Tax Credits: Cash Savings for Technology Companies as They Scale

CHRYSTELLE CAMAR: Hello everyone. Thanks for tuning in to Cherry Bekaert's technology podcast. My name is Chrystelle Camar.

I am a tax partner in the Technology Group. I am joined today by our Tax Credits & Incentives Advisory group to talk about cash savings that your technology company could benefit from, particularly in its early stages or during periods of growth.

These are cash savings from government credits. I would like to welcome Marty Karman, who leads Cherry Bekaert’s Tax Credits & Incentives Advisory practice, as well as Melinda Young and Vivian, who are both directors in the same group.

I have worked with all three of these professionals. Between them, they know everything there is to know about federal and state tax credits. They have assisted many of my clients in the past, and I am sure you will be impressed with what they have to share today.

MARTY KARMAN: Thanks so much, Chrystelle. We are happy to be here.

We have encountered a number of issues specific to the tech space where credits and incentives are both a challenge and an opportunity. Melinda and Vivian will have more to share on that.

CHRYSTELLE CAMAR: I know Melinda has been working on an item that is very valuable for technology companies experiencing staffing issues. In the current environment, I think most companies are facing these challenges.

Understanding how the government can help with these issues is very interesting to me and my clients. Melinda, if you could speak to that, I know many people would be interested.

MELINDA YOUNG: Absolutely. There has been a significant migration of startup companies moving from Silicon Valley to other parts of the country.

Austin, Denver, Atlanta, New York City, and Boston are top destinations. All these locations offer some type of tax credit for job creation.

They also offer financial and tax incentives if you negotiate with state and local governments in advance. For example, Colorado offers an Enterprise Zone program covering about 85% of the state.

The benefits include an $1,100 job tax credit. If the company also offers health insurance and pays at least 50% of the benefit, you can receive a $1,000 credit per employee for the first two years.

There is also a 12% training credit for onboarding these new employees. Another great example is the Startup-NY program.

If you partner with a local college, the program offers tax-free zones. This waives all business taxes, including corporate tax, sales tax, property tax, and even income tax for both the company and employees for 10 years.

As you can see, these are great tax-saving opportunities that provide significant value to startup tech companies, especially those strapped for cash.

CHRYSTELLE CAMAR: That is excellent information. Since the pandemic, many companies are utilizing remote work.

With remote work comes opportunities, but also states reacting to employee Nexus. Can you speak to the incentives or high-level points you have seen regarding remote work?

MELINDA YOUNG: That has been a very interesting topic for both companies and states. Initially, states required employees to live within 60 to 90 miles of the office to qualify for incentives.

Since then, states have relaxed the rules quite a bit. As long as the company has a registered location in the state and the employees are residents or paying withholding tax, they will be eligible for these benefits.

The technology industry has always been a top priority for many states. These companies usually bring high-paying jobs, which equate to higher consumer spending and a larger impact on the local economy.

To summarize, if you are creating at least 25 new jobs at a single location, offering health insurance, and paying the average county wage, we can negotiate with the state and local government for incentives. Keep in mind that negotiations must be conducted prior to making any public announcements or job postings.

CHRYSTELLE CAMAR: Is that for companies with only remote workers, or do you have to be headquartered there?

MELINDA YOUNG: It does not have to be just remote workers. Whether it is a headquarters or a non-headquarters location, as long as you are expanding in the state, you may qualify for incentives.

CHRYSTELLE CAMAR: Thank you, Melinda. You are always a wealth of knowledge.

Another big credit that affects many technology companies is the R&D Tax Credit. Vivian, this is something you work with extensively. Can you speak to this from a technology company standpoint?

VIVIAN: Absolutely. Nowadays, when people hear "tech," they immediately think of the R&D Tax Credit.

There is a lot of familiarity with this benefit because it is quite generous. Many people think they must be doing state-of-the-art work or obtaining a patent to qualify, but that is not the case at all.

There is also exciting news in this arena. Starting in the 2023 tax year, Qualified Small Businesses can get up to $500,000 in R&D Tax Credits to offset federal payroll withholding tax.

