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
Reduce burn
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.
Forms:
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.
How Much Can My Company Claim Via The R&D Tax Credit?
How much is an R&D credit really worth to your business? Here are four examples based on real companies to give you a better sense of the massive value of filing for the credit with Neo.Tax.
Tax Day 2023 is arriving at a precarious moment for innovative American companies. The last year has seen a wave of layoffs and a loss of value for many companies in industries like tech, manufacturing, and many other sectors. On top of that, changes to tax law with regard to R&D Capitalization have massively changed what companies will owe the IRS in April or October. That’s why it’s never been more beneficial for innovative companies to claim the R&D Tax Credit.
The federal R&D tax credit is a 10% cash-back credit for product development expenses. Startups with <$5M revenue and <5 years of revenue can apply up to $250k against payroll taxes. All companies can apply it against income taxes or carryforward. Neo.Tax has built a software solution that maximizes your credit and prepares your filing in <30 minutes.
But how much is an R&D credit really worth to your business?
Here are four examples based on real companies to give you a better sense of the massive value of filing for the credit with Neo.Tax.
A reminder from Neo.Tax:
Based on new guidance from the IRS, it seems likely there will be a more stringent view of amended returns — the burden of proof is on the company and will need to be even more detailed — which means waiting to amend the returns may become more expensive and cumbersome going forward.
So, make sure to file your credit with your taxes (or to file an extension so you can get your R&D credit for this year). Book a call and we can walk you through all the ways to make R&D spend valuable for your innovative company!
Even though R&D Capitalization was passed into law back in 2017, almost everyone expected the massive tax law change to be repealed before it ever took effect. But for the last year-plus, we’ve been preparing for the possibility — which has become a reality — that R&D Capitalization is here to stay (at least for now). So, without further ado, Neo.Tax presents: A Simple Guide to R&D Capitalization…
Even though R&D Capitalization was passed into law back in 2017 as a part of Former President Donald Trump’s Tax Cuts and Jobs Act (TCJA), almost everyone expected the massive tax law change to be repealed before it ever took effect. But for the last year-plus, we’ve been preparing for the possibility — which has become a reality — that R&D Capitalization is here to stay (at least for now).
Without further ado, Neo.Tax presents: Your Definitive Guide to R&D Capitalization…
What is R&D capitalization?
The TCJA changed the way that R&D expenses can be deducted by American companies. Up until this Tax Year, R&D could be deducted all at once, meaning that innovative companies who spent on R&D would appear in the red both in their books and in the eyes of the IRS. However, the new law states that R&D expenses must be amortized over 5 or 15 years (depending on if the expenses are domestic or international). Therefore, only a fraction of a company’s R&D expenses can now be deducted in a given year.
All of a sudden, pre-revenue startups will begin to appear in the black in the eyes of the IRS — so what would have been a valuable NOL will now be a hefty tax bill. And startups are not the only ones affected: CFOs from the largest American companies have warned Congress that this change will stifle innovation. Yelp’s effective tax rate will jump 20 percent this year compared to 2019 due to R&D Capitalization!
Do we have to capitalize?
We’ve heard from many companies who are confused by the change. They ask: if we don’t file an R&D credit, do we still have to capitalize our R&D expenses? The short answer is YES. An accountant is responsible for making sure your filing is compliant with the law. R&D Capitalization is the law (at least for now). So, not amortizing your R&D expenses is not an option. In the event of an audit, the IRS may be inclined to disallow any R&D credit and/or re-calculate the expenses claimed.
So, as of now, any expense that can be categorized as an R&D expense must be amortized over 5 or 15 years whether or not you file for the R&D credit. Therefore, companies that forgo the money they’re owed in the form of a credit will simply be burdened with an even higher tax bill this year.
The true effect of the change is that it makes it imperative for innovative companies to commit to Tax Strategy year-round to minimize the impact on their tax bill. R&D expenditures that are considered “qualified expenses” can be claimed on an R&D credit; those that are not “qualified” now must be amortized. The difference between qualified and not qualified R&D spend come Tax Day? Almost 10x.
What is a qualified vs. non-qualified research expense?
Okay, so, clearly it’s essential to maximize “qualified” expenses and minimize “non-qualified” R&D costs. But what is the difference between the two?
IRC §41 (Section 41) defined a “qualified” expense that can be claimed via the R&D Tax Credit as any R&D expense that passes the Four-Part Test: Permitted Purpose; Elimination of Uncertainty; Process of Experimentation; Technological in Nature. You can read more about the Four-Part Test here, but basically, these are expenses directly related to the creation of new products or novel uses of existing products (that includes wages, research expenses, supplies, and even cloud computing costs).
