R&D Tax Credits for Startups: How to Claim and Maximize

A comprehensive guide to the Research and Development tax credit: what qualifies, how to calculate it, and how startups can use it to offset payroll taxes.

Last Updated: December 2024|15 min read

The Research and Development (R&D) tax credit is one of the most valuable tax incentives available to startups, yet it remains underutilized. Many founders assume their company doesn't qualify, or they don't realize that pre-revenue companies can use R&D credits to offset payroll taxes—putting real cash back in their pockets every quarter.

If you have software engineers, developers, or anyone building new technology, you likely qualify for R&D credits. This guide explains everything you need to know to claim and maximize this valuable benefit.

The Bottom Line

Qualifying startups can claim up to $500,000 per year in R&D credits against payroll taxes. For a typical startup spending $1M on qualified R&D, this could mean $65,000-$100,000 back annually—regardless of whether you're profitable.

What Is the R&D Tax Credit?

The R&D tax credit, formally known as the Credit for Increasing Research Activities, was created in 1981 to encourage American companies to invest in innovation. It provides a dollar-for-dollar reduction in tax liability for qualified research expenses.

Key Facts About the R&D Credit

Federal Credit Rate

Generally 6-8% of qualified research expenses using the simplified alternative method, or up to 20% using the regular method.

State Credits

Many states offer additional R&D credits. California offers up to 24% additional credit on qualified expenses.

Payroll Tax Offset

Startups can apply up to $500,000 annually against employer payroll taxes (Social Security portion).

Carryforward

Unused credits can be carried forward for up to 20 years to offset future income tax liability.

The credit isn't limited to traditional "lab coat" research. Software development, engineering work, and process improvements all qualify. The key is that you're trying to develop something new or improve existing products/processes through a process of experimentation.

Startup Eligibility

The 2015 PATH Act made R&D credits much more accessible to startups by allowing "qualified small businesses" to use credits against payroll taxes. This is a game-changer for pre-revenue companies that have no income tax liability.

Qualified Small Business Requirements

To qualify for the payroll tax offset, your company must meet these criteria:

Gross Receipts Under $5 Million

Your company must have less than $5 million in gross receipts for the tax year in which you're claiming the credit.

Less Than 5 Years of Gross Receipts

Your company cannot have had gross receipts for more than 5 tax years prior to the current year. Essentially, you must be in your first 5 years of revenue.

$500,000 Annual Limit

The maximum payroll tax offset is $500,000 per year (increased from $250,000 in 2023). This applies to the employer portion of Social Security tax (6.2%).

Pre-Revenue Companies

If your company has no revenue, you qualify automatically (assuming you meet the other criteria). The payroll tax offset election is specifically designed to benefit startups that are investing heavily in R&D before generating revenue.

The Four-Part Test

The IRS uses a four-part test to determine if activities qualify for R&D credits. All four criteria must be met:

Technological in Nature

The activity must fundamentally rely on principles of physical science, biological science, engineering, or computer science. This is why software development qualifies.

Example: Developing a new algorithm for your recommendation engine relies on computer science principles and would meet this test.

Permitted Purpose

The research must be undertaken to create a new or improved function, performance, reliability, or quality of a business component (product, process, software, technique, formula, or invention).

Example: Building a new feature that improves user experience or optimizing code to improve application performance would qualify.

Elimination of Uncertainty

At the outset of the activity, there must be uncertainty about the capability of developing the component, the method of achieving it, or the appropriate design. You don't have to be inventing something entirely new—just facing technical uncertainty.

Example: "Can we make this algorithm run fast enough for real-time recommendations?" or "What's the best architecture to scale to 10x our current load?"

Process of Experimentation

The activity must involve a systematic process to evaluate alternatives. This includes modeling, simulation, systematic trial and error, or testing.

Example: A/B testing different approaches, benchmarking various implementations, or iterating on designs based on test results all qualify.

Qualifying Activities

For software and technology startups, many common development activities qualify for R&D credits. Here's what typically does and doesn't qualify:

Activities That Usually Qualify

Core Product Development

- Building new features and functionality
- Developing new products from scratch
- Creating prototypes and MVPs
- Major architectural changes

Performance Optimization

- Algorithm improvements
- Database optimization
- Scaling and performance work
- Load testing and optimization

System Architecture

- API development
- Integration engineering
- Cloud infrastructure design
- Security implementation

Support Activities

- Technical project management
- QA testing of new features
- Technical documentation
- Design work for technical features

Activities That Don't Qualify

Non-Technical Work

- Sales and marketing
- General administration
- Customer support (unless technical)
- Market research

Routine Activities

- Bug fixes for existing features
- Routine maintenance
- Data entry
- Cosmetic UI changes

Post-Development Activities

- Production support
- Training users on new features
- Documentation for end users
- Deployment of completed features

Other Exclusions

- Social science research
- Survey/studies funded by grants
- Research outside the US
- Research for others under contract

The 80% Rule

If an employee spends 80% or more of their time on qualifying R&D activities, you can typically claim 100% of their wages as qualified research expenses. Below 80%, you'll need to track and allocate time more precisely.

Calculating Your Credit

There are two main methods for calculating the R&D credit: the Regular Credit method and the Alternative Simplified Credit (ASC) method. Most startups use the ASC because it's simpler and often yields similar or better results.

Qualified Research Expenses (QREs)

First, you need to calculate your Qualified Research Expenses. These include:

1. Wages (65-70% of most claims)

Wages paid to employees for qualified R&D activities, including salaries, bonuses, and the employer portion of payroll taxes. This is typically the largest component.

