By Adam Jernigan
While innovation drives our economy, it does not come cheap. Innovation often requires significant investment in research, development and experimentation (R&D) THAT the federal government (and some states) help finance through the R&D tax credit. The R&D tax credit is the government’s way of incentivizing the private sector to continue investing in future innovations. In fact, domestic R&D-related spending makes up approximately 2.8 percent of GDP, which translates to roughly half a trillion dollars invested each year.
As the founder of a financial services company, I routinely work with startups and early-stage companies that are looking to scale or launch a new product. I've found the little-known recent changes to the R&D tax credit laws can help provide some of the cash needed to be successful. Here's what you need to know:
Tax Credit vs. Tax Deduction
A tax credit is different from a tax deduction. A tax credit is a dollar-for-dollar reduction in your income tax liability, whereas a deduction lowers your taxable income. The difference is not trivial; a tax credit is far more beneficial than a deduction. However, in order to credit back taxes, the business has to owe taxes. A tax credit can only be applied against your tax liability, meaning that in order to have a tax liability, your company would have to be profitable.
Antiquated and Unfair Tax Code
Most people would agree that our tax code is outdated. The R&D tax credit laws were written 35 years ago, back when Silicon Valley was still manufacturing silicon. Today, the majority of Silicon Valley tech companies operate at a net loss intentionally. The rationale for operating at a loss is that growing revenue and gaining market share is of primary importance, and so long as the top line is growing at an acceptable rate, investors are willing to fund cash flow constraints. Said another way, it is easy to reign in expenses at any time, but you can’t turn on growth because it is a function of timing and product-market fit.
However, it is easy for us all to connect the mental dots that a tremendous amount of innovation comes from Silicon Valley, especially as it relates to software and startups. Unfortunately, until recently, the intended incentive created by the government ignored these young, potentially innovative companies while unfairly financing some of the R&D spend of established, less innovative but profitable companies.
What Has Changed and Why You Should Care
In short, early-stage companies no longer have to be profitable to benefit from this incentive. They can now apply their R&D tax credit to payroll taxes. This is a unique scenario in which an income tax credit can be applied against future payroll taxes.
The ramifications of this change mean thousands of small businesses and early-stage companies will be eligible to benefit from this incentive for the first time. The Congressional Budget Office (CBO) estimates that for the fiscal year 2016, they will hand out close to $10 billion in new tax credits applied to reducing payroll taxes, an amount expected to more than double over the next decade. As a reference point, Pitchbook research shows that approximately $6 billion was invested in California in 2016.
When Will We See the Impact?
It is easy to envision that putting billions of dollars back into the hands of these companies will have downstream impact on society. For some, this new regulation sounds too good to be true and therefore specialty tax consulting firms like indago will have to educate the market. But, in what I believe is an excellent representation of this new regulation at work, indago built a web application called The rad app, dedicated to streamlining the application and claim process for the thousands of early-stage companies that are eligible to benefit for the first time. The better the education and the easier it becomes for companies to claim the R&D tax credit, the sooner we see will see the type of innovation that impacts everyone and advances our economic well-being.
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Adam Jernigan is the CEO of Financials OnTap. He helps early-stage companies develop go-to-market strategies, identify product-market fit, and track the key operating metrics that determine success such as customer acquisition costs and retention rates.