How to use research and development (R&D) tax credits for startups

Innovation is the name of the game when it comes to winning in the fast-paced world of startups. However, innovation rarely comes cheap, especially when it involves significant research and development (R&D).

Fortunately, you don’t always have to foot the entirety of this expense yourself. The federal government designed R&D tax credits to give startups a financial incentive to invest in innovation.

R&D tax credits can be a game-changer for young startups on resource-strapped budgets. Below, we walk you through everything you need to know about R&D tax credits to determine your eligibility and understand how you can use them to grow your startup.

What are R&D tax credits?

R&D tax credits are financial incentives provided by governments to encourage companies to invest in research and development activities. These credits allow your business to reduce the company’s tax liability and federal taxable income or receive a refund based on the amount you spent on qualifying R&D activities.

The primary purpose of these credits is to stimulate economic growth, foster innovation, and keep countries competitive on the global stage by incentivizing businesses to push the boundaries of what’s possible.

R&D tax credits aren’t a new phenomenon for startups, but they are a strategic asset that often goes forgotten and untapped. The United States introduced its first R&D tax credit in 1981 as part of the Economic Recovery Tax Act, and it was intended to encourage domestic innovation and reverse the trending decline in US research and development.

Over the last few decades, the government has refined and expanded these credits to include more diverse applications and eligibility.

The benefits of R&D tax credits for startups

R&D tax credits are more than just a financial perk for startups; they’re a catalyst for innovation and market presence. This section discusses how these credits not only bolster a startup’s financial health but also pave the way for experimentation and competitive differentiation.

Cash flow

For startups, every dollar counts. R&D tax credits can significantly boost a startup’s cash flow by reducing its federal tax liability. This means startups can reinvest the money saved back into their business, accelerating growth and development.

In some circumstances, your startup might even be able to receive a cash refund for your R&D qualified expenses, providing immediate capital relief.

Experimentation

R&D tax credits are designed to incentivize businesses to take risks and innovate. With the financial cushion and tax incentives provided by these credits, small businesses can afford to experiment with new ideas, technologies, and solutions without the fear of draining their resources.

This fosters a culture of innovation, where startups are encouraged to push boundaries and explore uncharted territories in their respective industries.

Competition

R&D tax credits give startups the financial flexibility to invest in cutting-edge research and development, allowing them to bring innovative products and services to the market faster. This helps your business capture a larger market share and position itself as a leader and innovator.

By leveraging R&D tax credits, your startup can differentiate itself from competitors and carve out a unique niche in the market.

Eligibility criteria for R&D tax credits

In the United States, not all activities qualify for R&D tax credits. Internal Revenue Code (IRC) section 41 explains all the details, but here’s a shorter summary. Generally, your investments should create new or improved products, processes, or software. This includes:

• Resolving technological uncertainties

• Designing and testing prototypes or models

• Developing new algorithms or software components

• Researching new materials or methods to enhance product performance

Your qualified research activities should be systematic, investigative, and experimental in nature. To qualify for innovation, there should be some level of technological uncertainty your startup is trying to resolve.

However, it’s not just the direct investments in your research and development that qualify. There are actually a few other qualified research expenses your startup can typically claim:

• Salaries and wages of employees directly involved in R&D activities

• Cost of materials and supplies used in R&D

• Third-party contractor expenses, if they are directly related to R&D activities

• Overhead costs that can be directly linked to the R&D project

Keep detailed records of all these expenses. During an audit, they’ll want to see a breakdown of costs and gross receipts.

In general, any business can apply for R&D tax credits. However, here is what you should consider if you’re a startup:

• Size and age of the business: Some jurisdictions offer more generous R&D tax credits for smaller and younger companies to encourage innovation at the grassroots level.

• Profitability: Startups that are not yet profitable might still benefit from R&D tax credits. In some regions, they can carry forward the credits to offset future tax liabilities or even receive cash refunds.

• Ownership structure: The startup’s ownership structure (especially if foreign investors or parent companies are involved) can impact the eligibility and amount of R&D tax credits.

We recommend consulting with a tax professional in your country or region to double-check you meet all the criteria requirements and maximize your R&D tax credit claims.

10 ways your startup can use a research and development tax credit

Research and development tax credits provide a unique opportunity for your startup to recoup a portion of its R&D expenses, providing you with additional capital. But beyond just financial relief, these credits can be strategically leveraged to fuel various aspects of a startup’s growth.

From reinvesting in innovation to expanding operations, here are 10 ways your startup can make the most of R&D tax credits.

1. Reinvest in further R&D: Use the savings from the tax credits to fund further qualified research and development projects, allowing your startup to stay ahead in innovation.

2. Hire more talent: Allocate the funds towards hiring specialized talent or experts who can accelerate your R&D efforts and bring fresh perspectives.

3. Purchase advanced equipment: Invest in state-of-the-art equipment or software to enhance your R&D capabilities and streamline processes.

4. Expand operations: Use the credits to expand your startup’s operations, whether it’s opening a new office, increasing production, or entering new markets.

5. Fund marketing and sales efforts: Allocate a portion of the savings towards marketing ideas or sales initiatives to increase brand awareness and drive growth.

6. Enhance product offerings: Direct the funds towards improving existing products or developing new ones based on your product roadmap, customer feedback, and market demand.

7. Training and development: Invest in training programs for your team, ensuring they’re equipped with the latest skills and knowledge in your industry.

8. Secure intellectual property: Use the credits to patent innovative solutions or secure intellectual property rights, safeguarding your startup’s unique offerings.

9. Strengthen financial health: Allocate the savings to bolster your startup’s financial reserves, ensuring sustainability and resilience against unforeseen challenges.

10. Engage in collaborative projects: Partner with universities, research institutions, or other startups for collaborative R&D projects, pooling resources and expertise.

Some businesses view research and development as a nice-to-have, while others view it as an essential part of doing business. Take Zoho, for example. In 2022, they crossed the $1 billion annual revenue milestone, yet they still didn’t slow down with R&D.

“Fundamentals matter now more than ever, and our industry has to learn to lower the friction of technology, so that technology becomes far more affordable,” says Sridhar Vembu, CEO and Co-founder of Zoho Corp.

That explains why Zoho spends three times its marketing spend on R&D and has already received 25 patents in just the last three years.

Innovate with DigitalOcean

Startups at the forefront of innovation, and an R&D tax credit provides the much-needed funds for you to invest in research, development, and growth.

And we want to help, too.

DigitalOcean’s scalable and flexible infrastructure allows startups to experiment, test, and deploy applications seamlessly, reducing the time and cost associated with R&D. Whether you’re building a revolutionary new application or innovating with AI and machine learning, we’re here to help.

Check out our simple, predictable pricing, and talk to our sales team if you want personalized help choosing the best mix of cloud solutions to meet the unique needs of your business.