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The R&D Tax Credit still exists, and it might be able to help you offset the Section 174 changes. Michele talks to R&D Tax Credit expert Jonathan Cardella of Strike Tax Advisory to learn more.
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Please note: This podcast is for informational purposes only and is not tax advice. Talk to your tax preparer for advice about your specific situation.
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Michele Hansen 0:00
Hi, everyone. I wanted to take some time today to talk a little bit about the r&d tax credit. So with all of the section 174 changes that we've talked about this year to research and experimental, expensing. There's also been a lot of confusion and a lot of questions about r&d versus r&d, and the r&d tax credit, a lot of folks coming forward who have never filed for the r&d tax credit, wondering if that's something that could be advantageous for them wondering if that can help offset these changes. And so I thought it was about time we bring in an expert on the topic. So today, I am joined by Jonathan Cardella. He is the founder and CEO of strike tax advisory. You've probably seen Stephen Comstock from his team talking about section 174, and r&d tax credits, on Twitter and LinkedIn. Stephen has been a member of our group and our movement, basically, almost since the very beginning, started talking to him back in March. And so as I've talked to him about the questions about the r&d tax credit, he suggested that we bring Jonathan on board. So thank you so much for joining me today, Jonathan.
Jonathan Cardella 1:21
Thank you for having me.
Michele Hansen 1:23
So I wanted to jump right into some of the the many questions that I have received from people about the r&d tax credit. But for starters, I think we should just start with what is the r&d tax credit, and what kind of activities and costs and expenses are covered under the r&d tax credit? Well,
Jonathan Cardella 1:46
the r&d tax credit is formally known as Internal Revenue Code section 41, which is the credit for increasing research activities. I know that doesn't mean probably much to anyone. So I will break it down in layman's terms. Or in my own words, this is a credit that's really greatly misunderstood. While it is the credit for increasing research activities, it's commonly known as the r&d tax credit. It's been around since about 1981. But it's changed quite a bit over the years and was made permanent by Congress more recently, in the mid teens. And it's still misunderstood. And I think as a result, a lot of companies are missing out on the opportunity to take the credit. But in a nutshell, when a company is developing a product for commercial purposes, right to make money to bring it to the to the market, whether it's selling it, leasing it, renting it, licensing it, that doesn't really matter, or whether it's offering subscriptions or whether it's even a service that might be enabled by some technology. These companies, they're they're touching the sciences and engineering disciplines, whether or not they their staff is credentialed or certified. That triggers sort of two of the four part test for the r&d tax credits. So the first one is it's for a commercial purpose. And the second one is that it's involving the hard sciences. And so the key determinant after that is whether or not there is uncertainty that needs to be eliminated in order to get this product or process. Or it might be considered a project by the company to market or in production, so to speak. So is there is there uncertainty, you know, it's usually a technical uncertainty or scientific uncertainty. And so what does that mean? So in my mind, when you're building software, especially if it's not in production yet, as one example, and, you know, naturally, developers are using trial and error to write code, run it tested, go back to the drawing board and tweak that code, and then run it and test it. And repeat that process. That is that's essentially trial and error. And that is a process of elimination of uncertainty. And what we do as experts is look at the sort of endeavors a company undertakes and look for that process of eliminating uncertainty however they do it. And if we can document that, then what we can do is we can qualify a substantial portion of the salaries, both w two potentially contractor salaries, the supplies, such as the cloud computing they might be using. On the other extreme side of the spectrum, you know, we've had distilleries and breweries, right. So when they're working on, you know, their formula or their process to produce their wine, their beer, their spirit, or their energy drink as another example, there's a lot of testing and trial and error that goes into place so they they use supplies. A lot of that gets thrown out, right? It's not production supplies, but it's all of the effort and costs Some wages that went into producing that new product line or that new beverage that we can qualify as r&d If a substantial portion of those expenses were really spent on eliminating the uncertainty required to commercialize that idea, effectively, I know that's a really long answer. So they want to really summarize that. But that's really at the heart of it, if that makes any sense.
