Startup business tax credits you need to know

Business credits are distinctive opportunities for businesses to reduce their taxes owed. If your startup fulfills specific requirements through its actions, you automatically qualify.

Tax credits lower the total amount you owe to the IRS on income tax. A deduction lowers your taxable income. 

A tax incentive reduces the amount owed for businesses that completed an action benefiting the economy. 

For example, the Work Opportunity Tax Credit is well-known. Utilizing incentives, credits, and deductions drastically lowers what you owe.  

Tax deduction example

If you make $50,000 a year and earn a $1,000 tax deduction, the IRS will tax you as though you made $49,000 that tax year. 

If you calculate using the 2022 income tax brackets, the deduction would mean you have to pay $6416.66. The original owed would be $6616.66, for a cost savings of $200.  

Tax credit example

If you have a $50,000 salary and earn a $1,000 tax credit, your total income tax cost would be $5616.16 instead of $6616 — a $1000 savings. 

Tax deduction and credit combination example

If the same person with a $50,000 salary takes the standard deduction of $12,950, their taxable income would be $37,050. 

With that taxable income, they would owe $4288.10 in taxes. If this person also had a $1000 tax credit, they'd remove that $1000 from the $4288.10 they owe, meaning they now owe $3288.10.

Tax credits to pay attention to

Often, tax credits only apply to a narrow subset of startups depending on their size, location, and type of business. 

However, some tax credits apply to a much more comprehensive range of startups. 

Tax credits aren’t a place you want to speed through. If you’re managing your taxes, carefully comb through all credits. 

We’ve done some legwork for you to make your life easier.

1. State R&D tax credits

Any startup doing research and development in the states listed below is eligible. Startups that meet the criteria receive a specified percentage dependent on state laws.

You can use State R&D tax credits in tandem with federal R&D tax credits, but each will reduce the tax cost based on qualified expenses on their associated return.

2. Retirement plans

Small employers often set up company retirement plans, such as a 401k plan or Simple IRA, to help employees build retirement savings. Doing so may qualify you for multiple retirement plan tax credits, depending on your number of employees and their compensation.

If you have 50 or fewer employees, this employer credit can cover 100% of the startup costs to open, administer, and educate employees about the plan for the first three years, up to certain limits. If you have 51 to 100 employees, it’s worth 50% of your eligible startup costs.

In addition, you may qualify for an employer contribution tax credit, which covers a portion of any employer contributions you make for a non highly compensated employee in the plan’s first five years.

An eligible employer that adds an automatic enrollment feature to the plan can also claim a tax credit of $500 per year for three years.

3. Work opportunities

The federal government created the Work Opportunity Tax Credit to aid in employment. Businesses will receive tax credits for hiring an employee from specific groups. 

• Recipients of state assistance

• Ex-felons

• Individuals who have completed a rehabilitation program

• Veterans. 

During the first year of employment, your business will be eligible for either:

•  $2,400 in credits

• 40% of the first $6,000 of the employee's wages

4. Health care

The IRS' Small Business Health Care Tax Credit offers credit to eligible employers who offer health plans through the Small Business Health Options Program Marketplace. Qualifying startups that pay at least 50% of the health plan premiums are eligible. The smaller the business, the larger the tax credit received.

5. Employment zone (EZ) employment credit

Startup employers operating in specific regions qualify for the EZ credit. The IRS targets these areas to push economic growth and heighten commerce traffic.

Empowerment Zones:

• Pulaski County, AR

• Tucson, AZ

• Fresno, CA

• Los Angeles, CA (city and county)

• Santa Ana, CA

• New Haven, CT

• Jacksonville, FL

• Miami/Dade County, FL

• Chicago, IL

• Gary/Hammond/East Chicago, IN

• Boston, MA

• Baltimore, MD

• Detroit, MI

• Minneapolis, MN

• St. Louis, MO/East St. Louis, IL

• Cumberland County, NJ

• New York, NY

• Syracuse, NY

• Yonkers, NY

• Cincinnati, OH

• Cleveland, OH

• Columbus, OH

• Oklahoma City, OK

• Philadelphia, PA/Camden, NJ

• Columbia/Sumter, SC

• Knoxville, TN

• El Paso, TX

• San Antonio, TX

• Norfolk/Portsmouth, VA

• Huntington, WV/Ironton, OH

6. Maryland biotechnology investment incentive tax credit (BIITC)

Startups operating in Maryland with a focus on biotechnology receive a tax credit of up to $250k. Maryland continues to encourage growth within this specific industry. If your startup is looking for an investment opportunity, this is a huge one. 

7. CA sales tax exemption

Startups in specified industries operating in California can apply for this exemption. Qualification depends on your startup’s NAICS classification. 

