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R&D Tax Credits and Startups: A Perfect Combination

28th September 2021

An innovative startup isn’t so much a company as a business experiment with a high failure rate—and potential to scale (as opposed to growing linearly). That failure rate is built-in: After all, these entities are typically driven by a new idea, concept, or product that hasn’t been tested before. Anywhere from two-thirds to three-quarters of them do fail. And yet, ounce for ounce, dollar for dollar, startups may be as good an R&D investment in the future as a government could make.  

Driven by desire and creativity, startups are better positioned than their weightier brethren to swing for the fences—and, once in a while, deliver a home run for the home team. Early-stage companies are risk-takers: They hire people, rent offices, pay local taxes, and benefit local economies. Governments looking to jumpstart spending and invent new employment opportunities would be smart to harness that startup energy, so these new-money businesses can thrive. 

Like a handful of other countries, the United States is making significant efforts to recognize and reward innovative startups for the special role they play on the R&D stage. Granted, the U.S. could do more in terms of generosity—and recent legislative proposals suggest it may in the future—but at least, it is encouraging companies to launch, innovate, and inject new dollars into the economy. Here, we show you how.  

The Need for Investment 

To some economists, startups are uniquely positioned to help drive economic recovery—but they can’t do it without fuel: enough cash flow to keep operating during those crucial first quarters. In many countries (including, up until 2015, the United States), the tax incentive system makes no concessions to pre-profitability companies: If you make a profit, you’re subject to immediate tax liability—but if you’re in a loss position, you don’t get an immediate tax benefit.  

Another structural factor that tends to weigh against startups (and smaller enterprises in general) is that R&D tax incentives end up favoring organizations with strong balance sheets, solid infrastructure, and armies of tax professionals dedicated to claiming every possible incentive. Established companies are much better positioned to weather the storm of a downturn or a failed experiment. The irony is that they can also be more risk-averse, and more likely to finance ideas they would have developed anyway or use incentive money to recirculate spending—which undercuts the intent of the incentive: to encourage investments in innovative products and services that could help spur economic growth.   

Most startups don’t have the bandwidth of their established competitors—in person-hours, cash, and strategic focus—to pursue the incentives that could help fuel their innovation and give them a shot at longer-term success. In fact, many of them aren’t even aware that benefits are available to them. They’re positioned to help economies regenerate, but they need support to do so.  

The U.S. Steps Up for Startups 

The U.S. R&D tax credit has certainly evolved. For its first three decades, the program held little value for early-stage companies because it was useful only to those already turning a profit. (How many R&D-heavy startups accomplish that feat in their first couple of years?) Today, with incentives worth roughly 6% to 12% of a U.S. company’s R&D spend after tax, the system is more generous—and more available to more companies—than it’s ever been.  

The turning point was unquestionably the passage of the PATH Act of 2015. Not only did this new law make the credit permanent (up until then, it was renewed only on a short-term, ad hoc, frequently retrospective basis), it also enabled early-stage companies who satisfy certain conditions to score up to $250,000—every year, for up to five years—in credits against quarterly payroll tax liability. That’s a powerful benefit since it allows immediate monetization of credits and one that helps level the incentive playing field between startups and other companies. The PATH Act also permits certain entities to use R&D credits to offset the alternative minimum tax (AMT), a benefit which has become less meaningful after the repeal of AMT for corporations included in the Tax Cuts and Jobs Act of 2017 (TCJA). 

Still, many would argue that the United States can do a better job at pinpointing and supporting the special needs of this group of taxpayers. In fact, by some measures, we may be swimming backward: In order to fit the TCJA into its “revenue-neutral” wedding dress, its designers used an accounting gimmick that is about to hit low-cash, high-potential companies hardest. Starting in 2022, R&D expenditures, which previously could be expensed in the same year, must now be capitalized and amortized over five years: a serious blow that dampens the incentive as a tool to influence companies’ behavior and could push some offshore in search of greener R&D pastures—or out of business altogether. 

As it is, by OECD standards, the U.S. falls short of a lot of other countries in terms of generosity, ranking 24th out of a pool of 34 rated economies. If that five-year rule is not overturned, many argue that the U.S. will slide even lower on that scale. 