Michele Hansen 5:27
So it sounds like for software companies, in a lot of cases, provided you have the proper documentation and evidence for it, developing a new product, in general might qualify for the r&d tax credit, or there are also cases where software companies have say made improvements to existing products, and received the tax credit.
Jonathan Cardella 5:54
So what is a new product is what we're, you know, what becomes at issue with software, each new version, each new build of the product effectively is a different product, right? So, you know, every time iOS pushes out an update, arguably, that's a new product that that version has new features, or significant changes to features. And it's not in production until you push it out onto everybody's device or make it available. And so naturally, in software development, usually you are doing version builds or you know, even if they're more minor version builds. And so we can qualify that as a new product effectively or as expensive as potentially, what you know, what doesn't qualify is the sort of like simple patching of bugs on a production product. So in theory, if the bug is obvious, it's simple to fix the products in production, even though it takes technical disciplines and resources. Technically, that sort of activity usually does not qualify. Whereas building a new feature or feature set, it's going to usually be pushed out as part of a new build to that software and said, it's a discrete update. And so usually, we can capture that that's the sort of expenses. But I wanted to kind of like confuse things more by saying that if we simply make that that software run 50 milliseconds faster, that project and its own, probably could qualify.
Michele Hansen 7:18
So it sounds like even small changes can sometimes qualify.
Jonathan Cardella 7:21
Yeah, I mean, just optimizing an existing process or product can qualify, literally making a function run faster, likely will qualify, you know, because there is uncertainty typically in that sort of work. And it is a trial and error. And it is technical. And it is for commercialization, and it's going to be in a new build of that product. So yeah, typically, we qualify that. But what I'm getting at is that it is the wages of the folks in house who are doing this sort of work. So think of the developers think of their managers think of the people supporting the developers can be project managers, there could be designers involved, there could be assistance, there's the CTO, there might be a founder, that is supervising and overseeing this, there could be outsourced contractors or agencies, and there is going to be usually like, if you're training AI models, as an example, there's going to be a lot of computational cycles that are utilized not for production, but for but to support that trial and error process, right, of training the model as another example. So but it's not just software, I mean, this is everything from people doing CAD drawings, to architects to engineering firms. But there's another key ingredient that I forgot to mention to you, which is simply that the taxpayer must take the financial risk, and stand to gain the rewards of the research that's being conducted. So if the research is funded, say by another party, arguably that then that that's the taxpayer that might qualify. So what I'm getting at is that just because I'm an architect, if I'm doing work for someone else, and maybe their tax credits, not mine, depending on who took the financial risk, and who gets the fruits of the of the research, as far as if there's any contract involved a contract research.
Michele Hansen 9:10
And so it sounds like what you're saying is that if say I have a freelance software development company, and I build a product for someone else, under a contract that then becomes their IP, and their product to commercialize, then my activity probably doesn't qualify. But if I have, say, received venture funding for my own company, and I would have the benefits of the product, even though I have investors in this scenario, then you would still qualify is that kind of the difference between doing contract work and really courses? Yeah,
Jonathan Cardella 9:51
there's a little more nuance to it than that. So let me add to it. So in the scenario where you're a startup, sure you have investors, but the startups the taxpayer, the startups taking the finance initial risk, the startup on the IP, which which can be different, by the way, then the fruits of the research, there can be some nuance there. So for example, like you get know how on how to perform that research, which is a fruit, whereas traditionally companies might think of the IP is just the software. But yes, generally, you're correct. But I would say that, that doesn't mean a contractor can't potentially be the recipient of the r&d tax credit, though, say, there was a contract in which I'm the contractor, the software development agency, I'm offering you a fixed bid startup, I'm gonna produce software for you, you're gonna own the software, but I'm going to on some of the rights to the findings, and the research or significant rights to the know how, and I'm going to give to you on a fixed bid, so I'm taking the financial risk. So in that scenario, it's not as clear, and it requires a close analysis of the contracts and what actually happened to make a determination as to who really had the most risk and rights and who deserves the credit. So it does become more nuanced. But in the case of the startup, that hires people as w two employees, and typically there's a mention assignment and everything with those employees, and it's clear that the startup took the risk and owns all of the fruits of the r&d, whether that's by foot by w two or 10 on and same thing in a contract like in your scenario. So I just wanted to clarify by saying just because it's a contractor doesn't mean the rights and rewards can't best with the contractor.
