Did you know that most startups are missing out on billions’ worth of tax savings? Research has shown that VC-backed startup firms are foregoing tax savings of up to $43.9 billion, simply because they’re not choosing tax-advantageous business entities.
Another way startups miss out on savings is by not leveraging startup-specific tax credits. A startup tax credit can give you the breathing room you need to fuel your operations and spur steady growth.
If you want to save on taxes as a new venture, we have some good news.
The new R&D Tax Credit allows VC startups to save up to $250,000 for this financial year. For the 2023 tax year, it’s doubled to $500,000. Besides this, there are more than a thousand other credits and incentives, offered on both federal and state levels.
Are you eligible for a portion of these tax breaks? Keep reading to find out if your startup qualifies.
The Definition of a Typical Venture Capital Startup
Before we get into the eligibility specifics around startup tax credits, let’s first clarify what a typical startup is.
First off, most typical startups are venture-backed Delaware C-Corporations. A lot of people use the term “startup” fairly loosely. For example, someone might refer to a newly launched Etsy shop as a startup.
However, for R&D tax purposes, we’re talking about a venture that’s seeking high growth. These types of companies are often rooted in tech, software, biotech, etc, and many have secured patents.
What’s more, venture capitalists can only invest in Delaware startups. Thanks to this, our definition of a “startup” also includes this provision.
Size
Most startups have less than 100 full-time employees. Famous, large startups like Apple, Google, and Facebook get a lot of attention in the media. This leads people to think that startups are big companies with lots of employees.
This is not the case. According to reports, there are over 32 million small businesses in the US, and they constitute 99.7% of all US businesses.
By definition, an SMB is an organization with less than 100 employees.
If your business has more than 100 full-time employees, first off, congratulations on your growth. However, this is not the norm for startups, and for tax purposes, this article isn’t for you.
Instead of researching startup tax credits, we’d recommend you focus your resources on hiring seasoned CPAs with expert tax knowledge. A team of knowledgeable CPAs will be able to help you comb over all the tax credits that exist and build a detailed tax plan that’s tailored to your specific needs.
Expense Allocations
Ventured-backed startups that have less than 100 full-time employees usually have similar expense allocations. In other words, there are lots of similarities in their spending habits. For instance, in the majority of startups that have less than 100 employees, roughly 80% of their expenditure goes to:
- Rent
- Payroll
- Contractors
Startups in this bracket usually pay their CEOs an annual salary of between $110,000-$130,000. These startups often onboard engineers, and tend to pay them an annual salary of around $120,000.
Headquarters
Startups usually have offices in metro areas such as New York, Los Angeles, and San Francisco. Their offices are more than likely in high foot-traffic locations, and in proximity to public transportation services.
Startups with fewer than 100 employees are also likely to have given up office space in response to the pandemic and facilitated remote working for employees. This transition has spurred some startups to relocate their shrunken headquarters to other states.
Unfortunately, these two developments have made it a lot harder for some startups to claim tax credits. Why? Because tax credits for startups are often based on employee and office location.
Lastly, in this guide, we are only addressing US-based startups.
Differences Between a Tax Credit, Tax Deduction, and a Tax Incentive
Another critical thing to clarify is the differences between tax credits, deductions, and incentives.
Tax credits are a direct subtraction against the taxes you owe.
In other words, they forgive a portion of your tax bill. For instance, let’s say you owe $7,500 in taxes and you have a $4,800 tax credit. Once this is deducted, you will only owe $2,700.
Tax incentives encourage businesses to take actions that will promote certain economic or social outcomes in a specific area. One example of this is the Work Opportunity Tax Credit (WOTC), which aims to encourage businesses to hire employees from less represented groups, including ex-prisoners and veterans.
Like tax credits, tax incentives are sometimes claimed directly against your tax liability.
To get an idea of how tax incentives work, here’s another example. If you owed $7,500 in taxes and had a WOTC of $2,800, your final tax bill after the credit would be $4,700.
Finally, tax deductions are everything you can claim against your income and mostly includes business expenses such as:
- Rent
- Wages
- Marketing costs
- Insurance
- Materials
- Repairs and maintenance
- Utilities
Tax deductions offset your revenue, thereby dropping your taxable income. Let’s say your startup generated $150k of revenue. If your expenses and tax deductions came to $90k, your taxable income would be $60k.
Under a 21% tax rate, your startup would have a tax bill of $18,900.
Commonalities Among the Many Tax Credits and Incentives
As we said above there are more than 1,000 tax credits available to businesses. If you add up all the state, federal, and local tax credits, you end up with a confusing array, enough to make any founder’s head spin.
To start making sense of the available tax credits, here are some of the common themes among tax credits in the US:
Renewable energy: tax credits that are available to businesses that offer green energy solutions to staff (such as EVs) or are actively engaged in renewable services and products
Research and technology: tax credits available to businesses in the technology sector that carry out R&D
Enterprise zones: tax credits available to businesses with headquarters and premises in areas that qualify as developing neighborhoods
Job training: tax credits available to employers that exist primarily to provide training for trades, including law enforcement, manufacturing, welding, etc.
Coal and gas: tax credits available to businesses that operate in the gas and coal sectors
Child and dependent care: tax credits for businesses that furnish employees with dependent care programs or on-site child care facilities
Angel and VC investment in tech companies: tax credits available to venture capital startups and angel investors who have vested capital into companies in the technology sector
Historic preservation and rehabilitation: tax credits available to companies that have rehabilitated or bought historic landmarks or buildings
Film, theatrical, and picture: tax credits for businesses in the film and theater industries that create content for a specified state or city
Now that we’ve covered some of the broad tax credit categories, let’s narrow things down and focus on what tax credits startups most frequently look into.
