The R&D Credit is one of the most valuable tax credits for businesses in the Software and Technology industries. It can return about 10% of engineering payroll to the business in the form of a direct dollar-for-dollar reduction in tax liability. Even pre-profit startups can now use the Payroll Tax Offset to reduce the FICA portion of their payroll taxes up to $250,000 per year for 5 years.
Estimating R&D Tax Credits
When we look at how R&D Studies are priced, the first thing to consider is the value this service brings to a business. Here’s a quick example. Let’s say a startup has 10 software engineers who each earned $100,000 in W2 wages last year.
Engineering payroll = 10 software engineers * $100,000 salary = $1,000,000
R&D Tax Credit = About 6-10% of Engineering payroll = $60,000 to $100,000*
That’s a $60-100K reduction in tax liability (or FICA payroll taxes) for the business. That’s huge!
*Assumes each software engineer spent at least 80% of their time engaged in Qualified R&D Activities related to developing new functionality, performance improvements, and reliability or quality improvements, etc.
Estimating the cost of an R&D Study
We’ve conducted interviews and held discussions about the R&D Tax Credit, the types of activities that Qualify as R&D, and how R&D Studies are traditionally conducted with over 100 accounting firms ranging from sole practitioners to Big 4 firms, R&D specialist firms, and SaaS startups.
Based on what we’ve seen in the market, R&D Study fees usually amount to about 20-30% of the resulting tax credit. When we first started researching the market, we were shocked at how high those fees seemed.
To get a quick estimate of the cost of an R&D Study, simply multiply the estimated tax credit by 20-30%. In the example above, a $100,000 tax credit will cost $20,000 to $30,000 in fees.
In other words, of the $100,000 tax credit the business earned by performing Qualified R&D, they only realize about a $70,000 to $80,000 tax benefit.
Many specialist firms will estimate the size of a company’s R&D Credit by looking at wages paid to full-time employees, payments made to 1099 contractors (wages and contractor payments make up over 82% of QRE across all industries), and supplies used in R&D processes, and quote a prospective client a flat fee equal to 20-30% of the credit.
Some firms will charge the fee at the end of the R&D Study, while others will allow businesses to pay the fee over the course of the next several quarters, while the tax benefit is being realized. We’ve found it’s also common for specialist firms to require clients to commit to 3-year (or other multi-year) engagements.
Let’s take a look at how these fees affect the business’s Net Benefit.
The Net Benefit
“Net benefit” refers to the actual tax credit benefit a business realizes net of all fees paid. The R&D credit can equal anywhere from around 6-10% of QRE depending on the stage and circumstances of the business, as well as any state incentives claimed.
Therefore, when a business pays fees equal to 20-30% of the tax credit for an R&D Study (again 6-10% of QRE), their net benefit is reduced significantly.
Now, most R&D specialist firms don’t work with startups and smaller businesses. The combination of the time required for a full interview-based R&D Study, the small business’s inability or unwillingness to pay hefty fees before realizing the tax benefit, and the small credit size (relative to larger companies) just doesn’t make sense for specialist firms.
This is where you come in.
Common R&D Study Pricing Models
We don’t recommend charging startups and small businesses the market rates of 20-30%. After all, startups and small businesses truly need the extra $20-30K (in the above example) they would otherwise have to pay out in fees.
But we do expect and encourage accountants to charge a significant fee for the value they’re bringing to their clients. Again, the R&D credit can return about 10% of engineering payroll back to the business. That's a direct 10% reduction in one of the the largest cost centers for startups and small businesses.
If you’re an accountant at a small or mid-size firm, you may be wondering what’s the best way to price your R&D Study services. We’ve seen several common pricing models emerge.
The Flat Fee
We see flat fees for startups (0-15 engineers) starting at around $2,000 + a variable fee per R&D employee.
The biggest advantage of a flat fee is its simplicity. Startup founders, intent on making the most of their current runway, will look at the price tag ahead of their decision to move forward with the R&D Study and determine whether they can afford the price you put in front of them.
If the client can’t afford the original quote price, you still have the ability to lower it as long as the time commitment on your end makes sense for the lower dollar amount. How much time does it take to complete an R&D Study using RetroacDev? As we know, every company is unique. Our partners tell us it’s often about 1-4 hours for a startup, sometimes more, depending on the client’s size and circumstances.
One main disadvantage to charging a flat fee is setting client expectations too low if you plan to change your pricing model in the future. If a startup doubles or triples in engineering headcount this year, and you decide you want to tie your fee in some way to the amount of the benefit they receive, they may look elsewhere for alternatives. Startup founders are resourceful by nature and willing to evaluate alternatives before making an impulse decision.
Another disadvantage has to do with the psychology of pricing. Setting your R&D Study price too low and you risk giving clients the impression that your work product is of lower quality than the competition. On the other hand, quote your clients too high, and they may evaluate alternative providers to find out if they can get a similar net benefit for less cost.
Percent of QRE
Possibly the most lucrative of all pricing structures, the firms we see charging a percentage of QRE are usually firms who have many clients eligible to claim the R&D Credit. QRE-based fees often range from 1% to 2.5% of QRE.
There are several advantages to charging a QRE-based fee. The first that comes to mind is the ease with which you can quote a client, even when you’re unsure what their QRE or resulting R&D Credit amount might be out the outset of the engagement.
Think about it this way, if the tax credit usually amounts to a range of 6-10% of QRE and you quote the client at a fee equal to 1% of their QRE, the client can expect their benefit to be in the range of 5-9%.
One main downside to charging a QRE-based fee is that you’re significantly reducing the client’s net benefit. In this example, a fee equal to 1% of QRE would reduce the client’s net benefit by 10-20%. That may be a large reduction, but it’s likely still better than market rates, which reduce the client’s net benefit by 20-30%.
Standard Hourly Rate
We commonly see accountants charging an hourly rate when they first launch their R&D Credit practice. The biggest advantage to charging an hourly rate is that it's what your clients are already expecting from you (assuming that's your billing model).
Ultimately, your fee will depend on 1) your standard hourly billing rate and 2) the time you commit to each client’s R&D Study. To the latter point, we see a variation in the amount of detail accountants require in their R&D Studies. Some require much more detail from clients, and therefore spend much more time on each study.
Accountants who use RetroacDev report that they typically spend about 1-4 hours total per R&D Study.
As long as you, the accountant, feel you’ve done your due diligence and the methodology you've employed to calculate the client’s QRE amount is reasonable and fair, you should feel confident finalizing the study and billing the client.
As the greatest tax opportunity available to most innovative businesses, it's no wonder there's an entire industry devoted to helping businesses claim the Research & Development Tax Credit. At RetroacDev, we help small, mid-size, and cloud-based accounting firms perform their own in-house R&D Tax Credit Studies by leveraging data analytics. Interested in learning more? Schedule an intro call with us today.