Michele Hansen 11:26
If that makes sense. That makes sense. And so
Jonathan Cardella 11:30
if your startup sorry, it was a pasture entity, though. Even though the company is a taxpayer and gets the credits, the credits would pass through to the investors if it's a pass through entity, such as a partnership, or an S corp. Whereas the credits would benefit only the company in the case of a C Corp. So the company will get a tax break essentially, before it, say distributed dividends or retained earnings. In the case of a C Corp, whereas in an S corp or partnership or traditional LLC, we have members, in those instances they have their credits actually passed for the investors and benefit usually their income generated from that business.
Michele Hansen 12:09
So you mentioned before how one of the pieces of evidence that companies use to get the r&d tax credit is contracts, and proving you know, who gets the the fruit of the research? Getting down to brass tacks a little bit? What are the kinds of evidence that software companies usually need to provide for the credit? Are we talking, you know, GitHub issues and conversations or server logs? Like Like, what is it? Is it simply a written write up of the research that was done? Or do people have to have timesheets? Like what like, what are those specific things that people need to produce? In order to prove the activity? Sure,
Jonathan Cardella 12:55
well, for one nowadays, whether you're so with the r&d tax credit, you can, you know, if you pay taxes, so first of all, you can look back at least three years federally, sometimes even more on a state level, because you can, you can get both federal and state credits, which offset both your federal and state income tax typically, as well as other types of federal taxation that we can talk about, such as your payroll tax. But that said, the sorry. I got a tangent. Michelle, what your question again,
Michele Hansen 13:27
about the kinds of evidence that companies produce, and specifically the god software company, so are, you know, are you looking at GitHub activity or, you know, written right up
Jonathan Cardella 13:38
the bar to take the credit is a bit higher, if you're amending your returns to get refunds from taxes you paid in the past, which is a possibility. But generally speaking, we need to understand that each for each calendar year, or fiscal year tax year, we need to understand the the type of projects that the company basically undertook that year, that could qualify what their purpose was, who was involved in them, both w two and 1099. Right, the the actual people, and how they, you know, essentially what they were paid, under how those caught whether the contracts were w two or 1099. And they were 1099. We need to analyze them. And that's just on the surface. You know, we need to look at tax returns and stuff. But as to the actual project documentation, which is what I think you're asking about, it's typically the stuff stored in JIRA, or your project management system. If you have a time tracking system, that would be invaluable, because usually it ties people to tasks and efforts and projects. But oftentimes, we can recreate this. Sometimes we've used email inboxes. Sometimes we rely on interviewing employees, and founders and executives at the company, and some combination thereof, but it's really the gold standard is what we call contemporaneous documentation. which would be the sort of things like the project plans and research notes and results that were captured or kicked off of the processes that ran at that, at that time when the research was conducted. That's why the sort of like task tickets Sprint's that might be in a project management system are invaluable. GitHub is a goldmine of this data, if a company is using that, you know, we have things there like we can sit typically, there's some sort of a GitHub flow or process that companies use to move code, you know, from a development state to say, a staging, and a production environment, potentially, we're different code branches that might have those significances. And if we can understand that, there usually is a lot of inherent sort of documentation or that exists in logs and what have you, with respect to, you know, the trial and error process that we talked about earlier, that company has conducted, like, there's usually a lot of digital footprints that we can leverage. Sometimes necessary, you know, it really depends on the complexity, the amount of money you're talking about also dictates the level of documentation. But ultimately, we really had to tie the projects, the people the expenses, if there were supplies, and the uncertainty in each one of those projects, as well as that process of experimentation we talked about and their commercial purpose, we need to tie that all together, to do our analysis and ultimately provide final documentation that documents all of that so that it's quote, unquote, audit ready.
