For entrepreneurs seeking to expand a small business or start a new one, access to capital is the most critical factor to success. But many fledgling organizations lack what it takes to secure private financing, such as strong balance sheets and lead investors.
One solution to this conundrum? The availability of government-sponsored research and development (R&D) incentive programs at the federal, state, and local level. Regardless of whether a business is the prototypical startup focused on technology and innovation or a more traditional non-technology small business, it’s likely to be eligible for some combination of tax credits, grants, and other incentives.
Many entrepreneurs may believe that, because they aren’t operating in technology and research-focused sectors, they aren’t eligible for R&D incentive programs. But given how many groups stand to benefit from such programs—businesses, the government, and, in some cases, even investors—it should come as little surprise that businesses across a broad range of industries can, and should, take advantage of R&D funding opportunities. Below, we explore just a few of the choices currently available.
Funding through Federal Incentives
Policymakers seek to foster environments that encourage businesses to create and retain jobs, make capital investments, promote development of distressed or rural areas, and promote U.S. innovation and technological prowess. The U.S. Small Business Administration (SBA), in particular, seeks to provide funding to entrepreneurs and small businesses when private banks are not inclined to do so.
There are several federal incentives available for small businesses from the SBA. For example, the Small Business Innovative Research Grant Program (SBIR), a federal program coordinated by the SBA for small businesses to help fund R&D, awards nearly $2.5 billion annually through contracts or grants. These funds are provided to businesses pursuing projects that have the potential for commercialization and meet specific U.S. government needs. Further, there’s the highly competitive Small Business Technology Transfer Grant Program (STTR), which expands funding opportunities in innovation by offering grants to small businesses to formally collaborate with research institutions.
The Internal Revenue Service has also designed programs to stimulate the economy, such as the federal R&D tax credit, an activity-based credit intended to incentivize investments in innovation within the United States. Businesses of all sizes and across many industries can use the benefits generated from spending on past and future R&D activities to increase their cash flow to hire more employees, invest in equipment, expand their operations, and explore new opportunities.
Now that the R&D credit has been made permanent by the passing of the Protecting Americans from Tax Hikes (PATH) Act of 2015, finance executives are better able to include these credits in their tax planning and decision making. As a part of the PATH Act, there are two new opportunities for certain eligible small businesses to offset the Alternative Minimum Tax (AMT) with R&D credits or for qualified small businesses to elect annually for five taxable years to take up to $250,000 in credits against the employer’s portion of federal payroll taxes (FICA). These opportunities allow companies to monetize credits where they previously could not because of a lack of federal income tax liability.
Federal R&D tax credits can cover a broad swath of activities — not just groundbreaking discoveries. In fact, research activities don’t necessarily have to be successful to qualify. They simply must meet the following four criteria:
- Permitted Purpose Test. Activities must be intended to develop or improve the functionality, performance, reliability, or quality of a product, manufacturing process, software, invention, technique, or formula (business component).
- Process of Experimentation Test. Activities must be designed to evaluate one or more alternatives to achieve a result.
- Technological in Nature Test. Activities must fundamentally rely on the principles of engineering or the physical, biological, or computer sciences.
- Uncertainty Test. Activities must attempt to eliminate uncertainty regarding the capability or method of developing or improving the component or the component’s appropriate design.
Companies in just about every sector, from a fashion designer experimenting with new textiles to a manufacturer exploring ways to reduce its ecological footprint, undertake activities that pass these tests.
State and Local Opportunities
At the state and local levels, there are many opportunities to support the various needs of startups and small businesses, including funding, tax credits, incubator space, and partnerships with other businesses. The opportunities offered by state and local governments vary, but stress the same theme: encouraging startup businesses to grow. States and localities provide both statutory incentives as well as negotiated incentives. As a finance executive, you should consider all opportunities offered by the state(s) and communities where you conduct business to ensure you aren’t leaving anything on the table.
State and local incentives include government resources and assistance, direct government financing, direct and indirect private investment incentives, R&D credits, SBIR and STTR Grant Program-related incentives, tax credits for startups, and sales/use tax and property tax exemptions. To paint a picture of how varied and significant these opportunities can be, we list just a few examples of different programs and incentives offered in three major states.
California offers incentive programs, government resources and assistance, R&D tax credits and other incentives. For example, the California Competes Tax Credit—25% of which is reserved for small businesses—is an income tax credit available to businesses that want to locate in California or stay and grow within the state. California also has California Small Business Development Centers, which provide small business owners and entrepreneurs with direct and personal technical assistance through professional consulting and low-cost or free seminars and conferences.
California’s R&D tax credit follows the federal credit and offers a benefit for qualified activities taking place within the state. Although the federal R&D credit can be carried back for one year and carried forward for 20 years, California differs in that the state credits can be carried forward indefinitely.
Through its START-UP NY program, New York offers new and expanding businesses that partner with, and are on or near, an eligible university or college the potential to pay zero taxes for 10 years. It further offers direct access to advanced research laboratories and development resources and experts in key industries or schools. New York City has also found ways to cut costs for startups. Informally referred to as the locations of Silicon Alley, the city offers several incubator locations that have provided initial housing or shared office space for many startups and their employees at minimal cost.
Massachusetts encourages startups to invest in R&D machinery and equipment by offering sales/use tax exemptions. If a startup in Massachusetts is buying gas, steam, electricity, or heating fuel, and has five or fewer employees, it can be exempt from sales and use tax through the Massachusetts Small Business Energy Exemption. Too, the Massachusetts Small Business Exemption provides a property tax exemption on commercial property that has an assessed value of less than $1 million and is occupied by a business that had a total average annual employment of less than 11 during the previous year.
States also provide direct government-financing options, including access to capital and preferred terms with banks, low-cost loans, cash grants, and seed capital. There are also incentives for investors in startups, either those directly investing in them or those investing in venture funds that invest in startups.
For example, New Jersey has an Angel Investor Tax Credit program available to investors in qualified emerging technology businesses in the state. The program enables individual and corporate investors to receive a refundable tax credit equal to 10% of the qualified investment in the eligible emerging technology company. Moreover, the individual or corporate investor need not be a New Jersey taxpayer to qualify for the refundable Angel Investor Tax Credit. Other state tax credits include employee health insurance credits, credits for setting up pension plans, and small business credits.
These are just a few examples of the numerous and varied financing programs, business assistance and tax incentives offered by federal, state and local governments to help startups and small businesses find creative ways to meet their business needs. CFOs and other senior financial executives should take advantage of those opportunities to help meet the programs’ goals of creating jobs, sustaining economic development, and assisting new ventures succeed and thrive.
Chris Bard is National leader of R&D tax credit services at BDO USA, and Janet Bernier is the leader of the Northeast region of the state and local tax practice and Chai Hoang is an R&D tax manager at the accounting and professional services firm.