This benefit has doubled from the previous $250,000 limit. To qualify as a Qualified Small Business, a company must have under $5 million in gross receipts and no more than five years of generating gross receipts.

This election must be made on a timely filed return, including extensions. It is always better to evaluate your R&D Tax Credits sooner rather than later.

In addition to federal benefits, nearly 36 states offer R&D Tax Credits. Certain states have very valuable credits, such as Virginia with refundable credits or Georgia, where they can be used to offset state payroll taxes.

For startup companies setting up operations, there are several things to consider if they want to claim the R&D Tax Credit. One area is contract negotiations.

The R&D Tax Credit requires taxpayers to retain financial risks and development rights. It is important to set up terms and conditions that benefit you in the R&D world.

If you are evaluating time-tracking systems, we can discuss how to set those up to enable contemporaneous documentation. This establishes the Nexus between qualifying activities and qualifying dollars.

In the event of an audit, the government will likely ask for documentation showing how your activities meet the four-part test. It is good to keep these records organized and readily available.

CHRYSTELLE CAMAR: You mentioned several important points, especially regarding contracts. I often hear from startups that they aren't making money or are in a loss position, so they don't think they need an R&D Tax Credit.

It is important for listeners to know that for the first five years of operation, you can often monetize the R&D Tax Credit even if you are in a loss position. The government can essentially help fund you during those early years.

MARTY KARMAN: I have to chime in here as well. The credits carry forward for 20 years.

Often, you have to choose which method you will calculate the credit under on a timely filed return. You may lose the opportunity to pick the most beneficial method if you wait until you are taxable.

There are many incentives to look at this in real time, such as the payroll tax offset. Furthermore, many startups may be reaching taxability sooner than they think.

CHRYSTELLE CAMAR: That is a great segue. Let's discuss Section 174.

This is a change in the law that occurred in 2022. Marty, can you expand on what Section 174 is and what it means for taxpayers?

MARTY KARMAN: Section 174 is not new; it has been around since the 1950s. It covers research and experimentation expenses.

It used to be a flexible provision that allowed you to either deduct or capitalize expenses. Beginning in 2022, companies are required to capitalize their research and experimentation expenses.

This includes all expenses that go into the research credit, plus other indirect expenses. Instead of currently deducting wages for R&D, they must be capitalized and amortized over five years for domestic work and 15 years for work performed outside the U.S.

This is an incredibly onerous change for tech companies that are R&D heavy. All software development is now deemed a Section 174 expense.

While there is bipartisan support to change this, we are currently stuck with it for 2022 and 2023. It is a massive shift from how things were previously handled.

CHRYSTELLE CAMAR: So a new company could actually end up in a taxable position because they are not allowed to deduct their research and development costs?

MARTY KARMAN: That is correct. In the first year, you can only deduct about 10% of your expenses due to five-year amortization and the mid-year convention.

Planning around this is vital. If you have Section 174 costs that are creating taxable income, you should likely have R&D Tax Credits to offset that impact.

The R&D Tax Credits are more valuable than ever before. There is also planning regarding what constitutes true development versus maintenance or configuration.

If you are acquiring software rather than developing it, the tax treatment differs. Most importantly, Section 174 is not elective; it is automatic.

Even if you aren't claiming a research credit, if you are performing activities with technical uncertainty, you have Section 174 costs. You should definitely look at the research credit to offset the negative effects of capitalization.

CHRYSTELLE CAMAR: My biggest takeaway is that startup companies need to look into this immediately. You should contact our team to evaluate R&D Tax Credits and Section 174.

The playing field has changed. There are many opportunities and landmines that can be avoided.

MARTY KARMAN: In my experience, the more granular data we have, the better we can identify items that do not need to be capitalized. This allows us to maximize the research credit at the same time.

CHRYSTELLE CAMAR: Thank you very much, Vivian, Melinda, and Marty. We hope our listeners found this valuable and will consider how these cash savings relate to their companies.

Our team is here to help, so please reach out anytime. You can find our contact information at cb.com.

To stay up to date on the latest accounting trends affecting technology companies, be sure to subscribe to this podcast. Thank you again for tuning in.