BoneChat #26 - No brainer R&D tax credit money for ortho startups

So we are live today with John and Sybil from Claris R D. Alyssa had recommended this tax break topic a while back and it was, it was voted up by the members. And so John and Sybil are the perfect pair to explain this. So I'm going to hand the mic over to John and Sybil. Welcome to Bone Chat.

Hi everybody. I'll start off with just a short intro on myself and I'll pass it on to John to get going on the topic of the R and D tax credit. But as Tiger mentioned, my name is Sybil Bailey. I'm a partner account executive at Claris R and D. Really happy to join and answer some questions on our favorite tax credit, the research and development tax credit. So I have one of the tax credit experts from our team, John Berku, on the call. I'll let him do a short intro and then we have a short slide deck that we'll go through and then we'll open it up to a Q and A at the end. Answer all of your guys's good questions. If there are any other questions that you guys have, you can put them in the chat and I'll answer those as we go. Also put some different links and resources in the chat for you guys to have for the future. But once again, thanks for having us.

Perfect.

Thanks, Sybil. My name is John Berkhue. Make sure I'm off mute. Yeah, my name is John Berkhue. I'm at Claris R and D as well. So I've Sybil mentioned I'm on our tax operations team. So our job is to help companies facilitate the credit our company developed. And we'll get into this in the presentation. But our company developed a software to help new or at the time, smaller businesses, but we've expanded into the much larger companies as well, help them claim the R and D credit. Our software acts as a hub for the R and D credit so it makes it easier, keeps everything in one spot. So our job is to help help companies work through the software and work through any tax questions that come up throughout claiming the credit, specifically related to development or how the credit's applied, things like that. So I'll go ahead and jump into the presentation. We'll talk through a little bit about the credit, the history, and then we'll get into talking about more about our application. And then Sybil will have some follow up on not just how to claim the credit, but how certain organizations can partner with us as well. If you're out there and you have multiple clients that you're working with. We have several ways to partner with us and make the credit available to different companies. Perfect. So.

Can everybody hear?

Yeah, I apologize. I'm getting some feedback. There we go. Okay, I apologize. Perfect. Yeah, my headphones are cutting out there for a second, but perfect. So we'll jump into the history of the credit first. So the credit came about the early 80s, specifically in 81. It was created by the US government in order to spur innovation and job growth in the US By US best workers. So the government realizes that innovation is expensive and they wanted to offer a tax break to companies that were performing R D activity and investing in furthering their product or investing in, you know, the development of new products across the board. So they realized that that development leads to the growth of domestic jobs and domestic business. And so that's why they wanted to create this incentive. They realized in 2015 that that incentive had been limited to much larger companies. There was. There's two. And we'll get into this in the next slide. There's two ways to monetize the credit. One is to offset income tax using the credit. And the other is for more early stage companies. You're able to use that credit to offset payroll costs, payroll tax costs as well. And so they realized up until 2015 that the companies that had access to claim the credit, it was being under claimed because a lot of the companies that were performing R and D are in those earlier stages, not yet profitable. They're not generating income tax at that point. So the only companies that could claim it were companies that had an income tax to offset. So with the PATH act pass that, and that created the R and D credit permanently in the code. So that that meant that there was no need to re up the credit on an annual basis. And then in addition to that, it created that payroll tax offset. And so with that, much smaller companies or early stage companies are able to claim the credit now. And so our model has been to make a credit more accessible for companies, early stage companies, from a cost perspective, in a technology perspective, kind of the more traditional way to claim the credit, you have people on site. So that model didn't really make sense for early stage companies that have two or three employees. So between a cost aspect and the way that the software works. And then finally in 2023, this past year, the R and D credit was expanded again through Inflation Reduction act. And the payroll tax credit has a limitation of $250,000 on an annual basis. However, the Inflation Reduction act actually increased that up to 500,000. And you're not only offsetting both Medicare and employer portion of Social Security tax as well. Perfect. So as I mentioned, there are two ways to claim the credit. The first one on the left is the payroll monetization route. Like I said, this is for companies that are a bit more early stage. In order to claim this monetization route, you have to have less than $5 million in gross receipts for the current tax year and you have to be within the first five years of having any gross receipts. So you can claim the payroll monetization up to five times. So you're not limited to using that in that five year period though. So if you claim it four or five times and you accumulate a significant amount, you can carry that forward for up to 20 years and continue to use that even while you claim the income tax credit as well. So the second version is the income tax credit. This one is applied if you're generating, if you're profitable and you're generating an income tax liability, you can use the credit to offset that liability on a dollar for dollar basis. And that also can be carried Forward up to 20 years. So a little bit on what qualifies for the credit. So the four part test, which is what's on this slide, governs the R and D credit and outlines the types of work that will qualify for the credit. So in order to meet the criteria, there's two kind of easy tests first, and then it gets into two that will kind of parse out more of that R and D work. And so the first one is just that there has to be a permitted purpose. So there has to be a new or improved product or process that your company is working to develop. So it sounds just by talking to Tiger so far that a lot of the companies or a lot of you guys have either products that you're working to develop or a process as well. And then not only are you developing that, but you can be improving that business component as well. So if you're improving something that already exists on the basis of the function, the performance, the reliability, or the quality of that business component, that activity will qualify as well. The second test that we look at in order to qualify for the credit is at the bottom here it's number four. So the activity has to be technological in nature or otherwise based on the principles of a hard science. So it has to rely on either physical sciences, biological sciences, engineering, or computer science. So like I said, those two are pretty straightforward. We'll go back up to number two. So in order to Qualify for the credit, you have to have uncertainty in relation to the capability, the methodology or the design and for developing or improving that business component. Looks like we have a hand up.