2. Supplies (5-15% of most claims)

Tangible property other than land or buildings that is consumed during research. For software companies, this often includes cloud computing costs (AWS, GCP, Azure) used for development and testing.

3. Contract Research (15-25% of most claims)

Payments to third parties for qualified research. You can claim 65% of amounts paid to US-based contractors (not the full amount). This includes contractors and outsourced development work.

Alternative Simplified Credit Calculation

ASC Formula

Credit = 14% × (Current Year QREs - 50% × Average of Prior 3 Years QREs)

Or, if you have no prior QREs:

Credit = 6% × Current Year QREs

Example: A startup with $1,000,000 in QREs and no prior R&D history would calculate: $1,000,000 × 6% = $60,000 federal credit

Sample Calculation

Expense Category	Total	% Qualifying	QRE Amount
Engineering Wages (5 engineers)	$750,000	80%	$600,000
Cloud Computing (AWS)	$100,000	50%	$50,000
Contract Developers	$200,000	65%*	$130,000
Total QREs	$1,050,000	-	$780,000
Federal R&D Credit (6% × $780,000)			$46,800

*Contract research is limited to 65% of payments under the ASC method

Payroll Tax Offset for Startups

This is where R&D credits become especially valuable for early-stage startups. If you meet the qualified small business requirements, you can elect to apply your R&D credits against the employer portion of Social Security tax (6.2% of wages) instead of income tax.

How It Works

Make the election when filing your income tax return (Form 6765)
Credits apply against payroll taxes starting the quarter after filing your return
Maximum offset of $500,000 per year (increased from $250,000 in 2023)
Must have less than $5M in gross receipts and less than 5 years of revenue history

Timing Example

Scenario: You file your 2024 tax return in March 2025 with a $100,000 R&D credit and elect the payroll tax offset.

Q2 2025

Credits begin offsetting payroll taxes

Each Quarter

Up to 6.2% of wages offset until credit is exhausted

For a company with $1.6M in annual wages, that's about $100K in Social Security tax. Your $100K credit could cover almost an entire year of employer Social Security taxes.

Important: You Can't Double-Dip

You can't use the same credit for both payroll tax offset AND income tax offset. If you elect payroll tax offset for a credit, that portion can't later be used against income tax. For pre-revenue startups, the payroll tax offset is almost always the better choice.

Documentation Requirements

Proper documentation is crucial for R&D credit claims. The IRS can audit R&D credits years after they're claimed, and inadequate documentation is the #1 reason claims are denied or reduced.

What to Document

Time Records

Employee time spent on qualifying activities
Project-level time allocation
Contemporaneous records (not recreated later)

Project Documentation

Technical uncertainty at project start
Alternatives evaluated
How uncertainty was resolved

Financial Records

Payroll records for all employees
Contractor invoices and contracts
Supply invoices (cloud costs, etc.)

Technical Evidence

Design documents and specifications
Code commits and PRs (Git history)
Test results and iterations

Practical Tips

Use project management tools: Jira, Linear, Notion, and similar tools create automatic documentation of what was worked on and by whom.
Track time by project: Even rough allocations are better than nothing. Some companies use time tracking tools; others do quarterly surveys of engineers.
Document uncertainty: When starting a new project, write a brief note about what's uncertain. "We don't know if approach X will meet performance requirements."
Keep contractor agreements: Ensure contracts specify that work is performed in the US and describe the technical nature of the work.
Tag cloud expenses: Separate development/testing cloud spend from production if possible. Development environments are more clearly qualifying.

How to Claim the Credit

The process for claiming R&D credits involves several steps:

Identify Qualifying Projects

Review all R&D activities and determine which meet the four-part test. Work with your engineering team to understand what technical uncertainties were addressed.

Calculate Qualified Research Expenses

Sum up wages, supplies, and contract research expenses for qualifying activities. Apply appropriate percentages for partial-time employees and contractors.

Complete Form 6765

File IRS Form 6765 (Credit for Increasing Research Activities) with your tax return. If electing payroll tax offset, complete Section D.

For Payroll Tax Offset: File Form 8974

Starting the quarter after your tax return is filed, include Form 8974 with your quarterly Form 941 to claim the credit against payroll taxes.

Maintain Documentation

Keep all supporting documentation for at least 7 years. The IRS can audit R&D credits years after they're claimed.

Consider a Specialist

R&D tax credits are complex enough that most startups benefit from working with an R&D credit specialist—either a CPA firm with R&D expertise or a dedicated R&D credit provider. Many work on contingency (typically 15-30% of credits identified), so there's no upfront cost.

Common Mistakes

Avoid these common mistakes that reduce or eliminate R&D credit claims:

Not Claiming at All

The biggest mistake is assuming you don't qualify. If you have engineers building software, you almost certainly have some qualifying activities.

Poor Time Documentation

Reconstructing time records years later for an audit is problematic. The IRS wants contemporaneous records. Start tracking now, even if imperfectly.

Including Non-Qualifying Activities

Overclaiming (including routine maintenance, support, or non-technical work) creates audit risk and can result in penalties. Be conservative and accurate.

Forgetting State Credits

Many states offer additional R&D credits. California's credit, for example, can add another 15-24% credit on qualified expenses. Don't leave state credits on the table.

Missing the Payroll Tax Election

Pre-revenue startups must elect the payroll tax offset to get value from their credits. This election is made when filing your tax return and can't be changed later.

Want Help With R&D Credits?

Eagle Rock CFO can help you identify qualifying activities, connect you with R&D credit specialists, and ensure you're maximizing this valuable benefit.

Schedule a Consultation