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R&D Tax Credit Qualified Activities for Startups & Tech Companies

Research and development tax credits can play a crucial role in helping small businesses recover costs associated with innovation. Understanding qualified R&D activities can be tricky. For example, suppose your startup is developing a new software program. While evaluating existing technologies to improve this project certainly qualifies for the R&D tax credit, what about the costs associated with creating the software itself? Do all of these expenses qualify for the credit? What about the costs of developing a video to help users understand how to use the new program? What if the software project fails? These are the types of questions that can keep business owners up at night. One often overlooked aspect is R&D capitalization, which determines whether certain R&D costs must be capitalized and amortized over time instead of being immediately expensed. This article will shed light on qualified R&D tax credit activities, helping startups and tech companies recover their R&D costs and achieve financial stability.

If your business is struggling to understand the R&D tax credit, you’re not alone. Haven offers accounting services for small businesses to help you navigate the complex world of tax credits and incentives so you can focus on what matters: growing your business.

Research & Development Tax Credit for Startups

startup team discussing - R&D Tax Credit Qualified Activities

The R&D tax credit has long helped profitable companies reduce their tax liability and improve cash flow. But thanks to legislative changes, early-stage startups with little or no taxable income can now benefit, too.

Historically, the credit served as a dollar-for-dollar reduction on income taxes, helping established companies turn qualifying R&D efforts into immediate cash savings. Startups were often left out simply because they weren’t yet profitable.

How the PATH Act Opened the R&D Tax Credit to Pre-Revenue Startups

That changed with the Protecting Americans from Tax Hikes (PATH) Act of 2015, which introduced a pivotal provision for qualified small businesses. Since January 2016, eligible startups can now use R&D tax credits to offset up to $500,000 in employer FICA payroll taxes annually, even if they aren’t yet paying income tax.

This is a significant win for early-stage businesses involved in product development, prototyping, or software development. Many startups mistakenly assume they don’t qualify, but the definition of “qualified activities” is broader than most realise.

Unlocking Long-Term Value: R&D Credit Carryforwards and Pass-Through Tax Benefits

Additional benefits include:

Credit carryforwards: Unused credits can be applied to offset future income taxes, including capital gains, for up to 20 years.
Pass-through entity advantage: For LLCs, partnerships, and S-Corps, credits flow through to owners, reducing personal income tax.

Despite its value, many startups either don’t know the credit exists, assume they don’t qualify, or don’t know how to claim it. However, with the expansion of eligibility to pre-revenue companies, it has become a vital tool for reducing burn and extending the runway.

How the Credit Works

The R&D tax credit allows qualified startups to offset payroll taxes, even if they aren’t paying income taxes yet. Instead of waiting to become profitable, eligible small businesses can apply the credit directly to the employer portion of their FICA payroll taxes.

In 2022, the FICA tax rate was 6.2% and applied to the first $147,000 of an employee’s wages. If a startup qualifies for the maximum annual R&D tax credit of $500,000, it can use that amount to reduce payroll tax obligations significantly.

This provision offers more than just a tax break; it’s a financial lifeline that helps early-stage companies during critical growth periods:

Fund innovation
Improve operational efficiency
Extend runway

Which Startups Qualify for R&D Tax Credit?

tax files - R&D Tax Credit Qualified Activities

Many startups miss out on R&D tax credits because they don’t realize their eligibility. If your business is developing or improving a product, process, or software, you may qualify for significant cash back, regardless of whether you’re profitable or paying federal income tax.

Even if your business is developing or enhancing its technical capabilities on an iterative basis, that work may qualify for the R&D tax credit.

Who Qualifies for the R&D Tax Credit?

Any U.S.-based startup that is:

Developing or improving a product, process, technique, invention, or software.
Operating as a corporation, LLC, sole proprietorship, or partnership.
Paying U.S. wages (especially to technical or product-focused employees).
Has less than $5 million in gross receipts in the current year and no more than five years of gross receipts, making them eligible to apply the credit against payroll taxes (not just income taxes).
Has less than $50 million in average annual gross receipts over the past three years (to offset AMT if applicable).

You don’t need:

A formal R&D department.
A team of engineers or scientists.
To be profitable or pay federal income tax.
To succeed with your innovation (unsuccessful R&D still counts).

What Activities Qualify as R&D?

To qualify for the R&D tax credit, your project must pass the IRS’s four-part test:

Permitted Purpose: The activity must aim to develop or improve the functionality, performance, reliability, or quality of a product, process, software, or invention.
Technological in Nature: The work must rely on principles of physical or biological sciences, engineering, or computer science.
Elimination of Uncertainty: You must be trying to resolve unknowns about how to develop or improve a product or process, not simply conducting routine testing.
Process of Experimentation: You must evaluate alternatives, build prototypes, or test different approaches to overcome technical challenges.

This test is designed to ensure that only truly innovative, problem-solving efforts qualify, not routine operations or cosmetic changes.

How Startups Benefit From the R&D Tax Credit

The R&D tax credit offers substantial financial benefits for eligible startups, up to $500,000 per year to offset payroll taxes, even if your company isn’t yet profitable. Unused credits can be carried forward to offset future income taxes and, in some cases, applied against the Alternative Minimum Tax (AMT).

Turning Innovation into Investor Confidence: The Strategic Value of R&D Tax Credits

Beyond the immediate cash flow impact, claiming the credit signals value to potential investors. It demonstrates that your business is capturing financial benefits from innovation.

If your startup is engaged in technical development, even through minor, iterative improvements, you could be overlooking a powerful opportunity. The R&D tax credit is designed to reward experimentation and technical risk, two areas where startups excel.

Founders First: Scalable Finance Support for High-Growth Startups

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 to learn how our dedicated team can help you focus on building rather than bookkeeping.