NAICS classification

• 3111 - 3399

• 541711 

• 541712

• 221118 - 221122

The codes above qualify for this exemption. There are specific tangible purchasing qualifications alongside the coding requirements.

Examples of qualified purchases

• Machinery

• Equipment used for repairs or maintenance

• Operational equipment (computers, printers, etc.)

• Tangible personal property used in pollution control

• Special-purpose buildings used in production

The most important business startup tax credit: R&D

One major startup tax credit that founders should know about is the federal R&D tax credit. You qualify if your startup made less than $5 million in annual gross receipts and technology design.

Qualifying startups can receive a credit against their Social Security and Medicare payroll tax liability of up to $500,000. You can apply money spent on supplies, consultants, employees, and computer rentals. 

Ensure you keep accurate records of your expenses to track how much money is applicable.

Startups, especially SaaS-based ones, spend a lot of money on research and development. 

Once launched, it will take a while to produce enough revenue to offset that startup expense. Taking advantage of federal and state R&D puts money back into the company. 

The majority of startups qualify for this specific tax credit. If you’re working with a CPA, double-check that they’re utilizing this credit. 

Changes to the R&D tax credit section 174

In 2017, the Tax Cuts And Jobs Act updated businesses’ ability to expense their section 174 costs. Section 174 expenses now must be capitalized and amortized by domestic and foreign research. 

• Domestic Research - capitalize all costs over five years utilizing a half-year convention.

• Foreign Research - capitalize all costs over 15 years utilizing a half-year convention.

The changes implemented may affect your current taxable year. If you’re self-filing, research these changes thoroughly before applying for the federal tax credit. 

How to take advantage of tax credits

Working with a highly experienced CPA in your vertical is the key to gaining every startup credit available. 

Taxes require attention to detail and knowledge of state and federal tax laws. Due to the sheer volume of tax credits available to startups, the benefits of a professional outweigh the cost. 

If you believe your startup qualifies for one or more tax credits, you must fill out Form 3800. 

The instructions for how to fill out the form are relatively extensive and subject to change. The IRS requires you to list how much you're claiming per credit. 

These forms each have their own requirements. However, on every form, you must calculate the amount of credits you can claim

Things to avoid when claiming startup tax credits

When dealing with complicated business taxes, you can make plenty of mistakes. Potential missteps encompass all aspects of business taxes, including applying for tax credits. 

Here are some common pitfalls you'll want to avoid:

Poor record-keeping

Many tax credits depend on knowing how much you've spent on certain expenditures. The more you spend, the higher your tax credit. Others require you to know information about your employees' prior economic status. 

You need to keep track of this information correctly to understand how much of a tax credit you can claim. The last thing you want is to fill out a tax credit form and realize you need to know what information to enter.

Failing to apply for tax credits in the right order

Not only do you need to calculate each of your business's tax credits on separate forms, but you also need to apply for them in the correct order. 

The order you apply the credits depends on when you used them and what type of credit they are. The IRS provides a detailed list of the order in which you must apply for tax credits.

Forgetting to apply for carryforward and carryback tax credits

Businesses can often qualify for more tax credits than they can apply to their taxes in a single year. To mitigate this, the IRS lets companies apply unused tax credits to future years. 

The IRS also allows startups to use certain unused tax credits for prior taxable years. Each credit has different rules for how far forward or backward you can apply it.

Why shouldn’t I apply on my own?

The short answer: taxes are complex and rely heavily on correct filing. The advantages of using a tax advisor or CPA far outweigh the benefits of doing your taxes. 

CPAs have a cost, but the money saved on hiring costs pales compared to the money saved using tax credits and deductions.

A professional should comb through the sheer amount of deductions and credits applicable to startups. 

Researching on your own uncovers a few, but experts know where to find those hidden gems.

Incorrect filing or missing the filing deadlines comes with penalties and fees. 

We know from our tax filing blunders with our first startup. During our first tax cycle with a CPA, many credits were missed due to the CPA’s lack of experience with startups. We lost money and paid more.

Maximize your tax benefits 

Tax credits are meant to help you reduce your tax liability. The IRS designed startup-specific tax credits to offset qualified startup costs involved in opening and scaling a business. 

All tax credits apply to fiscal or calendar tax year filers. 

If you’re filing your tax return and are not a CPA, there’s a high chance you’ll miss essential credits. That’s just money down the drain. Instead of fighting through your tax cycle, make the most of the tax year.

Tax professionals and CPAs focused solely on startups are out there. Their entire job description is helping founders make the most of every tax credit. 

In addition to the tax credits we’ve listed, there are industry-specific credits. 

We can help you find and claim the credits you deserve. Schedule a free consultation with us.