"R&D" isn't always what you think
How R&D tax credits apply to more than just software startups
In this article:
- A (brief) history of R&D tax credits
- A customer case study using the IRS's four-part test
- Saving with MainStreet's tax credit program
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First things first: A brief history of R&D Tax Credits
The Federal R&D Credit, or the Credit for Increasing Research Activities, is just that – a credit to incentivize companies to increase their research activities. Provided for in Section 41 of the Internal Revenue Code (“IRC”), this credit was initially introduced under the Reagan Administration as a two-year incentive in 1981 and remains part of the tax code today as a way to reward U.S.-based companies for doing R&D.
So what does that mean?
Any business that attempts to develop new, improved, or technologically advanced products or processes may qualify for R&D tax credits. Many startups qualify, as these credits are designed to be a no-brainer for new companies raising venture capital to bring new products to market in nearly every industry.
Once you’ve pushed past the confusing language, it’s a straightforward incentive for innovative businesses in virtually any industry. R&D applies to way more companies than founders expect.
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A closer look: MainStreet x DoughDash
Let’s look at this through the lens of a new startup. For this example, we’ll use a (sadly) imaginary company, DoughDash.
DoughDash is a bread-making subscription service that sends a new dough-making kit to your door each month. The dough arrives pre-made in a recyclable, ready-to-bake package, so all you have to do is pop it in the oven and take all the baking credit. Carbs to table - what more could you ask for?
This company is on the rise and, like any new startup, they’re focused on increasing their cash flow. DoughDash hired an accountant to check out possible incentive programs that would help bolster their bottom line but were unimpressed with the results. Lucky for them, they’re also active on Twitter and noticed a few persistent ads about claiming free money through government tax credits. So they reached out to MainStreet.
To qualify for the Federal R&D Tax Credit, DoughDash needed to pass a four-part test, per the IRS’s Audit Techniques Guide. This test generally determines whether their service/product fits within the parameters of the incentive program. Let’s break down the test slice by slice:
Part 1: "Permitted Purpose"
“The activity must be intended to develop a new or improved business component of the taxpayer in terms of performance, quality, reliability, and/or functionality.”
Simply put, your R&D activities should aim to improve a new or existing product or process. In DoughDash’s case, they are the only ones on the market with a bread subscription service. They’ve developed a new product and process not previously offered to taxpayers. That’s an easy one.
Part 2: "Technical Uncertainty"
“There must be technical uncertainties from the outset of the activity in terms of capabilities, methodology, and/or appropriateness of the design of the business component.”
You'll likely satisfy this test if you have initial questions about the feasible application of your product or process. For DoughDash, they had a number of questions around whether or not this subscription service would actually work. “How do we ship the dough without it going bad?” “Can we create packaging that allows for the dough to proof* in-transit?” “Are we certain that people are bready for such an incredible product?” Okay, maybe they didn’t ask that last one, but you get it. To establish “technical uncertainty”, DoughDash must be solving for something technical.
*Bread dough needs to proof, or rise again, to properly ferment. And yes, I did learn this term from binge-watching every season of the Great British Bake-Off.
Part 3: "Process of Experimentation"
“...must demonstrate they employed a methodical plan involving a series of trials to test a hypothesis, analyze the data, refine & retest the hypothesis so it constitutes experimentation in the scientific sense.”
Broadly, you need to be running experiments as you build your product: this can be anything from A/B tests, MVPs, or prototypes.
One of DoughDash’s main concerns centers around preservation and packaging. As a mail subscription service, they wanted to make sure that their product would arrive fresh and ready to bake.
In order to ship a breadwinning product, DoughDash spent the last year testing a variety of dough recipes and packaging methods to ensure their dough can properly ferment during the shipping process. They hired a team of engineers to test a range of ingredients and tested over 100 varieties of their signature sourdough before arriving at their perfect recipe. Talk about a dream job.
Part 4: "Technological in Nature"
“The activities must fundamentally rely on hard sciences, such as engineering, physics, chemistry, biology, or computer science.”
As long as you are building in the worlds of chemistry, biology, physics, computer science, or engineering, you'll meet this part of the test. We’re no scientists, but even we know that baking qualifies as chemistry. Precise measurements, changes in the physical and chemical compositions of ingredients, the occasional frustration when the recipe isn’t just right - while unconventional, DoughDash’s product is technological in nature.
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Saving with MainStreet
In this hypothetical example, DoughDash passed the four-part test and uncovered $56,023 (!!) in government tax credits to invest back into their business. As a standalone figure, this is an incredible boost for a startup. Even better, Federal tax credits are renewable, meaning additional savings are baked in year after year. They also submitted proof (not the baking kind) of their R&D activities to ensure that they’re covered in the unlikely event of an IRS audit.
Stories like this are pretty standard when startups partner with MainStreet. The government sets aside over $11B for these incentives every year. Isn’t it time you grab a slice? (Last 🍞 pun, we promise.)
