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Innovative businesses often struggle to understand how to capitalize on the R&D tax credit. The government offers this lucrative incentive to offset the costs of experimentation, but many startups are unsure where to start when it comes to claiming it. Fortunately, numerous examples are available that illustrate the types of activities that qualify for the credit. In this article, we’ll walk you through R&D tax credit examples for small businesses to help you get a better idea of how the program works and how your startup can benefit.
As you read through these examples, consider how Haven, with their accounting services for small businesses, can help you identify qualifying activities for the R&D tax credit and get the money your business deserves.
Table of Contents
What is R&D Tax Credit?
The R&D tax credit, formally known as the Research and Development Tax Credit, is a government-backed incentive designed to encourage companies to invest in innovation. It provides a dollar-for-dollar reduction in tax liability for eligible research expenses, helping businesses offset:
Federal income tax
Payroll taxes
Making Innovation Affordable: R&D Tax Credit Benefits for Startups and Small Businesses
This powerful credit supports companies developing new or improved products, processes, or technologies. Easing the financial burden of R&D, it fuels innovation and helps businesses stay competitive. Initially introduced in 1981 as a temporary measure, the R&D tax credit proved so effective that it became a permanent part of the tax code. The PATH Act of 2015 expanded its reach, making it more accessible to startups and small businesses, broadening the impact of this essential tool for growth.
R&D Tax Credit’s Startup Provision
The R&D tax credit’s startup provision is designed to support and incentivize early-stage startups and small businesses to invest in research and development. Recognizing the unique financial challenges startups face, this provision offers additional opportunities to benefit from the credit. Eligible startups, with gross receipts under $5 million in the current tax year and no more than five years of gross receipts, can apply the R&D tax credit against their federal payroll tax liability. This includes the employer’s portion of Social Security and Medicare taxes, allowing startups to benefit even if they have little or no federal income tax liability, which is common in early stages.
Boosting Innovation: How Startups Can Reinvest R&D Tax Savings
By offsetting payroll taxes, startups gain a valuable cash benefit that can be reinvested into further research, development, or other business priorities. The credit is capped at $250,000 annually for up to five years. Starting in 2023, this cap increased to $500,000 per year, allowing startups to claim up to that amount each year for a maximum of five years. Once a startup becomes profitable, it may also apply any unused credit against income tax liability, especially if its qualified research expenses exceed the payroll tax cap. This provision thus provides meaningful financial relief and encourages innovation during critical growth phases.
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R&D Tax Credit Examples of Qualifying Activities
Product Development and Improvement: The Quest for Innovation
Creating a new product for commercial use, especially when technical challenges must be solved to bring it to market. Enhancing an existing product’s performance, quality, durability, or reliability through technical experimentation. Prototyping and testing new products or components to refine designs and functionality. Reducing time-to-market through iterative design and testing of production methods or components.
Manufacturing Innovation: Improved Processes and Products
Designing a new manufacturing process to produce a product at scale efficiently. Improving an existing process to:
Reduce waste
Increase throughput
Automate steps
Solve bottlenecks
Engineering upgrades to techniques like drilling, finishing, or coating to meet specific performance goals.
Software Development: Beyond the Box
Building software to be sold, licensed, or used by customers, such as mobile apps or cloud-based tools. Developing internal-use software to streamline operations or connect disparate systems. Creating custom platforms or APIs to bridge between third-party systems and internal departments.
Scientific and Technical Advancements: Experimenting for Success
Experimenting with formulations, such as in:
Pharmaceuticals
Food products
Chemical compounds
Improving existing technical methods, including:
Welding
Machining
Material selection
Energy use
Conducting patentable work, even if a patent is never filed, the technical challenge involved may qualify.
Use of Third-Party Resources: Collaboration Counts
Engaging consultants or contractors to perform any of the above activities can still qualify, provided the work is technical and performed on behalf of the taxpayer. Even routine-seeming activities may qualify if they meet the IRS criteria. The key is to document the technical uncertainty, the experimentation process, and the purpose behind the innovation. If your team is tackling technical problems or improving products or processes through trial and error, there’s a good chance you’re doing qualified R&D.
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Why Do Startups Invest in R&D?
Research and development (R&D) refers to the activities a company undertakes to acquire knowledge aimed at developing, designing, and improving products, services, technologies, or processes. Beyond creating new offerings or enhancing existing ones, R&D plays a crucial role in aligning various aspects of a company’s strategy and business plan. According to the latest Business Enterprise Research and Development survey by the National Center for Science and Engineering and the U.S. Census Bureau, businesses invested $32.5 billion in R&D activities in 2020 alone.
