5 startup tax credits available in the US

Starting a new business is fun, exhilarating, and comes with the potential for immense success. Of course, it’s also expensive. Cash running out, or the failure to get more capital, is often listed as the top reason why startups in the United States tend to fail.

Fortunately, capital investments or personal savings aren’t the only opportunities to raise the funds needed for your startup to survive and thrive. Savvy founders know where to unearth tax credits that can help to reduce expenses and drive innovation.

These credits can change over time, and some can be difficult to find. So we’ve made it simple. As you build and grow your startup, consider these 5 tax credits as potential opportunities for your business.

1. The $250,000 R&D federal tax credit

As perhaps the biggest tax credit available to U.S. startups today, the research and development credit deserves top billing on this list. First introduced in 2015, eligible startups can use up to $250,000 in credits against their payroll liability every year.

The R&D tax credit is only available to startups that have generated revenue for less than five years, and have generated less than $5 million in annual revenue while not yet being profitable. Costs that can be claimed towards the R&D tax credit include developing new or improving existing products, processes, or services, trial and error processes, and science-related activities.

To receive the R&D startup tax credit, the IRS requires exact documentation of all activities related to the cost to be claimed. That includes payroll records for any employees involved in R&D, supplies and equipment and any third-party payments related to R&D, as well as the blueprints, patents, designs, and prototypes coming from the research process.

2. The small business health care tax credit

The federal health care tax credit for small businesses provides up to 50% of health care premiums to eligible businesses. It’s designed to promote and encourage small businesses and startups to offer health care to their employees.

To become eligible, your startup should have fewer than 25 full-time equivalent employees, meaning their total hours should add up to less than the work hours of 25 full-time employees would take. Each employee for which you claim the credit should earn less than $56,000, and employees should be enrolled in a federal small business health plan.

Once those criteria are established, claiming the credit is fairly simple. Eligible employers simply need to complete the IRS Form 8941 to calculate their tax credits and provide the form as part of the income tax return.

3. The startup tax credit for retirement plans

As outlined by the IRS, startups can also benefit from offering their employees a qualifying retirement plan. More specifically, eligible businesses can claim up to $5,000 annually for up to three years when they start a company-wide retirement plan for their team.

Any startup is eligible for this credit as long as they have 100 or fewer employees, with at least one being a non-highly compensated employee. Finally, none of the employees for whom you claim the credit can have received a different type of retirement plan from your business.

The tax credit consists of 50% of the cost to start up the retirement plan, up to a $5,000 annual limit. Claiming it requires completing IRS Form 8881 and submitting it during the three years for which your startup is eligible as part of its income tax return.

4. The CARES Act employee retention tax credit

While the above tax credit opportunities are well-established and largely permanent, 2020 threw a wrinkle in the tax landscape for startup businesses. In an effort to reduce layoffs among small businesses, the CARES Act added funding specifically designed to help fund the retention of employees of new startups.

Renewed with increased funding in 2021, this tax credit provides up to $7,000 in credits per employee for each of the third and fourth quarters in 2021, with a total cap of $50,000. While the program was designed for 2021 and 2020 only, businesses that were negatively impacted by the COVID-19 pandemic can still retroactively claim their credits for the previous year.

The eligibility requirements are fairly straightforward: the business has to have begun its operations after February 15, 2020, with annual gross revenue since then not exceeding $1,000,000. Once eligibility is confirmed, only W-2 employees that are not the owner or their relatives count towards the credit.

As the IRS outlines, claiming the retention tax credit simply includes amending Form 941 for payroll tax according to its eligibility requirements. The credits will be issued under normal business tax return procedures. While eligibility ends for workers who were employed with the end of 2021, claims can be filed through the end of 2022.

5. The work opportunity tax credit

Finally, startups and other small businesses who hire certain targeted groups, as defined below, are able to receive a work opportunity tax credit of up to $9,600 per employee through at least 2025. There is no limit to how many employees can be claimed.

Targeted employee groups that are eligible for the tax credit include:

• Military veterans
• Ex-felons
• Vocational rehabilitation referrals
• SNAP recipients
• SSI recipients
• Long-term unemployment recipients
• And more

The credit can extend to every employee who fits that group but is limited to the income and social security tax liability of your startup. In other words, you cannot get more money back through the work opportunity credit than you own in income and social security taxes.

To claim employees under this tax credit, your startup will need to complete Form 5884, as well as mention the credit as a general business credit on Form 3800.

Building your startup, the smart way

Of course, these are just some of the many tax credits that your startup business might be eligible for. Some of them are industry-specific, and many are built on state and local statutes. In fact, some experts estimate that there are more than 1,000 federal, state, and local tax credits available for qualifying startups.

No matter the exact number, you still need to be prepared. Tax credits can drive down costs, but you still need an efficient digital operation to help your startup succeed.

That’s where DigitalOcean comes in. Our simple cloud solutions can help startups across industries improve the efficiency of their daily operations. Ready to learn more? Read how other customers have leveraged our solutions for sustainable success.