tax, and our mission hasn’t changed.