Jul 25, 2025
Your startup might be sitting on tens—or even hundreds—of thousands of dollars in unclaimed R&D tax credits. Many founders don’t realize that the code their team writes, the features they ship, and the problems they solve every sprint can qualify for powerful federal and state tax credits built to reward innovation.
The R&D tax credit isn’t some obscure loophole. It’s a permanent incentive, backed by IRC Section 41, and designed to support exactly what you're doing: building new technology, improving existing products, and solving hard technical problems.
But many startups miss out—or claim far less than they should—because their CPA treats them like a traditional business instead of what they are: an engine of innovation.
What Qualifies as R&D for Tax Credits (It's Broader Than You Think)
The IRS uses a four-part test to define what qualifies as R&D—and it’s surprisingly founder-friendly. If your team is building tech, solving tough problems, and iterating on new ideas, there’s a good chance your work qualifies.
Here’s how the IRS breaks it down:
1. Developing New or Improved Functionality: If you're building new features, designing better algorithms, or improving user experience through technical innovation, you're likely doing qualified research. Writing code to solve problems without obvious answers? That’s a green flag.
2. Eliminating Technical Uncertainty: This applies whenever your team tackles a technical challenge where the path forward isn't guaranteed. Think: optimizing database performance, scaling your infrastructure, integrating with tricky third-party APIs, or debugging behavior no one’s seen before.
3. Following a Systematic Process: No need for lab coats or academic papers. If your team works through problems by identifying issues, testing solutions, and iterating based on results, you're already doing what the IRS expects. Agile sprints, pull requests, and retros? That counts.
4. Engaging in Technological Experimentation: Trying multiple solutions, running A/B tests on technical implementations, or experimenting with different architectures and data models all count. It's not about success—it's about the process of testing what could work.
Common Startup Activities That Qualify
Most startups qualify for R&D credits on more activities than they realize. If your team is building, optimizing, or experimenting with technology—not just maintaining it—there’s a good chance those efforts qualify.
Here are specific examples of activities that typically meet the R&D credit criteria:
Software Development Beyond Basic Coding:
Building machine learning models or algorithms
Developing new frameworks or libraries
Creating complex third-party integrations
Building mobile apps with novel functionality
Developing data ingestion, transformation, or processing pipelines
Working with advanced AI systems (e.g. building or fine-tuning generative AI models, integrating LLMs like GPT-4, or creating prompt engineering frameworks)
Product Development and Enhancement:
Designing and releasing new features
Rebuilding or improving existing functionality
Developing internal tools that don't exist commercially
Creating custom reporting dashboards or analytics systems
Building APIs or full software platforms from scratch
Infrastructure and Performance Optimization:
Scaling architecture to handle growth or load
Optimizing database or query performance
Building automated CI/CD and deployment pipelines
Developing security or encryption layers specific to your use case
Creating real-time monitoring, alerting, or health-check systems
Technical Problem-Solving
Debugging issues with no clear fix or known solution
Engineering around limitations of third-party tools or APIs
Developing custom workflows for edge-case business needs
Creating new technical processes to improve speed, quality, or cost-efficiency
The key insight is that if your team is solving technical problems that don't have obvious, off-the-shelf solutions—you’re probably doing qualified research.
How Much Money Are We Talking About?
The federal R&D tax credit is typically worth 7–10% of qualified research expenses (QREs) for startups using the Alternative Simplified Credit (ASC) method. In some cases, the benefit can be even higher.
For most tech startups, QREs include:
Employee wages for time spent on qualified activities ((often 60–80% of developer time, depending on how much of their work is technical and problem-solving)
Contractor payments for software engineers, data scientists, or other technical contributors
Supplies and materials used in experimentation, testing and prototyping
Cloud computing costs for dev, test, and staging environments (e.g., AWS, GCP, Azure)
A typical early-stage startup with five to ten developers can claim $50,000 to $200,000 in federal credits each year. Later-stage startups often claim $200,000 to $500,000 or more, depending on headcount and project scope.
You can also amend prior-year tax returns—usually up to three years back—to claim missed credits and potentially get cash back.
Note that the 2025 tax law permanently reinstated full expensing of U.S.-based R&D costs, reversing the rule that had required businesses to spread deductions over five years. This change means startups can now deduct 100% of eligible R&D expenses in the year they’re incurred—resulting in faster tax savings and better cash flow.
