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Code Section 41
See Tax Code
The Internal Revenue Code Section 41 provides for two methods of computation: the “Regular Method” and the “Alternative Simplified” method. Both methods measure and award credit for companies that increase research efforts (relative to sales) year over year. The “Regular” method, however, allows for “startup” companies (without a history of comparable R&D) to get approximately a 10% credit for most qualified research costs. Companies with 3+ years of prior R&D can qualify for a higher percentage of credit under the Alternative Simplified Method.
Claiming an R&D Tax Credit does NOT increase your chance of audit.
Prior to 2012, R&D had a “Tiered” System that labeled credits as a high-risk “Tier-1” issue. However, since then, the existence of an R&D Credit no longer raises a “red flag” for audit. In fact, the credit is such a significant benefit to companies, it’s unusual for a tech startup NOT to claim the credit.
While claiming the credit does NOT increase risk of audit, there are factors of a credit that could increase the chances of having the R&D Credit audited if your company is selected for examination. Those factors include: the overall size of the credit relative to company expenses, claiming the credit for companies in industries not typically known for innovation, and amending prior year returns to increase claimed credit amounts.
It varies based on the age of the company and the computation method used. Most startups will get about 10% of their qualified R&D wages (and 6.5% of qualified contract research expenses). However, some startups can get nearly 14% on their 4th and 5th year of R&D. Although there is no maximum credit that can be generated in a year, qualified startups can elect a maximum of $250,000 of that credit to be applied to payroll taxes.
Code Section 174
See Tax Code
In order to be able to claim the credit against payroll taxes, a company needs to meet the definition of a “Qualified Small Business” which is defined as a company with:
“Gross receipts” of less than $5,000,000 during the taxable year in which the credit is claimed and
ZERO ($0) “gross receipts” for any taxable year before the five-year period ending with the taxable year.
NOTE: “Gross Receipts” includes ANY form of income, including Sales, Interest income on a bank account (even $1!), or government grants or research awards.
So, for example, a company can claim a Payroll credit on their 2020 corporate income tax return if they had less than $5million of gross receipts in 2020, and ZERO gross receipts in 2015 or prior tax years.
The credit is first claimed on your company’s income tax return, with an election to be applied to future payroll taxes (provided the company meets the Qualified Small Business Requirements).
An interesting remnant of the original R&D Credit rules from 40 years ago has recently become relevant again. The regulations — which qualify the cost of “leased computers” used for R&D to be included in the credit — were written to allow companies to include the expense of leasing processing time on expensive mainframe computers. In the 1980s, those computers were generally owned by only the largest companies or universities. However, the text of the law allowing leased, off-site computer processing clearly translates to modern-day cloud computing (such as AWS).
This part of the law was intended only for processing power, and not for software costs. Thus cloud expenses that host your R&D processing efforts do qualify, while cloud software (such as Adobe Cloud, G-Suite, Microsoft 365, etc.) do not qualify.