February 21, 2023
As a startup founder, you can use R&D tax credits even if your company isn't making a profit yet. The Inflation Reduction Act of 2023 doubled the previous limit, allowing you to claim up to $500,000 against payroll taxes each year. This increased amount applies to tax years beginning January 1, 2023, and you can split it evenly between Social Security and Medicare taxes – up to $250,000 for each.
Your startup must meet two key conditions to qualify. First, your gross receipts must be under $5 million for the tax year you're claiming. Second, you can't have had any gross receipts before the five-tax-year period ending with your claim year. For example, if you're claiming in 2024, you couldn't have had any gross receipts before 2020, though you could have existed as a company before then without revenue.
The types of expenses you can include are:
You can claim these credits for up to five years, potentially accessing up to $2.5 million in total credits. If you don't use all your credits for payroll tax reduction, you can carry the unused portion forward for up to 20 years to offset future income taxes once you become profitable.
Many states offer additional R&D credits on top of the federal benefit. For example, California provides a 15% credit on qualifying R&D activities, while Arizona offers 24% on the first $2.5 million in qualifying expenses and 15% after that. These state credits typically apply to income taxes rather than payroll taxes.
The federal R&D tax credit typically amounts to about 10% of your qualified research expenses (QREs). To calculate your potential credit, you first need to identify all your qualifying research activities and track their associated costs.
Start by looking at your employee wages. When your technical employees work on qualifying projects, their salaries become part of your QREs. For example, if a software engineer making $120,000 per year spends 80% of their time developing new features, you can count $96,000 as a qualified expense.
When calculating contractor expenses, remember you can only count 65% of what you pay them. For instance, if you spend $100,000 on outside developers for qualifying work, only $65,000 counts toward your QREs.
Supply costs add another layer to your calculation. You can include materials used directly in research, like specialised components or test materials. But permanent equipment, land, or general office supplies don't count, even if used in R&D work.
Let's work through a practical example: Your startup has three engineers earning $100,000 each, spending 75% of their time on qualifying work. You also pay contractors $200,000 for related development and use $50,000 in qualifying supplies. Your calculation would look like this:
Since this amount is well under the $500,000 annual limit, you could use all of it to reduce your payroll taxes, splitting it between Social Security and Medicare tax obligations.
Remember that state credits can add significantly to your total benefit.
To claim your R&D tax credit against payroll taxes, you need to follow a specific filing process that happens in two stages. Let's walk through each step so you understand exactly what to do and when.
For the first stage, you'll file Form 6765 (Credit for Increasing Research Activities) with your income tax return. On this form, you'll specify how much of your R&D credit you want to apply to payroll taxes. You can designate up to $500,000 for payroll tax reduction, which you'll split evenly between Social Security and Medicare taxes – up to $250,000 for each.
The timing of this first filing is crucial. For C-corporations with a December fiscal year, you need to submit by April 15. If your C-corporation has a different fiscal year end, your deadline is four and a half months after your year ends. S-corporations with a December fiscal year must file by March 15, or if you have a different fiscal year, by the 15th day of the third month after your year ends.
After completing the first stage, you move on to the quarterly payroll tax returns. Here, you'll use Form 8974 (Qualified Small Business Payroll Tax Credit for Increasing Research Activities) along with your regular Form 941 (Employer's Quarterly Federal Tax Return). Form 8974 shows how much credit you're using for that quarter, while Form 941 reports your overall payroll tax obligations.
You can start using your credit in the quarter that begins after you file your income tax return with the payroll tax credit election. For example, if you file your income tax return in March 2025, you can start applying the credit to payroll taxes beginning in the second quarter (April-June) of 2025.
If your quarterly payroll tax obligation is less than your available credit, don't worry. Any unused credit carries forward to the next quarter automatically. This means if you elected to use $500,000 in credits but only have $100,000 in payroll tax liability each quarter, you can keep using the credit until you've used the full amount.
One important note: when working with your payroll provider, make sure they know you're claiming these credits. They'll need to adjust their calculations accordingly to properly reflect the reduced tax payments in their system.
When budgets are tight, your best move is to plan how, where, and with whom you spend your R&D funds. If you’ve already sorted out how employees and contractors factor into your qualified expenses, the next step is to organise those people in a way that makes it easy to track and substantiate R&D activities. Consider grouping developers or engineers into focused project pods that dedicate the majority of their time to qualifying work. This approach not only helps you stay on top of actual hours spent on R&D, but also simplifies the data you’ll need to pull when claiming the credit.
On the materials side, zero in on consumables — whether that’s prototyping components, testing supplies, or small parts used directly in the research process. Keep large capital expenses (new equipment, for instance) to a minimum unless absolutely necessary, since those typically don’t qualify. By directing your limited funds toward truly eligible activities and supplies, you boost both your project’s momentum and the resulting tax credit. In short, smart resource allocation is about more than saving money on day-to-day operations — it’s about building a credible, well-documented R&D pipeline that maximises your tax benefits when you need them most.
