R&D Tax Credit For Startups

by Joseph Bien-Kahn in

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The US Federal R&D Tax Credit is like free money for tech startups. To summarize: a startup can claim a % of each employee's payroll as long as the work they’re doing relates to research and development. The % you claim depends on the employee and how much time they are actively spending on R&D. Accountants or specialists will help you identify the correct percentages per employee but, for example, an engineer might spend 70% of their time on R&D tasks (so that means 70% of the salary paid to them is dedicated to R&D) while a salesperson at an early stage company may only spend 10% of their time on R&D (since at an early company, even the sales team helps with product and customer research).

In the past few years, a number of companies have launched to help startups claim the R&D tax credit. The reason is simple: many accountants forget or do not know how to file for it, so the credit remains widely unclaimed. If you don’t claim it in a given year, you lose out on the money you’re owed. And after 5 years of revenue, the startup can no longer claim the credit. The same is true of any company that has gross receipts over $5M in the taxable credit year.

The R&D tax credit is legislation specifically passed to incentivize American companies to invest in innovation. However, while the most disruptive ideas often come from startups, many miss out on the R&D Tax Credit. In 2014, more than $12 billion worth of R&D tax credits were claimed, but much of that money went to Fortune 500 companies. These last few years, Congress has taken specific action to make certain that early-stage startups can claim the credit they’re owed. The R&D tax credit is specifically designed to give American startups the runway they need to create innovative, valuable ideas and products.

A startup can use the credit against up to $250,000 in payroll taxes. If AbstractOps' client is using Gusto as their payroll provider, the credit can be applied automatically against every payroll run. If the customer uses Rippling or another payroll provider, they will receive quarterly disbursements from the government. Over the next few years, our bet is that most other providers will automate and copy Gusto’s implementation.

Once the R&D tax credit is claimed, it is almost always signed off by the government. The credit against payroll begins Day 1 of the subsequent calendar quarter. The R&D Credit was built to promote innovation in the U.S. and is the simplest way to immediately extend your startup’s burn. 

It’s important to note that there is a chance the company claiming the credit will be audited. And yes, a tax audit is scary. However, the chance of it occurring if you use one of the below recommended solutions is very low.

The Risk of Audit

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The government audits tax credits when they believe fraud has occurred. From what we've heard, part of the audit check process is to look up a company online (yep, that simple). If a company has a legitimate looking website, that is step one in demonstrating that they are a company building innovative technology. However, the auditor may still request a document — called “the study” — that can be created outlining the reasoning behind the credit. If the study does not sufficiently substantiate the credit, then and only then would an audit begin. 

Even in that worst case scenario, so long as the mistakes were honest, you won’t be charged penalties or interest, just the adjustment in the value of the credit. If you are a technology company with less than five years of revenue, the R&D Credit was built for you. 

How Pricing Works

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For qualifying startups, the R&D Credit generally works out to 10% of qualified expenses — for example, if you spend $2.5 million on research and development, the credit would offset $250,000 against payroll taxes. It can be tricky to understand the true cost of having someone prepare the filing of the R&D Credit for you because some CPAs/R&D Preparers charge based on a percentage of the qualified expenses and others frame it as a percentage of the value of the credit itself. So, if someone charges 2% of expenses that generally works out to 20% of the credit; if someone charges 1% of expenses, that works out to about 10% of the credit.

The reason for these differing framings is not always nefarious (though obviously, some companies do seem to try to frame their pricing as the percentage of expenses to seem more affordable than they are); the IRS has a rule against what they call “contingent fees” for credits. A CPA or R&D Preparer cannot technically promise that they’ll only take a percentage of the credit if it is granted. Framing pricing around qualified expenses rather than the credit insulates a company from this “contingent fee” pitfall — for customers, the important thing to remember is to check which metric they’re using to understand the true cost.

R&D Tax Credit Services, Ranked

The first step for any founder looking to claim the R&D Tax Credit is to check with your accountant. Not every accountant is familiar with the credit (which is why such a high percentage of startups fail to claim the money they’re owed), but see what they charge for filing the claim. On occasion, accountants will roll the cost into their service, but many charge between 15-20% of the claimed credit value to complete the R&D filing. Aside from that high price, the other issue with opting for an accountant is that if they’re not an expert, they may make mistakes in the filing which can lead to two issues: 

  • Higher chance of an audit. Filing for and claiming an R&D tax credit is rarely their specialty. Mistakes can be made. This can also lead to...
  • Higher chance of them missing some key elements thereby reducing the amount claimed. There are 200 different types of potential credits. That is difficult for any human accountant to accurately track. At most early-stage companies, your accountant is not likely an expert (since you’re probably going with a more affordable person or firm churning through many returns). It’s also unlikely they’ll be diligently searching for every dollar you’re owed. Using your accountant may be penny-wise and pound-foolish in that you’ll save money on their fees, but miss out on a much larger credit. 

