Angel Insights Blog

By: Marianne Hudson, ACA Executive Director

This post originally appeared on Forbes.com

One of the best parts of being an angel investor is supporting companies after you invest.  And now angels have a new support tool in our pockets for portfolio companies – a new federal tax benefit that can add up to $250,000 per year for these young businesses.  This is real money for startups – and better yet, it is totally non-dilutive to angel investor equity!

I learned about the Federal Research and Experimentation Tax Credit and how it will change for qualified startups at a recent meeting of the Angel Capital Association and I think it is important to get this news to as many angels and entrepreneurs as possible, so they can benefit as soon as possible.  Cash is short for angel-backed companies, so finding extra money – especially of this size - is really important.

Beginning in 2017, the R&D tax credit includes a new way for “qualified small businesses” to receive a credit for their research expenditures by offsetting their payroll taxes.  Let me say it another way so that the benefit for startups is clear:  the R&D tax credit has existed for 35 years, but the credit went to a company’s income taxes.  Because startups don’t generally have much income, the credit was rarely applied, making it irrelevant to them.  But startups DO have employees – so they really can monetize credits to their payroll taxes.

As Brent Johnson of Clarus Solutions (a tax service that focuses on the R&D credit) puts it, “The R&D Tax Credit was pretty much a ‘big boys club’ with an income-based credit. This didn’t work for startups that didn’t have income.” Congress recognized this problem, as well as the fact that new businesses are job-creators, and passed legislation that creates a second way to take the tax credit.  I guess startups are now members of an expanded club.

Newer companies qualify for the payroll offsets for the 2016 tax year if the startup was launched after 2011 and their 2016 revenues are less than $5 million.  2017 is the first year companies can file for these expenses in the 2016 tax year.  There are many detailed requirements to take advantage of the credits, but here are the main points:

• The tax credit can be up to 10 percent of a company’s expenditures in the creation of innovation” (AKA Research & Development). These expenses are for research-related employees, contractors, and non-depreciable supplies. As Jeff Haskett of Clarus Solutions notes, “imagine a company that has spent $1 million in developing their new product or service – the benefit could be as high as $100,00 that year.”  The maximum benefit is $250,000 per year.  If the company is entitled to more credit than $250,000 in a year, it can carry forward that excess as an income tax credit for up to 20 years.

• Startups have a five-year window to take advantage of the R&D credit via the payroll offset option.  After five years, the credit can only be monetized through income taxes.  So it is important for qualifying companies to file as early as possible so they don’t miss any quarters of possible benefit.

• New companies need to “elect” to take the credit as early as they can in 2017 to maximize their benefit.  This requires filing an IRS Form 6765, before or along with their quarterly payroll report, to start the credit process.  Naturally, this IRS form is really related to income taxes, so the process isn’t crystal clear. There are some questions the Federal Government needs to answer to provide a clearer path for filing their credit election paperwork.  What is clear is that this form needs to be filed on or before the extended due date of the company’s income tax return in order to be valid.  Missing this date will result in missing the opportunity to monetize the credit against payroll tax for 2016.

• Startups should connect with a payroll company or other third party to make sure they qualify for the credits, to calculate the credit, and to determine their best options to monetize the credit.  Experts can put together a report that backs up the company’s election filing and answer questions about how the program works.  It might take a day or two of time, but the potential $250,000 per year is worth it.

• The new rules also allow for companies with $50 million or less in revenue to offset liabilities for the Alternative Minimum Tax, so there are additional benefits for startups as they mature and grow, and are no longer eligible for the payroll offset.

Johnson and Haskett provided many other details in a recent ACA webinar focused on this topic. (ACA members can listen to the archive for free here.)   They believe it is really important for angels to share information about the new credit rules with the companies they work with, and I agree.  Johnson says, “If you think about it, this money is a new form of non-dilutive capital that can help companies be more successful.”  As mentors and advisors to startups angels can let startups know about this credit so they don’t miss the boat and ask questions to ensure they are negotiating the process and rules in the right way.