Yeah. Melissa?

Yes. Are the credits transferable? Meaning can I sell them to somebody?

Yeah. So you can't sell the credit. There are certain states like Pennsylvania, if you claim in Pennsylvania, you can, once the tax liability is satisfied, you can sell the balance of the credit. It's not necessarily on a dollar for dollar basis, but there is some value. But at the federal level that's not an option. But they are transferable. If you guys are looking to sell your business, they're an asset that can be a part of the sale. So it does bring some value. Again, not probably on a dollar for dollar basis, but it does provide another selling point or it can be so.

But there are certain states where they are transferable.

Pennsylvania, I think is the only one right now where you can sell them for cash. Perfect. So yeah. And then if there are other questions as well that come up during the presentation, feel free to jump in. And that was a good one to start with. So when we look at the elimination of uncertainty, if you have uncertainty, it has to be related to the technical development activity that's taking place either on the, on the capability, the methodology or the design. Like I mentioned that business component. And then if you have that uncertainty, you're going to try and resolve that naturally through a process of experimentation where you're attempting to test one or more alternatives in order to achieve your objective. And so that's a requirement for the credit. And you can do that through a number of different ways. So you can do trial and error is a common one where you set a hypothesis and work through the scientific method in order to test out what you're developing and things like that. So there are several ways that you can go about doing modeling, simulation, things like that in order to test your business component. So as long as you meet all four of those criteria, that work will qualify for the credit.

Yeah, that's kind of a slam dunk, John. I think every orthopedic startup's checking those four boxes if they're doing product development.

Absolutely. Yeah. And that's. We, we've worked with a lot of different companies in the medical space that, that are doing this type of development and it's a good benefit. And we'll talk about on this next slide how we actually take that technical criteria and then we monetize that activity. So these three buckets of cost are what we look at when we, if you guys were to do a study, the first part is just looking at the people who are performing the R and D internally. So these are your W2 employees. And we take a portion of that W2amount and include it as to what's called a cure or qualified research expense. So you guys will allocate a percentage of that person's year and then the product of their W2amount and that percentage then become a QRE. And that's what goes into the bucket of cost that's used to calculate the credit.

Can 1099s. I'm going to blurt out a question. Can 1099 count? Because a lot of startups use consultants.