R&D Tax Credit Qualified Activities for Startups & Tech Companies

According to the IRS, Qualified Research Activities (QRAs) are technical undertakings aimed at developing or improving a product, process, technique, invention, or software, even if the project ultimately fails to succeed.

For startups and tech companies, the R&D Tax Credit can be a powerful financial incentive, especially since many are innovating daily without realizing their activities may qualify.

Examples of Qualified Activities for Startups & Tech Companies

Software Development

Whether building a SaaS product, mobile app, or internal platform, most core development efforts qualify:

Developing new software architecture or integrating third-party systems
Creating scalable backend infrastructure or APIs
Improving performance, security, or scalability
Resolving technical issues during development
Developing proof-of-concept or MVPs

Example: A fintech startup coding a new fraud detection algorithm based on machine learning is possibly performing qualifying R&D.

Product Design & Engineering

Startups designing hardware, wearables, or IoT devices often engage in qualifying research:

Prototyping new devices or components
Testing different materials or circuit designs
Addressing thermal, mechanical, or wireless challenges
Enhancing device durability or battery performance

Example: A startup experimenting with antenna placement on a wearable fitness tracker to improve signal strength would likely qualify.

UX & UI Experiments That Are Technically Driven

If a startup is solving technical challenges in user interface or experience development:

Rendering speed improvements
Integrating real-time data streams
Responsive design frameworks
Complex interaction logic using JavaScript or React

Example: A health app testing various technical approaches to visualise biometric data in real-time could qualify.

Cloud & Infrastructure Optimization

Building platforms that rely on cloud computing? If you're optimizing for performance, scalability, or resilience, you're probably doing R&D:

Configuring auto-scaling systems
Improving server response times through code-level changes
Building microservice architecture or containerisation

Example: A social media platform rewriting its infrastructure to move from monolith to microservices could be eligible.

Developing Internal Tools or Proprietary Algorithms

Even if it’s not customer-facing, internal R&D counts:

Building a custom CRM or recommendation engine
Writing a script to automate technical processes
Creating new analytics or search algorithms

Example: A marketplace startup developing a proprietary pricing algorithm is likely conducting qualified research.

Activities That Typically Don’t Qualify

Purely aesthetic design (e.g., branding, graphic design)
Data entry, routine testing, or QA without technical uncertainty
Market research or consumer surveys
Customizing existing software without technical experimentation
Bug fixing or regular maintenance (unless it involves new methods)

Pro Tip

Many eligible startups don’t claim the credit because they think R&D must be groundbreaking or require a lab coat. That’s a myth. The IRS cares more about technical uncertainty and experimentation, not how big your company is or how famous your product becomes.

If you’re unsure, speak with a tax advisor who specialises in startup R&D credits. A well-documented claim can mean tens of thousands of dollars back in your pocket.

How to Claim the R&D Tax Credit for Your Startup

getting help with taxes - R&D Tax Credit Qualified Activities

1. Track and Document Your R&D Activities

The IRS requires you to substantiate your credit with clear, contemporaneous documentation.

So, before you even begin filing, make sure you're keeping track of:

Employee time spent on qualified research (engineers, developers, designers, etc.)
Payroll records broken down by R&D versus non-R&D work
Contracts or statements of work for any outsourced development or technical services
Technical documentation, such as product specs, design documents, code commits, wireframes, test results, whiteboard sketches, and prototypes
Meeting notes or emails that show discussion and technical decision-making
Invoices, receipts, and supply costs tied to R&D activities

2. Choose Your Calculation Method

Startups can calculate their R&D credit using one of two methods:

Regular Credit Method:
- Compares current year R&D expenses to a base amount calculated from historical data.
- More complex and best for companies with older R&D programs.
Alternative Simplified Credit (ASC):
- Claims 14% of your current year's qualified R&D expenditures that exceed 50% of your average R&D spend over the past three years.
- Most startups use this method because it's easier to calculate and doesn’t require historical R&D spend.

Tip: If you're in your first few years of business and don't have a three-year average, you'll use zero as a base, so 14% applies to all qualified spend.

3. Fill Out IRS Form 6765

Form 6765 - Credit for Increasing Research Activities - is where you formally calculate and claim your R&D credit.

This form has four sections:

Section A: Regular credit method
Section B: Alternative Simplified Credit (use this if you're a startup)
Section C: Payroll tax election (startups only)
Section D: Controlled groups or business entities

For startups, Sections B and C are most relevant.

4. Complete and File Your Business Tax Return

Once you've filled out Form 6765, include it with your federal business income tax return, typically:

Form 1120 (for C-corporations)
Form 1065 (for partnerships)
Form 1040 with Schedule C (for sole proprietors)

If you're claiming the payroll tax offset, you'll also need to:

File Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) with your quarterly payroll tax filing (Form 941)
You can offset up to $500,000 of payroll taxes annually if you qualify under the new Inflation Reduction Act (up from $250,000 previously).

5. Monitor for IRS Rule Changes

The IRS has introduced new documentation requirements starting in 2024 for amended returns and may expand those to original filings soon.

That means:

You may need to submit a narrative of each business component
Include specific names and roles of employees involved in R&D
Provide detailed project timelines and costs

Stay informed by checking with your CPA or tax advisor, especially as updates are likely in the years ahead.

Bonus: Common Startup Mistakes to Avoid

Waiting too long to track R&D activities (do it from day one)
Assuming you need a profit, you don’t
Believing that outsourced work doesn’t qualify. It can, under U.S. supervision
Overlooking software development or internal tools as qualifying activities

Book a Call to Learn More About our Accounting Services (Trusted by 400+ Startups)

Haven takes the stress out of your startup's finances. As you focus on building your business, we help you manage the financial responsibilities that come with your growth. 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.

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