The Future of Generosity 

In the U.S., incentivizing innovation is one of the few issues that seems to unite lawmakers in both political parties. And even if they disagree on how to go about it, there are reasons to be hopeful that more and better change is coming to support innovators, including startups. Here are some of the bills currently in play:  

  • In May of 2020, a bipartisan, bicameral group introduced the FORWARD Act, which, while it does not address the five-year-amortization issue, substantially enhances the generosity of the R&D credit program for startups. It allows companies with up to $20 million in gross receipts to use the credit to reduce the payroll tax obligation over the course of eight years—up from $5 million and five years today. 
  • In October of 2020, two Republican congressmen introduced the American Growth Act, which calls for repealing the amortization provision, as well as doubling the regular R&D tax credit rate to 40%. (An earlier Republican-introduced bill proposed the same measure—plus a doubling of the Alternative Simplified Credit, or ASC, rate to 28%—to help jumpstart the COVID-19 recovery.) 
  • In February of 2021, the American Innovation and R&D Competitiveness Act, a bipartisan bill, was introduced in the House with the express purpose of repealing the provision requiring amortization of R&D spending.  
  • As of the summer of 2021, both the House and the Senate have proposed (drastically different) bills to substantially beef up R&D assistance to American companies. The final reconciled bill may have a dramatic effect on American industrial policy—including R&D incentives for startups. 
  • Finally, President Biden has called for significant new investments in R&D—including a $300 billion investment in breakthrough technologies, with the creation of an estimated five million new jobs in manufacturing and innovation. 

All in all, the sun is looking increasingly bright if you have (or are planning to launch) a startup in the U.S. You can finally count on the permanency of the R&D tax credit. The standard for qualified research has been significantly loosened since the credit’s inception. The ASC provides an easier way (although not necessarily the most advantageous one) to apply. You can get major support with payroll taxes for your most critical talent—even if you lose money for five straight years. And there’s enough promising legislation in the pipeline that it seems likely more improvements are coming, especially on the troublesome five-year-amortization issue 

Failure Is an Option—So What’s Holding You Back? 

To date, the R&D tax credit has provided tens of billions in tax savings in the U.S. alone, and the rules of the road are easier than they ever have been. Yet, shockingly, only about one in 20 companies who qualify for the credit actually applies. And—no surprise—startups are overrepresented in that group of 19 non-applicants.  

But why? Let’s have a look at the blind spots and misperceptions.  

R&D tax credits don’t apply to me. Some entrepreneurs may believe that R&D credits don’t apply to their industry—or that they have to have a room full of scientists and technicians laboring over expensive machines, finding a cure for a disease, or inventing a new chip, to qualify. The truth is any company in any industry could be eligible, so long as they are focused on creating a new (not even new-to-the-universe, just new-to-the-company) product or process… or even just improving one.  

Our experiments failed. Some may think that a failed experiment would make their R&D expenses ineligible. Projects don’t need to succeed to qualify—they just need to fit the four-part test set out by the IRS. 

We’re not profitable, so we don’t qualify. Another misconception is that the company must be already profitable to file for a tax credit. Not so: Startups and other small businesses can now take as much as a quarter-million-dollar offset for payroll taxes each year for a maximum of five years. As long as the company can show gross receipts of less than $5 million for that tax year—and gross receipts for five years or fewer—it can benefit. Even if you don’t have employees yet, contracted costs are eligible, and the credit can be carried forward to the next quarterly return; it doesn’t expire until you’ve used it up against payroll tax. Alternatively, you can elect to allocate just part of your credit to payroll tax while leaving the rest to offset income tax. Unused income tax credits may be carried back one year and forward for twenty.  

Startups need cash and support to survive and grow. Countries and economies need startups, too—and for the very same reasons. In the long run, new ideas—even untested ones, even ones that fail—are worth more than recirculated ideas. U.S. R&D tax incentives have never been friendlier. So, if you happen to operate a small, high-potential company, there’s no better time to see if you can take advantage of R&D tax credits—and there’s a good chance you can.