Startups: Be sure you’re claiming tax credits fully — and correctly
This is a guest blog post from By Matt Barbella, Wipfli tax manager
Even with 2021 in the books, it’s important to look back a year or two to help you get a better handle on cash flow in the year ahead. When reviewing the financials for your startup, you may be able to find ways to keep more cash in your bank account. An important first step is to check your eligibility for tax credits.
Tax credits incentivize specific business activities, including retaining employees, creating jobs and spurring innovation. By helping the U.S. economy, you are rewarded with tax credits that can be used in multiple ways. They potentially can be refundable, carried forward or, in some cases, even sold on the state level.
Here are two tax credits that can be a great way to improve the cash flow for your business.
Employee Retention Tax Credit (ERTC)
This credit was created as part of the CARES Act and expanded under the American Rescue Plan to encourage businesses to retain their employees during the COVID-19-related business slowdown. The credit can be used against payroll taxes and can also be refundable. This means that if your credit exceeds your total payroll taxes, the government will still pay you. This credit can be claimed retroactively, so be sure to read below to see if your company qualifies for both 2020 and 2021 tax years. You may be required to file an amended payroll tax return.
Here are key qualifications for the ERTC for the past two tax years:
- 2020: Gross receipts on a quarterly basis fell 50% from 2019 to 2020.
- 2020: A full or partial suspension of the trade or business due to government order limiting commerce, travel or group meetings due to COVID-19.
- 2020: ERTC is capped at $5,000 per employee for the full year.
- 2021: Gross receipts on a quarterly basis fell 20% from 2019 to 2021. Businesses started in 2020 should compare 2020 with 2021.
- 2021: A full or partial suspension of the trade or business due to government order limiting commerce, travel or group meetings due to COVID-19.
- 2021: ERTC is capped at $7,000 per employee for each quarter.
Businesses that started up after February 15, 2020, qualify for the ERTC when average gross receipts were less than $1 million annually. The credit can only be applied in the third quarter of 2021 and is capped at $7,000 per employee (with a maximum of $50,000 for all employees).
You cannot take the ERTC credit on wages that were used for other tax credits or if you received PPP loan forgiveness, an alternate CARES Act incentive. Also, note that that ERTC credit ended in the third quarter of 2021 under the terms of the infrastructure legislation. We recommend consulting with a tax advisor to see if you qualify.
Research & Development Credit (R&D)
The R&D credit was created to incentivize innovation, create jobs and ensure technical resources are retained in the U.S. The IRS allows businesses to calculate a tax credit based on qualified research expenditures. Here are some benefits of the R&D credit:
- It can be used to offset income or payroll tax (with limitations) liabilities.
- Any unused credit can be carried back one year, then carried forward 20 years.
- Approximately 40 states currently offer their own credit incentive, with some allowing the taxpayer to sell their credits.
The tax definition of a research expenditure requires meeting a four-part test. The expense qualifies if:
- It is a development of a new or improved business component.
- It is technological in nature.
- It is deductible under IRC § 174 (eliminate uncertainty).
- Capability: Can we do it?
- Methodology: How do we do it?
- Appropriate design: What is the best design to meet our objectives?
- It involves the process of experimentation.
What expenditures qualify for the R&D credit?
- Wages from employees that are either directly performing, supervising or supporting the project. Eligible compensation includes wages subject to withholding and incentive bonuses. (Fringe benefits, payroll taxes and travel costs do not qualify.)
- Supplies that are used in the research and development activity. (Land or depreciable property cannot be included.)
- 65% of contracted research can be included if the activity would have qualified if performed by an employee, was not performed by an international contractor, and your company still has the rights to the technology and bears the financial risks of the research.
If your business is just starting up, you may qualify to offset your payroll taxes with the R&D credit. This election for “qualified small businesses” is available within the first five years of origination, and you can claim it retroactively. To qualify, it must be:
- Either a corporation, partnership or individual.
- Have less than $5 million in gross receipts in the current year. All businesses owned by an individual must be aggregated to meet the $5 million-dollar gross receipts limit.
The credit is claimed on Federal Form 6765 that accompanies your businesses tax return, and you can amend up to three prior years to receive the credit retroactively. If you qualify for the payroll tax credit, that is reported on the following quarterly payroll tax return (941), that is filed directly after filing the 6765.
We recommend discussing a formal R&D study with your tax advisor before claiming the tax credit. This helps creates the supporting documentation needed if the IRS challenges the credit. The credit almost always offsets the cost of the study.
An experienced research and development credit professional can help identify opportunities to maximize your credits. Consulting a knowledgeable tax advisor can ensure you are not claiming costs that may not be eligible under complex IRS regulations.
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