Importantly, the law also includes a catch-up provision for small businesses. If you were required to amortize R&D costs in prior years (starting in 2022), you may now be eligible to amend those returns or claim a one-time catch-up deduction for the remaining unamortized balance. This can generate a significant refund or offset current-year income, depending on your situation.
The Startup-Specific Advantage: Claiming Credits Against Payroll Taxes
Here's where the R&D credit becomes especially powerful for startups: if you don’t owe much in income tax (which is most early-stage companies), you can use the credit to reduce your payroll tax bill instead—and get the benefit now, not years down the road.
Thanks to provisions originally introduced in the PATH Act and later expanded by the Inflation Reduction Act, qualified small businesses can now use up to $500,000 of their federal R&D credit per year to offset payroll taxes:
$250,000 against the employer portion of Social Security taxes, and
$250,000 against the employer portion of Medicare taxes
This split gives startups access to more immediate cash—even before they’re profitable.
For example:
If your engineering team earns $1.5M in qualifying wages and you generate a $120,000 R&D credit, you could apply that credit directly against your company’s payroll taxes—reducing your required tax deposits and freeing up cash each quarter.
To take the payroll tax offset, your company must:
Have less than $5 million in gross receipts in the current year, and
Have no gross receipts before the five-year period ending with the current year
Make the election on a timely filed original federal income tax return (including extensions) for the year the credit is generated
Missing the filing deadline—even by a day—means you lose the ability to use the credit against payroll tax. This is one of the most common and costly mistakes startups make with R&D credits.
To claim the credit, you need the following forms:
Form 6765 is used to calculate the credit and make the election for payroll tax offset
Form 8974 is used each quarter to apply the credit to payroll taxes
These forms are submitted with your federal income tax return and your quarterly Form 941.
State Credits Can Double Your Benefit
While federal R&D credits get most of the attention, state-level credits can add tens (or even hundreds) of thousands more to your total benefit—especially if your team is building in states with strong programs.
Many states offer their own R&D credits, and they often stack on top of the federal benefit. Some are even refundable, meaning you can receive cash back even if you don’t owe state tax yet.
Here are a few standout examples:
California: Offers a 24% credit for in-house R&D wages (15% for contract research). Unused credits carry forward indefinitely, and the credit is often larger than your federal benefit—especially for startups with significant development teams in-state.
New York: Offers a 9% credit, with additional incentives for small businesses and high-tech startups. Unused credits can carry forward for up to 15 years.
Connecticut: Offers a 6% credit, including a refundable option for qualified small businesses—meaning you may get a check even without tax liability.
Illinois: Provides a 6.5% nonrefundable credit with multi-year carryforwards, and additional support for small and mid-sized companies doing technical work in-state.
Many startups now operate with remote or distributed teams, which makes it especially important to read the fine print when it comes to state R&D credits. Each state has its own rules for determining whether research activity qualifies as “in-state.” Some look at where employees physically work, while others focus on where payroll is run, where IP is managed, or where leadership is based. Getting this right can significantly increase your total credit. Getting it wrong can mean under-claiming—or worse, inviting audit issues. If you're operating across multiple states, it's worth working with a tax advisor who understands how to navigate both federal and state R&D credit rules.
Common Mistakes That Cost Startups Money
Town’s team has helped many startups with their tax planning. navigate R&D credits—and we’ve seen a familiar pattern of avoidable mistakes. These are the most common ways companies leave money on the table:
Filing Tax Returns Late and Losing R&D Credits Entirely
“The biggest mistake we see is startups filing their tax returns late,” says Anjum Tunuli, Head of Tax at Town. “Even though they qualify for the R&D credit, they can’t use it—because the rule is, if you file late, you can’t use it to offset payroll tax.”
This hits early-stage startups the hardest. As Anjum notes, “Most startups, because they’re not profitable, don’t pay income tax. So 90% use the R&D credit to offset payroll tax.” Miss that filing deadline—even by a day—and you lose the entire benefit, regardless of how much you qualified for.
Treating R&D Credits Like a Compliance Afterthought
Many founders approach R&D credits reactively—scrambling at tax time instead of tracking qualified activities as they happen. The best results come when you document technical work throughout the year, not when you're trying to reconstruct it under deadline.
Underestimating Qualified Activities
It’s common for CPAs to take a conservative stance and only claim credit for core product development. But a lot more typically qualifies—like infrastructure work, optimization projects, AI/ML experimentation, and internal tooling. If your team is solving hard technical problems, there's a strong chance it qualifies.
Overlooking State Opportunities
Startups often focus on the federal credit and miss valuable state credits, especially in states like California, New York, and Connecticut. These can materially increase your benefit—and in some cases, are refundable even when you’re not profitable.