Investing in R&D: What It Means
The IRS defines R&D as investigative activities undertaken to discover:
New products
Product lines
Services
For tax purposes, qualifying activities don’t have to result solely in discoveries. R&D can be broken into two parts:
Research: The pursuit of new scientific knowledge or innovative thinking. This is divided into basic research (the academic exploration of scientific principles) and applied research (the practical use of that knowledge to solve real-world problems).
Development: The process of applying new knowledge or innovations to create or improve a product or service.
While R&D is the initial step in product innovation, product development itself covers the entire product lifecycle, from idea conception and launch to updates and eventual retirement.
How R&D Drives Growth and Differentiation
R&D empowers companies to gain competitive advantages that are difficult for rivals to replicate. By improving business processes, such as reducing costs or increasing productivity, companies can outperform competitors.
Industries Transformed by Research and Development
R&D often sparks innovation that revolutionizes industries. For example, without R&D, mobile phones, the internet, and countless other technologies wouldn’t exist as we know them today. Through R&D, businesses identify problems and develop unique solutions, creating diverse product and service variations that benefit consumers and stimulate competition. Industries heavily reliant on R&D include:
Automotive manufacturing
Software development
Cutting-edge technology
Pharmaceutical industry
The R&D Tax Credit
Since 1981, the IRS has incentivized companies to invest in research and development through tax credits, making it financially easier to innovate. Qualifying companies, including startups and small businesses, can offset their tax liabilities with these credits, which also include a generous 20-year carry-forward provision.
Qualifying Expenses for the R&D Tax Credit
Eligible expenses may include:
Cloud computing costs
Wages for employees directly involved in research
Payments to contractors performing testing or research
Supplies needed for product development, such as software licenses
All expenses must be incurred within the United States to qualify.
Buyouts, Mergers, and R&D
Many entrepreneurs and startups have rapidly grown their value by selling innovative ideas or technology to larger firms with greater resources. This is especially common in the online sector, but it also occurs across industries driven by innovation. Investing in R&D can make your business or ideas more attractive to investors and potential acquirers, fueling growth opportunities and long-term success.
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What Are the R&D Tax Credit Qualifications & Requirements?
The IRS uses a Four-Part Test to determine if your activities qualify for R&D tax credits. Think of this as your eligibility checklist; all four criteria must be met for your work to qualify. Let’s break each component down with practical examples.
Technological Foundation Requirement
The foundation of your R&D activities must be rooted in hard sciences. This means your work should fundamentally rely on principles of:
Physical science
Biological science
Engineering
Computer science
Consider a software company developing a new machine learning algorithm. The work qualifies because it's based on computer science and engineering principles. Market research for the same product wouldn't be eligible, as it doesn't rely on these technical foundations.
Process Improvement Goals
Your R&D efforts must aim to improve:
Functionality
Performance
Reliability
Quality of a business component
For example, a manufacturing company developing a more efficient production process would qualify, as it is working to improve the functionality and performance of its operations. Simply changing the color of a product for aesthetic reasons wouldn't be eligible, as it doesn't involve technical improvement.
Technical Uncertainty Elimination
Your research must address specific technical uncertainties. This means you're:
Working to discover information not readily available
Attempting to eliminate technical uncertainty about development or improvement
Addressing questions about capability, methodology, or design
A biotech company testing new drug delivery methods faces clear technical uncertainties about effectiveness and safety. These experiments would qualify. Routine quality testing of existing products wouldn't be eligible, as it doesn't address new technical uncertainties.
Systematic Experimentation Approach
Your development process must follow a systematic approach, including:
Testing and analysis
Modeling or simulation
Systematic trial and error
Evaluation of alternatives
For instance, a software company systematically testing different algorithms to optimize performance would qualify. Making minor visual updates to a user interface without systematic testing wouldn't meet this requirement.
How to Ensure Your R&D Activities Qualify for Tax Credits
All four parts of this test must be satisfied for your activities to qualify. Missing even one component could disqualify otherwise innovative work from receiving these valuable credits.
What Activities Do Not Qualify For the R&D Tax Credit?
Some activities are excluded from qualifying for the R&D tax credit, including the following:
Research in the social sciences.
Research after the commercial production of a business component.
Adaptation of existing business components to a particular customer’s needs.
Duplication of an existing business component.
Surveys and studies.
Foreign research.
R&D tax credits are restricted to the portion of qualified research performed in the United States.
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R&D Tax Credits for Architects
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Let your business take flight while Haven manages your financial runway. Built by founders for founders, we handle everything from daily bookkeeping to complex tax filings and R&D credits that put cash back in your pocket, as well as fractional CFO services. Join 400+ startups who've saved millions in tax credits, countless hours of administrative work, and never missed a filing deadline, all while accessing 24/7 Slack support from CPAs who understand the unique challenges of growing businesses. Book a call today and discover how our dedicated team can help you focus on building rather than bookkeeping.