Now, IRC §174 (Section 174) defines the way companies must deal with all R&D expenses: both “qualified” and “non-qualified”. But obviously, the larger the percentage of your R&D spend that “qualifies” for an R&D credit, the smaller the amount that you’ll need to amortize. Examples of R&D costs that are not qualified (aka do not pass The Four-Part Test) include: R&D after commercial production; research for internal use only; research funded by a grant; and most research tied to social sciences, arts, and humanities.
To be an innovative company, R&D spend is essential. So, the key now is maximizing the percentage of that spend that qualifies for an R&D credit and minimizing the spend that must be amortized over 5 or 15 years.
Why do we have to include foreign expenses?
As long as you’re a company doing business in the United States, you have to pay taxes in the United States. In many ways, the reason for this massive change to R&D taxes is an effort to move more research jobs and spending back into the United States.
The amortization structure is designed to punish R&D spend made outside of American borders. A quick example to explain why the 15-year amortization is so much more punitive than the 5-year amortization:
In its simplest form, a deduction can be thought of as an expense that is subtracted from taxable income. So, if you made $10M in revenue and spent $5M on R&D, deducting that amount would make your taxable income $5M ($10,000,000 minus $5,000,000). But under the new R&D capitalization rules, the amendment means the deduction must be amortized, or in simpler terms, spread over 5 or 15 years, depending if the expense is domestic or international, respectively. On top of that, Year 1 can only be amortized as half a year, so that means only one-tenth or one-thirtieth of the R&D expenses can be subtracted from the taxable income that first year.
So, if your company’s R&D occurred in the States, the equation becomes $10 mil minus $1M; if it’s done abroad, the equation becomes $10M minus $333,333.33. Eventually, over the 5 or 15 years, you will technically be able to deduct the same amount as before, but this obviously increases your tax bill in the near term by quite a bit. For the company that spent exclusively in the States — that’s a $9M taxable income; for the company that did R&D abroad, that’s $9.67M. With the 21% corporate tax rate, for Year 1 taxes, that’s an extra $140K!
Will capitalization be repealed?
This is the big question, and for now, the only responsible answer is: NOT YET.
For the last six months, there have been rumors that a deal is close, but none have come to fruition. Many CEOs, CFOs, and even accountants are keeping their fingers crossed, but, unfortunately, the Crossed Fingers Method is not IRS-compliant.
So, the safest route forward is to either file now and hope the law is repealed and companies are retroactively made whole for their 2022 or to file an extension, pay your quarterly taxes as if the law is still on the books, and then hope that your quarterly taxes are refunded if the law is eventually overturned. Either way, make sure to file an R&D credit when you file your taxes — they cannot be filed retroactively.
As anyone who has watched Washington these last five years knows: betting on compromise is a longshot wager. So, plan as if the law on the books is the law of the land, and get your books in order. And, remember: we’re here to help! So, book a call today.
The Takeaway
If you’re a company involved in software, manufacturing, architecture, engineering, food, or construction, it’s very likely that you qualify for an R&D credit. It’s just as likely that you have expenditures that can be considered R&D spend.
Two things to remember…
Any company with R&D expenditures needs to amortize their deduction to be compliant with the new R&D Capitalization rules.
The best way to offset that cost and extend runway in a non-dilutive way is to claim your R&D credit. It’s the closest thing to free cash for innovative companies. It’s written specifically for companies like yours. So, don’t leave that money on the table!
Neo.Tax is the only software solution that solves for both R&D Capitalization and for R&D credit filing. Let us help you navigate this massive change. We’ve been deep in the weeds on this for 12 months; we’d love to walk you through the best way to maximize your credit and minimize the impact of capitalization!
Neo.Tax & Bench Team up to Deliver a 360° Tax Solution
Extending runway has never been more important than at this precarious financial moment. And changes to the tax code that just went into place mean that tax strategy will be the difference between massive bills and valuable credits this April. Good accounting is an essential part of building a valuable innovative business. Neo.Tax x Bench can make it effortless for you!
With Neo.Tax x Bench, you'll have everything you need in one place. From tax calculation and preparation to financial management and bookkeeping, we've got you covered. Our solution is designed to streamline your tax process and help you make informed financial decisions with confidence.
And there's more! Our R&D tax credit optimization tools can help you claim all eligible R&D tax credits and maximize your tax savings. With Neo.Tax x Bench, you'll have access to a team of tax experts who will guide you through the process and help you claim all the credits you're entitled to.
Bench offers bookkeeping, income tax prep, and filing done by experts so you can focus on growing your business. By partnering with Neo.Tax, Bench customers also get access to the only software solution that solves for both R&D filing and R&D Capitalization. Basically, Neo.Tax x Bench means your tax season just got a whole lot less stressful and a whole lot more valuable for your startup.
Extending runway has never been more important than at this precarious financial moment. And changes to the tax code that just went into place mean that tax strategy will be the difference between massive bills and valuable credits this April. Good accounting is an essential part of building a valuable innovative business. Neo.Tax x Bench can make it effortless for you!