Startup R&D Tax Credits: How Your Startup Can Benefit
Let's talk about free money for doing what startups do best — innovating. The R&D tax credit is one of the most powerful tax incentives available to founders, yet many are leaving this cash on the table due to misconceptions about how it works or not having the right tax guidance.
Here's something most founders miss: the government actually wants to help fund your innovation. They've built specific provisions into the tax code to reward companies investing in research and development.
This credit isn't just for big tech. It's a serious opportunity for startups of any size to put real money back into growing their business.
Ready to stop missing out on this benefit? Let's break down exactly how your startup can take advantage of the R&D tax credit and turn your development costs into cash flow.
What is the R&D Tax Credit in the US?
The research and development (R&D) tax credit is for companies that are developing new or improved products, processes, or software in the US.
You do not need to invent or introduce something “new to the world” to qualify for this tax credit. Instead, you only need to improve your product or process while following the rules laid out by the IRS. So, although we mostly see it used by companies in the life sciences, software/SaaS, and advanced manufacturing niches, it’s not uncommon to see companies from all kinds of industries taking advantage of it to reduce their tax bill.
The government just wants to see you solving technical challenges through trial and error — basically, the kind of problem-solving most startups do every day. And if you can do this, you can significantly reduce your startup’s tax liabilities (income or payroll) and use those savings to continue to grow your company.
Who can benefit from the R&D tax credit?
Currently, the R&D tax credit can benefit all kinds of companies, regardless of their industry.
Even companies that aren't currently profitable should take advantage of the R&D tax credit if they can, as it can be used to offset income taxes or payroll taxes.
Here's how it works:
- Profitable companies can use the credit to offset income taxes, whether corporate or individual (for flow-through entities like partnerships).
- Startups that are not yet profitable can elect to use the "payroll tax credit" to offset the business portion of FICA (payroll taxes) starting from the first day of the next quarter after the claim is submitted.
It is important to note that you can only use the payroll tax R&D credit for the first 5 years and cannot claim it once you have passed $5 million in annual gross receipts.
We've seen the payroll tax credit save growing startups hundreds of thousands in payroll taxes, allowing them to hire additional employees they otherwise couldn't afford.
Not sure if you qualify? Talk to a tax advisor. They can help determine your eligibility and which type of credit makes the most sense for your situation. Even if you're not profitable now, you might want to save the income tax credit for future years when you are — sometimes that's more valuable than taking the immediate payroll benefit.
Tax credits vs deductions
A tax credit allows you to reduce the amount of taxes you owe, while a tax deduction lowers your taxable income.
While business tax deductions typically receive most of the attention, a tax credit can be far more beneficial for some startups. We often hear new startup founders say, "We don't pay taxes, so we don't need to worry about tax credits or any type of tax planning."
This reasoning is flawed because these credits can also offset other types of taxes or can be used to offset inevitable future taxes. Why pass on something that will save your business money in the long run?
How can you tell if your project qualifies for the R&D tax credit?
The IRS uses four specific criteria to determine if your work qualifies for the R&D credit. Since they've recently tightened their documentation requirements, it's more important than ever to understand these tests. Getting familiar with them now helps you track the right activities and maximize your benefits all year long.
1. Permitted purpose
The goal of your research should be making something work better, not just look better.
While changing colors or fonts doesn't qualify, pretty much any technical improvement does — whether it's to your products, processes, software, or internal systems. If you're making something work more efficiently or reliably, you're on the right track.
2. Technological in nature
Your research must fall under one of the following to count: physical or biological science, engineering, or computer science.
This means if you’re going to qualify, your research needs to be based on science, not style or opinion. Luckily, most startup work easily qualifies — whether you're doing engineering, building software, or working with data. The definition of "computer science" is especially broad, which works in your favor.
3. Elimination of uncertainty
Your research needs to tackle real technical unknowns — you can't be sure how to solve the problem when you start.