Michele Hansen 16:30
Right. And in there was actually something that is very good news for companies who are struggling with the 174 changes this year, and the end taking a financial hit as a result, which is that you mentioned that companies can file for the r&d tax credit for previous years, even if they have already completed those returns. Can you say a little bit more about that?
Jonathan Cardella 16:56
The Federal Code says that a company can look back three tax years from their present tax here. Typically, after three years, you can't really amend things or change things. And the three that what starts the clock is a little bit technical, but oftentimes, it's when you filed that return three years ago, starts the clock, right? And everybody files, you know, not everybody files on the date it's due. So I think it's the actual like postmark date of your tax return three years ago that you're looking at, and you have a three year window from there. So you can look back, but each year, in theory, if you're more than three years old, you're losing a year of potential r&d tax credit or qualified expenses that you get credits on. The thing is, there is there's the tax code itself, like section 41 that we talked about, but then there's case law. And there's case law that says that companies can go back to Inception if they've never paid, you know, if all income, if all years are open, meaning they haven't paid income tax, yet, they haven't hit profitability on a tax basis yet, that they can actually go back potentially, to inception and capture all of their expenses. And that's, you know, so if you catch a company, or if a company catches this opportunity, right, before they become profitable for the first tax year, it can be a massive tax savings that they can harvest all at once. And they can apply, you know, a good portion to the current tax year, their first year profitability, and then they carry those credits forward for up to 20 more years. So typically, you look back three or more years and carry forward 20 years once you get the credits. And that's that's the beauty of it.
Michele Hansen 18:23
It sounds like it can be a very valuable tax credit for people to get, and certainly very helpful this year, as a lot of entrepreneurs are feeling a bit panicked. To put it mildly about their tax situation. I'm
Jonathan Cardella 18:41
sorry to cut you off. But if they pay taxes last year, last few years, and they had r&d, they didn't realize it they can they stand to get a large refund, right. So this is not just a, you know, a reduction of future taxes, but a potential immediate source of cash for some of those companies.
Michele Hansen 18:56
Yeah, and that really gets to my last and quite frankly, the biggest question that I that I hear from people about this is, can the r&d tax credit completely offset? The section 174 changes?
Jonathan Cardella 19:10
It's possible. Definitely, because of the fact that the 174 changes took effect for the first time in tax year 22. But yet, we can look back three or more years, sometimes all the way to inception. So potentially, the credits could be used to offset the entire increase from 174. But it really depends on each company's tax situation. 174 is pretty interesting, but for most companies, it's definitely increasing taxable income, or creating an income tax situation where there is no actual income, right? So you can have a situation where a company does a lot of r&d and it has some revenue, and it's losing money on a cash basis. But when but under 174, because the taxpayer now doesn't have the option to expense the r&d tax. fences in the present year. In fact, this year can only take about 10%. So in 22, if you did 2 million in r&d, you might only be able to expense 200,000. But at the same time, say you had 2 million in revenue, and you know, you were in a zero tax position, and yet we're negative because you had some other expenses. Now, because you can't book 1.8 million of your of your r&d expenses, you actually look like you have income, let's say a million dollars, or in this case, what you know, could be a million dollars plus in this case. And so now say you have, you know, 300,000, or whatever it is, and an income tax do federally, it is very conceivable in a scenario like that we would have more than 300,000 and tax credits, because we look at this company's been spending 2 million a year and we look back three years or more. And so in that scenario, they may be able to entirely offset those 174 taxes, where the income tax that results from 174 and still have credits leftover, but it really depends on how much revenue are they generating, how much other expenses do they have? And then whether they're doing onshore or offshore r&d? And how much about how much they actually have in r&d expenses, and how long they've been doing that for. So there's just so many variables involved, that it's really hard to answer, but it is a possibility as well, I
Michele Hansen 21:11
think we should probably end on that encouraging note. And, you know, I am personally still very hopeful that we can get this 174 Mess solved by the end of the year. Of course, we know that Congress doesn't fix anything, or really do anything until they absolutely have to at the absolute last minute. But, you know, there could be companies who are in a situation who now realize that they have qualified for r&d tax credits, or potentially qualified for them for the entire company's existence. And so while 2022 may have a difficult cash position, once they get those credits going, and 174, as you know, knock on wood fixed, going forward, and of course, retroactive to 2022, they could potentially be in a in a better position in the future.
