How to Turn Your IP R&D Expenses into Tax Free Revenues

Does your business employ technical staff or use outsourcing to research, develop and test your technology or new product? If so, there’s a little used tax credit that can turn those R&D expenses into tax free revenue.

Boeing used it to save $145 million in taxes; Texas Instruments saved $87 million; Mattel saved $4 million; and Caterpillar saved $87 million using it.

While the big companies are cutting their taxes by using the R&D tax credit, many startups, small and mid size businesses are overlooking this strategy. The R&D tax credit is not just for putting a man on the moon and curing cancer; it’s for making improved office equipment (Xerox: $19 million in savings), software (Google: over $300 million in savings) and radios (Raytheon: $31 million in savings).

The R&D tax credit program was created as an incentive for businesses of all sizes to invest in R&D and innovation. The idea is to reward businesses for improving current products and technologies and creating new ones, giving them a benefit for taking the risk and investing even if they fail. R&D tax credits are offered in many countries around the world, including Europe, Canada, Australia, Japan, Korea, and Mexico.

R&D credits are attractive for startups and small companies because they can be taken retroactively and transferred in an acquisition. They are particularly good for startups, since the R&D is heaviest up front when the company has no income and are carried forward to offset taxes on future profits.

According to an article in Bloomberg, R&D tax credits is a multi billion dollar program, yet less than 10% of the eligible startups and small businesses claim this credit. Startups that did claim it received an average of $151,000 per R&D tax credit claim. For a startup or small business where early revenues are your lifeblood, that can add up to significant tax savings on these revenues.

The credit is calculated on fifty percent of the average amount your startup or business spent in the previous three years on R&D expenses. So if you spent an average of $100,000 annually over the previous three years, you multiply that by 50 percent, and you’d get $50,000. Anything you spend above $50,000 the next year, you can use as your credit base and multiply it by 14 percent (which is the tax credit rate) to determine your tax credit. For example, if your company spends more, say $150,000 the next year, you’d have a $100,000 credit base amount which gives you a $14,000 tax credit (150,000 – 50,000 X 14%).

But it gets better for startups. Because the tax credit takes 3 years to prove your average R&D spending, the program was recently amended to include payroll taxes. Starting in 2017, if your startup is generating less than $5 million dollars in revenue you can claim a credit up to $250,000 in payroll tax payments against your current or future revenue.

The R&D tax credits cover a broad number of activities, and they don’t necessarily have to be successful to qualify. Changes to make the manufacturing process cheaper, greener, cleaner and quicker, building prototypes, technology research, testing and experiments to prove market viability, researching and filing patents, employing engineers for product development, or outsourcing your R&D activities are all possibilities for the R&D tax credit.

Here is a list of the four categories of R&D expenses that meet the criteria:

  • Permitted Purpose – activities intended to develop or improve the functionality, performance, reliability, or quality of a product, manufacturing process, software, invention, technique, or formula or business component (but not the way a product looks). Enhancing existing software to improve its processing ability is one example.
  • Process of Experimentation – activities to evaluate one or more alternatives such as product prototypes, pilot testing, sales modeling, or technology simulations to achieve a result (e.g.  does this product actually solve the specific problem).
  • Technological Uncertainty – activities that rely on using engineering, physical, computer or biological sciences, such as developing new medical devices or drug treatments.
  • Uncertainty Test – testing capabilities or methods for developing or improving a product or process, to decide if a goal can be reached and how reach it. For example, creating a website to evaluate customer interest before investing in (expensive) technology prototypes.

Just about every type of business and industry can qualify for the R&D tax credits, from a fashion designer experimenting with new textiles to a manufacturer exploring ways to cut its ecological footprint. Keep records of all your R&D activities, even if it’s in your garage, including concepts, designs, pictures on napkins, whatever the case. Also keep track of how much time is spent on the actual R&D activities. Both salaried and contract R&D qualify.

Many startup and small companies claim these R&D credits as part of their exit strategy. Having the credits on their books enhances their value and it proves they have technology someone else is likely to want. The tax credits are carried forward for 20 years, meaning the credits can be claimed in one year and taken in future years, reducing your tax liabilities when your company starts generating revenues. The tax credit is also transferable to new ownership, which is attractive to potential buyers of your company.

For a startup where every dollar counts, the combined R&D and payroll tax credits can really add up, and are another way of funding your business. To find out if your business qualifies for these tax credits, speak with a qualified financial adviser or CPA.

Extracting value from your IP assets doesn’t always mean having to wait until its generating revenues. Effectively managing your IP assets means using it at every stage of its life cycle. And that requires being smart about taking advantage of the many ways you can leverage your IP. One of those ways is through the R&D tax credit program. It enables your startup or business to turn one of your biggest expenses into an asset, increase your business value and generate tax-free future revenues that goes right to your bottom line.

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