This is the make-or-break test for many R&D credit claims. If you know exactly how to achieve your goal from day one, it's not R&D. But if you're testing different approaches to solving technical challenges around design, methodology, or capability? That's exactly what the IRS is looking for.
4. Process of experimentation
Real experimentation is required to qualify for the R&D tax credit. You can't just brainstorm solutions — you need to test different approaches to solve your technical challenges.
Luckily, this is how most startups operate:
- Identify what you're unsure about
- Try different solutions
- Learn from the results
- Adjust your approach
If you're building and testing prototypes or running beta versions, then you should pass this test.
It’s important to note that this four-part test applies to each project within your business rather than to the overall business. For instance, if you're developing a new application, you may have several concurrent projects. The IRS requires that you apply the four-part test to each of these projects.
We often hear startup founders say, “Our whole business is R&D.” While that may be true, the IRS requires tracking by project in order to qualify for the credit.
What kinds of expenses qualify for the R&D credit?
After determining which projects qualify, the next step is to figure out which of your expenses are allowable under IRS guidelines. Here are the main qualifying expenses that fall under the R&D credit:
Wages
Salaries (W2) paid to employees directly involved in R&D activities, including those providing direct supervision or support to those performing the work, qualify for this credit.
Eligible roles often include:
- Software engineers
- Developers
- Project managers
- Management.
Even the wages of the business owner can count, but the IRS requires that these are separately tracked, given there could be more scrutiny.
Don’t forget that the IRS has an 80/20 rule for R&D wages. If your employee spends more than 80% of their time on qualified R&D work, you can actually claim their entire salary for the credit, not just the R&D portion.
Supplies
Any tangible property you use in the R&D process qualifies for this credit.
This can include:
- Prototype materials
- Testing supplies
- Consumables used during experimentation.
Unfortunately, any fixed assets used during R&D do not qualify.
Contract research expenses
You can include payments to third parties for conducting qualified research in your R&D credit — but there's a catch. You can only claim 65% of what you pay U.S.-based contractors, and only if you're the one taking the risk.
That means if you're paying a contractor $20,000 to do research, but the contract says they only get paid if they succeed (like a contingent contract), that doesn't count.
However, if you're paying them regardless of the outcome, then you can claim $13,000 (65% of $20,000) towards your credit.
Computing expenses
Any costs associated with processing or storing data for research purposes count towards the credit.
In practice, we often see companies with substantial AWS, Google, or Cloud expenditures benefiting from allocating these costs between R&D and non-R&D activities.
How to quantify and report the R&D tax credit
With the R&D tax credit, you can typically expect a credit worth about 10-12% of your qualifying R&D costs. But before you get excited about those dollars, here's what you need to know:
Documentation is crucial. The IRS has recently tightened its requirements, and as someone who's defended these credits in audits, I can tell you — good records make all the difference. Work with your tax advisor to complete a proper R&D study that meets IRS standards.
From a tax reporting perspective, this credit will go on Form 6765 of your business tax return. Starting in 2024, additional disclosure and attachments are required when filing your business tax return. These disclosures include specific projects and the key personnel who participated, making it even more important to keep your records up to date.
If you choose to take the payroll tax credit, you will receive a separate form to provide to your payroll company as soon as possible (especially if you are near the end of a quarter).
Pro tip: Think you missed out on past credits? You might be able to claim them retroactively - up to three years back. But you'll need solid documentation to support those claims.
Recent changes to R&D expense deductions (IRC 174) have made things more complex, especially if you're profitable. While that's a topic for another day, make sure to discuss these changes with your tax advisor.
Don’t take a chance on your taxes
The R&D credit is just one example of how the tax code rewards innovative startups. But don’t think it’s the only one. There are dozens of other provisions designed to help companies like yours grow, too.
Smart founders know that professional tax guidance isn't just about filing returns — it's about strategically using these benefits to put more money back into your business.
Ready to make sure you're capturing every tax and accounting advantage you deserve?
Book a call with us today so we can see how the experts here at Digits can help you build a tax strategy that fuels your growth.
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