If you’re an entrepreneur, startup founder, or small business owner, it’s worth asking: can your business claim the R&D tax credit? The answer is likely yes—and the benefits can significantly boost your cash flow, especially if you qualify for special startup provisions under federal tax law.
When most people hear “Research & Development (R&D) tax credit,” they picture large technology companies, laboratories with white coats, or billion-dollar corporations pouring millions into new products. The credit is not limited to large companies and there is no minimum R&D spend required to calculate the credit. The $5 million gross receipts threshold is often thrown around due to its connection with the startup payroll credit which we’ll explore below.
In this post, we’ll explain:
- What the R&D tax credit is
- How the startup payroll tax offset works
- Who qualifies (with a focus on the $5 million gross receipts test for small businesses)
- What expenses can be claimed
- How to claim the credit
- Common pitfalls
Let’s break it down so you don’t leave valuable dollars on the table.
What is the R&D Tax Credit?
The federal Research & Development Tax Credit, formally known as the Credit for Increasing Research Activities under IRC §41, is designed to encourage companies to invest in innovation within the U.S. It has existed in some form since 1981, but Congress made it permanent in 2015 through the Protecting Americans from Tax Hikes (PATH) Act.
The credit rewards companies that develop or improve products, processes, techniques, software, or formulas. Many companies mistakenly assume they don’t qualify because they don’t have dedicated R&D departments. In reality, a wide range of activities—like improving manufacturing efficiency, developing prototypes, or writing custom software—can qualify.
The credit is generally non-refundable, meaning it can only be used to offset tax expense. No taxable income = no immediate cash benefit from the R&D credit, except in the case of the startup payroll tax offset.
The Startup Payroll Tax Offset
Here’s where small businesses come in: In addition to offsetting regular income tax, the PATH Act added a special provision for startups.
If your business has:
- Less than $5 million in gross receipts for the credit year, and
- No gross receipts for any tax year more than five years before the credit year,
then you can apply the R&D tax credit against your employer portion of Social Security payroll taxes (up to $500,000 per year) instead of income tax.
Why does this matter? Many early-stage businesses spend heavily on product development but don’t yet have taxable income. This provision lets you benefit immediately—by reducing payroll tax liabilities—rather than waiting until you’re profitable.
Who Qualifies Under the $5 Million Rule?
To qualify for the payroll tax offset, you must:
- Have less than $5 million in gross receipts for the current tax year.
- Have no gross receipts more than five years ago. For example, if you claim the credit for 2024, your first year with gross receipts must be 2020 or later.
“Gross receipts” means total sales plus any income from investments (interest/dividends) or incidental business activities—before subtracting returns or allowances. Even if you have zero taxable income, your gross receipts still count toward this limit.
Startups, small tech companies, and pre-revenue companies raising seed funding often meet these requirements.
What Expenses Can You Claim?
Eligible domestic expenses generally fall into four main buckets:
- Wages — The largest category for most claimants. This includes salaries for employees performing qualified research, directly supervising it, or directly supporting it.
- Supplies — Tangible materials used in the research process (like prototype components, lab supplies, or test materials).
- Contract Research — 65% of payments made to third-party contractors for qualified research performed on your behalf.
- Cloud Hosting & Computing Costs —when tied directly to the R&D work such as dev or test environments.
The expenses must be tied to qualified activities under a four-part test:
- Permitted Purpose: The work aims to develop or improve a product, process, software, or formula.
- Elimination of Uncertainty: The work aims to resolve uncertainty about capability, method, or design.
- Process of Experimentation: The work involves evaluating alternatives through modeling, simulation, systematic trial and error, or other processes.
- Technological in Nature: The work relies on principles of physical, biological, computer, or engineering sciences.
How to Claim the R&D Credit
To claim the federal credit, you must file Form 6765, “Credit for Increasing Research Activities,” with your federal income tax return. To use the payroll tax offset, you must elect on page 2 of the form 6765 and indicate the amount being applied. Form 8974, “Qualified Small Business Payroll Tax Credit for Increasing Research Activities,” must also be completed and submitted it with your payroll tax filings (Form 941) with the total overpayment being refundable.
Timing is important: You must elect the payroll tax offset on your originally filed return (including extension)—amended returns can’t add it later. Many companies miss this opportunity because they learn about it too late.
Documentation is crucial. The IRS expects you to keep detailed records showing:
- Qualified projects and activities
- Who worked on them
- How time was tracked
- How expenses were calculated
A knowledgeable CPA or tax advisor can help you gather this information and defend your claim if the IRS ever asks for backup.
Common Pitfalls
Some common pitfalls small businesses encounter include:
- Thinking they’re too small. Many companies under $5 million believe they don’t “do R&D” when they actually do.
- Missing the deadline. If you don’t elect the payroll tax offset on your original return, you lose the chance to claim that year’s credit against payroll tax. You can still claim the R&D credit but it will only be available to offset income taxes
- Overlooking documentation. The IRS can disallow claims if you don’t keep proper records.
- Not coordinating with payroll providers. To use the payroll offset, you must coordinate with whoever files your quarterly payroll tax returns and include the form 8974. The credits carry forward to subsequent quarters until fully utilized.
How Tanner Can Help
If you’re unsure what qualifies or how to organize your data, our team can help. We guide clients through everything from estimating credits and passing the four-part test to preparing Form 6765.
We work with businesses of all size and provide the forms and instructions on claiming the R&D credit. Our tax team provides strategies to maximize both federal and state-level credits while helping you stay fully compliant.