Here are services we recommend using with the pros and cons outlined.

#1 Neo.tax:

Neo.tax is the most affordable option, charging just 10% of the credit (and only 8% for AbstractOps clients). Their founding team — a Stanford PhD, an Intuit veteran, and a Chief Tax Officer who spent 7 years as an IRS auditor — have built a high-quality machine-learning powered system that imports all your information and creates a near bullet-proof report. Their insider knowledge has allowed them to reverse-engineer the IRS audit process to create a best-in-class “Study” to insulate any customer from an audit. 

Pros:

  • Low cost
  • Uses intelligent technology to do this
  • Takes minutes to complete
  • $1 million in audit protection
  • Strong partnership with AbstractOps

Cons

  • Early stage startup so a bit less battle-tested

#2 Mainstreet:

Mainstreet charges 20% of the credit although via AbstractOps' partnership, they will charge our clients 15%.

Pros:

  • The largest R&D tax credit provider so it's the most tested.
  • Heard good things about what they offer.
  • Start paying out the tax credit immediately by basically providing a 0% loan
  • From what we understand, this sounds better than it actually is because the government also starts paying almost immediately, as well. Note: this is more valuable if the client is on Rippling (vs Gusto) since those clients do have to wait until the end of each quarter to get paid (vs each payroll). However, even then, unless the client is strapped for cash, we recommend choosing a lower cost option than paying extra to get the cash today. Put another way, is having money today worth an extra $5k (in the hypothetical $100k credit world vs Neo.tax)?
  • Audit insurance: Mainstreet will cover up to $1m in costs related to a tax audit.
  • Note that this may be more marketing than valuable for a few reasons:
  • Mainstreet claims none of their clients have ever been audited. Hence, the chance of an audit is low already.
  • We've heard that folks who have read their insurance policy in detail see many places where it would be easy for them to get out of actually covering the customer. Ex: they might say the fault lies with the customer if the IRS claims that the credit was fraudulent in the amount it requested per employee but the % per employee was given to Mainstreet by the customer.

Cons:

  • Expensive (but given their experience, you can rest assured on what they provide)

#3 Pilot.com:

Pilot.com charges 25% of the credit (lower for AbstractOps clients).

Pros:

  • Tied directly into Pilot - so somewhat less hassle for a client vs sharing new data but most of the other providers claim that they do not need major data.
  • Note that for our clients, AbstractOps will do a portion of the work to provide any key documentation (if we have it) thereby reducing the amount of work the client has to do. The client will always have to sign off.
  • Claims to do a detailed review that may be more detailed than the other providers above but exactly what that means is unclear.

Cons:

  • Very expensive
  • No audit insurance although they claim they will help you if you are audited 

#4 Clarus:

Clarus charges 8-15% depending on the credit size.

Pros: 

  • They’ve been around since 2016 and have done $50m in credits
  • If you happen to be a company that qualifies for the lower rate, it’s very affordable

Cons:

  • Difficult to find prices on the website and a pricing structure that varies widely. 

How To File Via Gusto

Many of the AbstractOps clients use Gusto for their payroll. The cloud-based payroll, benefits, and human resource management software makes the process exceptionally easy. As Gusto explains on their site:

Part One: Credit for Qualified Research

  1. Sign in to your Partner dashboard.
  2. Go to the Clients section.
  3. Click the Actions menu on the far-right.
  4. Click Federal R&D credit.
  5. Select the type of business income tax return this company uses.
  6. Select the Fiscal Tax Year this company uses.
  7. Enter the date this company filed its tax return.
  8. The filing date is used to determine the first eligible quarter that the credit can be claimed.
  9. If this company filed under a different Federal EIN at any point in their corporate tax year, the previous Federal EIN is required for the Federal R&D Credit filing.
  10. Enter the total Federal R&D Credit claimed. This amount can be found on Line 44 of the 6765 Form. 
  11. Click Save & Continue.

Part Two: Previous Credit Claims

  1. Select whether your client has claimed a part of this credit on Form 941 this fiscal year or not.
  2. If this company claimed the credit in any prior quarters, please enter these values so we may determine their remaining Federal R&D Credit.
  3. Click Save & Continue.

Part Three: Before You Submit

  1. Review the information to make sure everything is accurate. 
  2. Once you are ready, click File Tax Credit

Conclusion

The most important takeaway is this: every qualifying startup should be claiming an R&D credit. For years, because of the obscured nature of the tax code, most early-stage companies missed out on the money they’re owed. But luckily, in these last few years, a new batch of startups have launched specifically focused on helping you claim your R&D Credit.

You won’t go wrong with any of the listed providers; the only big mistake is to miss out on free money to do what you’re already doing: building amazing, innovative technology. You only have a short window to claim the credit, so what are you waiting for?