Jonathan Cardella 22:04
Definitely. I mean, it always makes sense to get your tax credits. You know, 174 is a totally different piece of tax code, it doesn't, you know, the r&d tax credit is still there, it's virtually unchanged, definitely not directly changed by 174. And the, you know, the thing that you need to realize is that 174 takes a much broader definition of r&d of the actual expenses, right? So in 41, where they're given you a credit, they call r&d One thing, and they really whittle it down to a subset of your r&d expenses effectively, whereas in 174, it's beyond your r&d expenses, it's an extension of that, I would argue it's any expense incident have this sort of software development or r&d of any kind. So you know, you're talking about building expenses, and rent, mortgages and depreciation of equipment, and just it takes a really, really broad, broad definition. So your 174 expenses are going to be more than your 41 expenses. But the thing is, whether you take r&d credits or not, doesn't affect really directly, whether you have 174, expenses, you know, 174 expenses based on whether or not you're you're doing r&d, and the government's count, as far as to say any software development is 174. So it's an interesting position is sort of like they've created a double standard. And it definitely will increase tax for a number of companies. But yes, I mean, one of the best remedies to it is to make sure that you have all your tax credits your r&d tax credits to offset and that's pretty much my only and best advice.
Michele Hansen 23:34
So if people listening are wondering how they can get started with r&d tax credits, where would you suggest they go next?
Jonathan Cardella 23:44
Well, you know, obviously, you can read up on them about on the IRS website. I wouldn't say it's unbiased, though, because you know, they have their own angle on things. And, you know, at stripe tax.com, we work hard to get the latest news out there to everybody and try to break it down into understandable terms. But as to the credit, yeah, there's a number of providers that will help companies provide the credit, the problem is that they're usually charging fees upfront or upon delivery of the credits. And companies aren't sure if they can use them when they can use them if the government will accept them. And so a lot of companies don't take the credit because there's a risk involved, you know, and capital loss by going after the credit. And the credit only has value if it's usable, and, you know, can give you more of an economic benefit and the cost to get the credit. So for that reason, a lot of small businesses haven't taken the credit traditionally, and that's why we came to market because we basically work with companies, educate them, identify the opportunities, help for them to take credits, value them and then we pay to do the work so they don't, they're not exposed to that capital loss risk. And then we only get a fee when the actual or the receive a tangible economic benefit, could be 20 years in the future in theory. So that's a pretty unique part. Opposition in the market is pay on utilization, not receipt of the credits, which is a nice asset on your balance sheet. And so, for that reason, I recommend that companies attempt to hire and qualify at strike tax, you know, we don't take every single company, because sometimes it isn't, you know, a smart opportunity for them, and we advise them on that. And you know, when it will be. But, you know, I would just say make sure that if you hire a company to get the credits that not only that you hire reputable company, but that you can really benefit from the credits more than the cost obtained significantly more. Because there are situations where it may not be lucrative.
Michele Hansen 25:44
Yeah, that makes sense. Like, like anything, make sure to shop around and look at, you know, look at your current tax provider, but also look to other sources and providers as well, to make sure you're getting the best deal on. Absolutely. Well, thank you so much for joining me today. I will have links to you and strike tax, as well as the IRS in the shownotes. For anyone who wants to learn more about this, which should be everybody listening, if you haven't taken the r&d tax credit so far. So Jonathan Cardella, thank you so much for joining me today.
Jonathan Cardella 26:23
Thank you so much for having me.