Weak Documentation and Time Tracking
The IRS expects reasonable support for how much time was spent on qualified R&D. If you can’t show what engineers or contractors were working on—and for how long—your credit could be reduced during an audit. Tools like Jira, Linear, or Asana (if configured well) can make this easier than you’d think.
For original tax returns, the IRS generally looks for five basic things: what you were building, what technical work was involved, who worked on it, what problems you were trying to solve, and how much you spent. For amended (refund) claims filed after June 18, 2024, some of the up-front requirements have been relaxed—but the IRS can still ask for full details later.
Bottom line: whether you’re filing now or amending later, keeping organized records gives you the strongest position—and makes the process much smoother.
Not Understanding Multi-State Implications
For remote or distributed teams, it's critical to understand how different states define "in-state" research. Rules vary, and misallocating expenses can lead to reduced credits or compliance issues. Multi-state claims require more nuanced guidance than most generalist firms provide.
How to Set Up Systems for Maximum Credit Claims
The most successful startups don’t treat R&D credits as a once-a-year scramble. They build credit tracking into their normal operations—making tax season faster, smoother, and more profitable.
Here’s how to do it without creating extra work for your team:
Start with project-based time tracking. Tools like Linear, Jira, or Asana can be configured to show how developers spend time across different initiatives. If you can tie hours to specific projects or problem-solving efforts, you're already doing the hardest part of IRS documentation.
Layer in technical documentation. You’re likely already doing more than enough—it just needs to be captured. Engineering specs, retros, design docs, source code repositories (like GitHub or GitLab, with clear commit messages), and notes on technical challenges or failed approaches all help support your claims.
Go beyond payroll by tracking expenses by project or activity type. That includes cloud spend, dev tools, data storage, or anything else tied to research work. Most startups underclaim here.
Finally, build in quarterly reviews with your tax advisor. These don’t need to be heavy lifts—just quick check-ins to flag qualifying projects, capture documentation while it’s fresh, and plan around any state-specific filing windows.
The key is to make this part of your operating rhythm—not something you reconstruct under pressure once a year.
Planning Around Funding and Growth
R&D credits don’t just get bigger as you scale—they also get more complex. How you plan for them should evolve with your company’s growth stage.
Pre-Series A
At this stage, focus on the basics that drive immediate cash flow:
Prioritize the federal credit with payroll tax offset
Explore state credit opportunities, especially if your dev team is located in a credit-friendly state
Build lightweight systems now—tracking time, cloud costs, and technical work is far easier when the team is small
Series A and Beyond
As your business matures, the credit becomes a strategic tool—not just a tax perk.
Start thinking about how equity compensation, multi-state operations, and contractor-heavy teams impact your claim
Consider timing credits with funding rounds or revenue milestones, especially if you’re moving from loss to profitability
Ensure your documentation processes scale with your team and codebase complexity
Exit Planning
R&D credits don’t disappear in a transaction—they can impact both sides.
Unused credits can increase deal value if properly documented and carried forward
Make sure your credit history and support files are clean; buyers will review them during diligence
Coordinate with legal and finance teams to maximize post-exit use of any carryforwards
The earlier you start planning, the easier it is to capture the full value at each stage. R&D credits aren’t just a tax break—they’re a growth asset.
Taking Action: Your Next Steps
Right Away
Start tracking development time by project and activity type using tools your team already uses—like Jira, Asana, or Linear. Look back at the last three years of technical work to identify potential missed credit opportunities. You can amend prior-year returns to claim credits and potentially generate refunds. Estimate what your credit could be based on developer wages, contractor costs, and cloud spend.
This Quarter
Set up lightweight systems to document technical challenges and solutions as they happen. Meet with a tax advisor who understands startup R&D to scope this year’s credit and identify optimizations. Begin mapping out state credit opportunities based on where your team actually works—not just where your HQ is.
Ongoing
Make R&D credit tracking part of your quarterly tax and finance cadence. Coordinate it with hiring plans, fundraising timelines, and multi-state expansion. If you’re growing, your credits should be growing with you.
Need help getting started? Town specializes in helping startups maximize credits,meet filing deadlines, and align credit planning with growth. If you'd like support, our team is ready to help.
The R&D tax credit is one of the most powerful financial tools available to early-stage and growth-stage startups—often worth more than any other tax benefit. The work you're already doing likely qualifies. The only question is: will you claim the credit, or leave it on the table for another year?
