Start-ups and small businesses that invest in creating new technologies to improve the way we work or live can benefit significantly from federal and state “Credit for Increasing Research Activities” (also known as Research Tax Credit or Research and Development “R&D” tax credit).

The R&D tax credit is a means for businesses to receive a dollar-for-dollar offset against their federal and state income tax. For every dollar spent on qualified activities in the U.S., businesses can earn approximately 10 cents in credit. For instance, if a business invests $1M in developing new technology or improving existing processes, it could potentially receive up to $100,000 in credit to put back into the business.

Examples of qualified activities include designing and building new products, adding features or improvements to existing products, and conducting tests, all of which are based on natural science principles. Moreover, this credit is available for various industries, including software, engineering and construction, pharmaceutical, biotechnology, and more.

If a company’s activities align with the definition of “qualified activities” under the tax law, then it can claim the benefits of the credit.

The R&D tax credit is an annual incentive and therefore, its analysis and gathering support should be performed annually. The sooner a company gathers evidence to support its tax position, the better prepared it is for the IPO or acquisition’s due diligence activities. Additionally, the tax rules change constantly, especially now with the R&E deduction is required to be capitalized, a company may have less tax deduction, thus more tax liabilities.

The R&D tax credit is a great way for businesses to save money, but it’s important to be aware of the potential risks. While claiming the credit on an original and timely filed return doesn’t increase the risk of an audit, there’s still a chance that tax authorities may deny your credit claims. That’s why it’s crucial to partner with knowledgeable tax professionals who can help you navigate the complexities of the R&D tax credit and ensure you have a well-designed study with appropriate documentation. This will minimize any risks and help you in the event of an audit. With the right approach and assistance, businesses can benefit from the R&D tax credit without fear of financial loss or penalty assessments.

The R&D tax credit is a legislative grace provided to the taxpayers, and as such, the taxpayers must bear the burden of proof. The key to a successful examination is preparation and a well-designed study. The devil is in the details, and procrastination when it comes to an R&D study does not end well. A delay in putting the claim on the original and timely filed return may cost the company its well-deserved credit.

In September 2021, the IRS issued enhanced documentation requirements for all claims filed on an amended return (CCM #20214101F). The enhanced documentation must be submitted with the amended tax return for the claim to be processed. A taxpayer must identify the following:

• all the business components to which the R&D Credit claim is related
• all research activities performed, all individuals who performed those activities, and the information those individuals sought to discover per component, and
• provide the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (Form 6765, Credit for Increasing Research Activities).

In addition to the financial benefits, savvy tax planning, and extending the burn rate, claiming the R&D credit is an opportunity to show investors how the company uses its funds effectively and efficiently. By being proactive, the founders may have more control over whose services they want to use or the timeline that is more convenient for the team.

In summary, small businesses or start-ups that invest in creating new technologies to improve the way we work or live can benefit significantly from the R&D tax credit. However, claiming the credit comes with risks and requires appropriate preparation, well-designed study, and documentation to increase the chances of successfully claiming the credit. By partnering with the right tax professionals and being well-prepared, businesses can maximize the benefits of the R&D tax credit and use it to reinvest in payroll, bonuses, equipment, or other expenses.