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Overview

The Federal R&D tax credit is an IRS tax incentive that rewards innovation in the US.

To claim it, a tax preparer needs to conduct a R&D study and include the claim with tax filings.

Startups can get back up to $500,000 for R&D Expenses spent in their first five years.

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Eligibility

If you spent money on qualified R&D expenses in the US, you’re eligible for these tax credits.


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R&D Expenses

Eligible expenses must be spent on creating something new or improving an existing product.

And it must be spent in the US - international expenses, like foreign contractors, are ineligible.


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How It Works

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Step 1: Determine credit amount

For startups, eligible R&D expenses are typically:

  • Gross pay for employees/contractors doing product, engineering, design
  • Raw materials for physical prototypes
  • Hosting and server costs
You must reasonably estimate and apply a % of time spent on eligible activities.
  • Include time on: scoping, designing, and coding prototypes and new features.
  • Exclude time on: bugs, support, user research, marketing, hiring, fundraising, etc.

Roughly 10% of R&D expenses can be claimed as credits. For example, if you paid an US-based Engineer $100,000 in salaries last year, then you can claim $10,000.

To get a more accurate estimate, see sample calculator at the bottom of this page.


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Step 2: Claim the credit

Your tax preparer will add the R&D tax credit amount to your annual tax return.

If the IRS has no issues, the credit is approved. But this is not money back yet.

Like a store credit with the IRS - it’s not cash, but it can be applied to future purchases.

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Step 3: Get the money

There are two approaches. Every year you must pick one.

Option A: Reduce income taxes amount

If profitable, the amount of taxes owed can be reduced from existing credits.

For example, say you owe $1,000 in taxes and have $5,000 of credits, then you can reduce taxes owed to $0 and still have $4,000 credits remaining.

Most startups are unprofitable with no taxes owed. So this approach is uncommon.

Like using your existing store credit to reduce what you have to pay the IRS.

Option B: Get refund for future payroll taxes

As you run payroll for salaried employees, you need to pay payroll taxes to the IRS.

The IRS will issue a refund to you via mailed checks for those payroll taxes every quarter until all credits utilized.

For example, say you claimed $5,000 of tax credits from taxes filed in March. Then in Q2 (April-June), you paid $1,000 in payroll taxes. Your payroll provider will submit this refund claim to the IRS, and you’ll receive a physical check from them in 10–12 weeks. This continues every quarter until the full $5,000 is claimed.

PEO payroll providers typically cause the refund process to take much longer because they claim all of their customers’ refunds under the same PEO legal entity.

Most startups are unprofitable with payroll expenses. So this approach is common.

Like paying the IRS then asking to get a refund using existing store credits.
Since this approach is a cash refund, it’s limited to companies that incorporated within the last 5 years, have ≤$5M in revenue for the tax year, and ≤$500K in credits to claim.

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Calculator

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