Understanding the complexities surrounding the R&D Tax Credit is no small task. We've interviewed and led discussions about the R&D Tax Credit, the types of activities that may qualify, how R&D Studies are traditionally conducted, and a whole lot more with hundreds of accountants, R&D tax credit specialists, startup founders, and company leaders. This is our working knowledge-base. Yours for the taking!
Importantly, we are not an accounting firm, none of this should be taken as tax advice.
We're a software startup! We're here to help businesses claim the R&D Tax Credit more efficiently by enabling accountants to perform R&D Studies using a combination of AI, data analytics, automation, and technical knowhow.
Calculating & Estimating the R&D Tax Credit
R&D Tax Credit Calculation
The first step in calculating the R&D Tax Credit is to determine the business's Qualified Research Expenditure (QRE) in the tax year. This is the primary objective of an R&D Study. In order to make that determination, businesses often look to their accounting group or an outside provider to help them determine how much Qualified Research Activity the businesses engaged in during the year. (Side note: The firm in charge of the R&D Study will compile their findings into documentation that will be used to defend their tax credit if the business is audited by the IRS in the future. More on the documentation process later.)
There are two ways to calculate the R&D Tax Credit: the Regular Credit method and the Alternative Simplified Credit (ASC) method. The credit's formal name is the Credit for Increasing Research Activities, and in both methods, the relative size of your credit will depend on the extent to which your current year QRE exceeded your previous year(s) QRE.
Because W-2 Wages and 1099 Contractor expenses make up over 84% of QRE across all industries (IRS data, 2014), year-over-year engineering team (or similarly, investment in engineering) growth is often a primary determinant of the size of the tax credit in a given year. Of course, that's not always the case, but it's a good rule of thumb.
The Regular Credit method is complicated and often used to calculate the credit for much older companies. Most startups and early-stage companies use the ASC method, so that's what we'll focus on here.
The Alternative Simplified Credit (ASC)
To calculate QRE using the Alternative Simplified Credit method:
First, determine the average QRE from the last three years.*
Multiply that average by 50%.
Subtract that amount from your current year QRE.
Multiply the remainder by 14% and you have your current year R&D Tax Credit.
*If there were no QREs in any previous tax years, calculate the current year's QRE and multiply by 6%. This is your first-year R&D Tax Credit.
Quickly Estimate a Business's R&D Tax Credit in 4 Simple Steps
Determine the business's engineering payroll. That is, how much in W2 wages were paid to engineers and engineering managers, plus any/all amounts paid to engineering contractors.
Other expenses like the wages of engineering support staff, supplies, some rental costs may qualify for the R&D Credit, but wages and contractors make up the majority (over 84% in 2014, the latest IRS data available) of Qualified Research Expenditure across all industries and are likely easiest to identify.
Estimate how much of the team's time was spent on Qualified R&D Activities.
For a startup, an estimate of 70% is a good place to start. The IRS allows businesses to claim 100% of the W2 wages for employees who spent "substantially all" (80% or more) of their time on Qualified R&D activities, so if you estimate the Qualified R&D amount to be 80% or more for salaried employees, you might as well use 100% instead. This rules does not, however, apply to contractors. In fact, the IRS requires you take a 35% haircut from any contractor expenses you're claiming toward QRE, right off the top.
Multiply engineering payroll by your estimated Qualified R&D percent (from #2) to get your estimated Qualified Research Expense (QRE) for the year.
Example: A startup has 10 software engineers each earning $90,000 in wages and 1 contractor who was paid $100,000 in the tax year.
W2 employees: 10 engineers * $90,000 salary = $900,000
Contractors: 1 contractor * $100,000 contractor payment * (1-0.35) = $65,000
Total engineering payroll = $965,0000
Qualified Research Expenses = $965,000* 70% (estimated Qualified R&D %) = $675,500
Multiply QRE by 6-10% to get your estimated R&D tax credit.
The 6-10% range represents variables including the federal credit + any state R&D credits, the amount of Qualified R&D, and the age of the company (startups developing brand new products are often engaged in more qualifying activities than existing companies). We'll use 8% in the example below to keep it simple:
Example continued: Qualified Research Expenses of $675,500 * 8% credit = $54,040 R&D tax credit
Economics of R&D Study Services
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.