Tax Credits to Pay Attention to as a Venture Capital Startup
Combing through the intensive list of local, state, and federal tax credits is a huge task. To make things simple, we have isolated a list of the main tax credits that can apply to startups.
However, take note, many startups don’t qualify for any of these. Some might only qualify for the R&D tax credit or the Employee Retention Credit.
Below is a list of tax credits you might want to look into as a venture capital startup:
- Federal R&D Tax Credit
- Employee Retention Tax Credit for Recovery Startups
- Credit for Small Employer Health Insurance Premiums
- Work Opportunity Tax Credit (WOTC)
- Empowerment Zone (EZ) Employment Credit
- Employer Credit for Paid Medical and Family Leave
- California R&D Tax Credit
- California Sales Tax Partial Exemption
- New York Life Sciences Research and Development Tax Credit Program
- Maryland Biotechnology Investment Incentive Tax Credit (BIITC)
- Pennsylvania Keystone Innovation Zones Tax Credit
Although you can research the qualifying criteria for these credits on your own, we’d advise that you enlist the help of a professional accounting advisory team. This will save you time and ensure your startup isn’t missing out on any advantageous tax credits.
Was Your Startup Founded During COVID? You Might Be Eligible for the Employee Retention Tax Credit for Recovery Startups
If your startup launched during the first year of the pandemic, there’s a good chance your business could qualify for the Employee Retention Tax Credit.
This credit was authorized in an effort to help new businesses keep their doors open and their staff employed during the mass disruption of pandemic conditions.
The two main requirements for claiming this tax credit are:
- Your startup must have been founded on or after February 15, 2020
- Your startup must earn less than $1 million in yearly revenue
Not only is the Employee Retention Tax Credit for recovery startups relatively simple to qualify for, but it can also net you substantial payroll savings.
If your startup qualifies—you could be able to save roughly $7,000 for each of your employees. The credit is capped at $50,000 for each financial quarter.
If you pay typical startup wages and have an average number of employees, you could easily enjoy a tax credit of close to $200,000 per year.
How to Keep Up With the New Tax Credits Coming Out
Every month, new tax credits roll out. This opens up doors of opportunity for startups, but it’s also a lot to keep up with.
How can you know that you’re not passing up any new tax credits?
The easiest way to ensure that your business is never missing out on an advantageous startup tax credit is to partner with a full-service accounting firm.
Here at Propel CFO, we always have our ears to the ground. It’s our job to keep up with changing tax laws and new developments, including tax credits.
We work with you to identify what tax credits your startup can qualify for. And this isn’t the only area where we can help you save on taxes. Through expert tax planning and accurate accounting, we can help you minimize your taxes and propel growth.
If you’ve been doing without a CFO because your business can’t support the cost—Propel CFO is the answer. We specialize in helping small and medium-sized businesses.
If you don’t need a full-time CFO, no problem. Instead, get the same professional knowledge and service, at half the cost through our fractional CFO services.
Final Things to Know Around Tax Credits
Before we leave you, here are a few last things to know about tax credits.
Firstly, did you know that even unprofitable startups can sometimes be eligible for tax credits? For instance, the Employee Retention Tax Credit allows you to gain a tax credit against your payroll taxes. This can help you effectively reduce your burn rate, even if you’re not paying income tax on your revenue yet.
Claiming for Tax Credits
The majority of startup tax credits need to get filed along with (or in) your yearly tax filings.
If you’re a Delaware C-Corp, this will be when you file Federal Form 1120. Most credits are filed with Form 1120.
Why You Should Work With a CPA
It doesn’t matter what type of business you are, it’s always in your interest to have expert accounting and tax advice in your corner.
However, it’s especially important if you’re a startup claiming tax credits. Firstly, the IRS would rather a certified tax expert prepares your return. Second, any time you claim a tax credit, you’re effectively receiving Treasury money.
This increases the chance of getting audited, which makes it especially important to work with a professional accounting service. If you know for a fact that your books are in order, getting audited after claiming a tax credit isn’t a big deal.
However, if your income and expenses aren’t accurately reported, you could wind up in hot water with the IRS.
Our teams at Propel CFO will make sure your accounting is accurate. We will also handle your tax filing for you and make 100% sure that everything on your return is correct and compliant. In the event of an audit, we will take care of all the details.
Things to Avoid When Claiming Startup Tax Credits
If you’re going to be claiming tax credits on your return, make sure you choose an accounting and tax preparation service that has a CPA on its team.
If you don’t, you run the risk of non-compliance with the IRS and all the ramifications that come with this. You may also risk being scammed. Recently, the IRS has warned the public of “ghost preparers” that input their own bank details to steal tax refunds.
The Most Impactful Tax Credit for the Majority of Startups
For most startups, the biggest tax credit is the R&D Tax Credit. Reducing payroll taxes assists new startups that conduct R&D to become profitable.
Do You Need Help Claiming a Startup Tax Credit?
Tax credits can give startups much-needed tax relief and can save SMBs thousands of dollars. However, figuring out which startup tax credit your business qualifies for can be tricky.
Do you need assistance with finding or claiming startup tax credits? We are the people to speak to.
We specialize in tax assistance for startups and are committed to providing tax and accounting services that truly move the needle for our clients.
Contact us today to book a free 30-minute consultation.