Yeah, absolutely. And that's this middle category here. So as far as contractors, you guys are able to include contractors that are performing work R and D work on on behalf of your business. There's a few restrictions here on who we can include. And then as you'll see, there's a 65% limitation as well. So we can include up to 65% of those contractor expenses. The reason for that is the government doesn't want to give credit on the markup by that by that provider. They want to give credit based on it if you had hired that person to do the work for your company as an employee. So that's why there's a limitation there. But the other parts of that is the contractor has to be doing the work inside the US in order to qualify, your company has to retain the intellectual property or substantial rights to that intellectual property, just meaning that you wouldn't have to pay a royalty down the road in order to access that it later on. And then the third one is those contractors have to be paid on a time and materials basis, which puts the risk on your business. So as long as those three criteria are met, you guys can include contractors as part of the R and D credit. And then in the development realm, the supply category can be a crucial part as well. So usually wages is the largest category of spend, but supplies are a nice bonus. So if you guys are doing prototype development as part of your development process, this is non depreciable tangible personal property which is used or consumed or destroyed rather during that development process. And those supplies, like I mentioned, are used during prototype. If you are going into production, there's still uncertainty and they're going to do like first run of of your product. We can oftentimes include the cost of that first run if there are still uncertainties with that. So, and that's Lab expenses as well. It's just the only thing that excludes is equipment to, to make your business component. So we're not looking at the machinery you're using to build it. It's more of the throughput of that machinery. And then finally on this slide, the credit comes out to between 7 to 10% of the qualified spend during the year. Perfect. So our company is, we're owned by Trinet and so as part of TriNet, we're a PEO. And PEOs typically have a longer route to obtaining access to that payroll credit. Just the way that they work. There's many companies that are filed on a single 941 or the payroll tax form that's filed quarterly. And so that process takes a little bit of time. However, as part of Trinet's offering, we've created a monetization route that speeds that up. It's an advanced program, so the month after you file your return, you would be able to start receiving advances from Trinet based on the amount of the credit. So we split that credit amount into 12 parts and then you'll be advanced the first six months. After the six month period, they look at utilization and they do it either speed it up for the rest of the year or they slow it down just based on how much you would have used the standard payroll provider. There's a couple of different ways that this is realized through other payroll providers. So through other payroll providers, they either have a real time processing method like companies like Gusto, or it's on a quarterly basis where you work with us. Our team does the payroll filings for you on an annual basis and then you'll receive those quarterly after about eight weeks after the quarter ends is when you'll see your benefit arrive. Perfect. So just talking about the defensibility of the R and B study, we have been around since 2016. Our company has not had any of our clients have a disallowed portion of their credit. So it just speaks to our software, how it's written. Our tax team in general and I work with a ton of qualified, qualified folks that all come from very similar backgrounds. Mine's from, I was with KPMG prior to joining Claris. And so basically the way that our software is built, in our review process, there's kind of a two step approach to doing the study. So you guys will go in, leave answers, and then our team goes through and helps to refine those just based on the criteria that the IRS lays out. So as part of that final product, after we've resolved all of that, all of the technical aspects of the study, and everything's where it needs to be, both financial and technical. We provide you with deliverables that go along with the study. So these are the items that you want to see in any R and D study that you have completed, whether it's with us or with another company. You want to clearly lay out that business component. And this just shows where in our reports you can find this data. So you want to have a clearly defined business component. What are you working on during the year and why does that qualify for the RD credit? You want to lay out the qualifying activities. So what are you doing that qualifies for the credit as part of that project? And you can find that in our qualifications section. And then from an expense perspective, you want to lay out in detail the expenses that qualify for the credit. So it's laying out the three main areas of cost and then including either the people or the supplies or the contractors that qualify in those areas and how we arrive at for those. And we provide that in our calculation detail report that you'll get as a part of the study. And then finally the calculation of the credit, which is in our method report. And it shows you exactly how you get from A to B based on the inputs and the math that's in the code. Perfect. So I talked about our solution a lot over the last 15 or so minutes. So just to touch on it again, this is a screenshot of our platform. There's a few different components I mentioned. It's a hub for your R and D credit. So not only can you complete your technical aspects and talking about the development of your product, but you also can load in your employees. We have payroll integration with the companies that you're working with currently, so it makes it easy to pull your employees in without having to go line by line and enter everybody in. If it's not an integration, we have an Excel sheet you can download and update. Makes it really easy to do. Looks like. Lissa, there's another question.

Sorry. Actually, Mark has a question first. He's ahead of me.

Perfect.

Oh, thanks. Can an American. Can a US Company that is partnered with an international company and doing the work internationally participate in this?

Yeah. So in order to qualify for the credit, the work has to be performed in the U.S. okay. Yeah.

Can the like. If manufacturing is done in the US can the manufacture. Does the manufacturing count towards it?

Yeah. So if you're using a. If you're using a coman, then that would be the R and D For the CO man figuring out how to scale up and how to do it. But if the company itself is doing its own manufacturing in the US and there's work around, how do we, how do we get from one unit to a thousand units and maintain quality and you know, produce it what we need to from an output perspective, those are all things that would qualify on the manufacturing side. If you have employees in the US that are doing that, that will, that will absolutely qualify.

So basically anything that's being charged within the U.S. with the, with U.S. manufacturers, U.S. companies in general can qualify. It's just the, anything that is done and charged outside the US is not specific. Okay. And my question for you is with regards to cons regarding contractors, I have one contractor that's on sal, that's on a salary. They get paid X dollar amount every single month. Does that apply or do I have to, I don't want to convert them over to a W2 yet.

Yeah, so that, that'll qualify. They're what they're, Are they doing development work for you?

IP patent work?

Yeah. So that's. So IP and patent work won't qualify for the credit. Mainly we're looking at development costs or development activity. So like legal, any administrative stuff won't qualify for the credit. And that, that's patent applications too. It qualifies for the deduction, but not the, not the credit. The thinking behind eliminating and making it more narrow to those three categories here is because this as a credit is a direct reduction of your tax liability, so the deduction reduces before it reduces your taxable income. This is a little different. This directly reduces your liability on a dollar for dollar basis. So that's why it's a little more narrow.

Well, within medical devices, as you know, it can be extremely cost prohibitive to start a company, particularly on capital expenditures such as instruments and implant, R and D and testing. So testing is included in this, I'm assuming?

Yeah, absolutely. Yeah. Especially where you're working through, you know, if you guys are, have a product that you've worked on and you're, you're continuing to, to iterate test it, that's all qualified. And then even after you release. So say you get to a point where you release your product and the R and D in theory would stop at that point on that. But then if you have another project that pops up related to it, where you're then improving a portion of that or looking into adding new features, adding new capabilities, continuing to improve quality aspects of it, you know that work will qualify again. So there are several opportunities to continue to claim the credit. Perfect. Well, I think that wraps up. Unless you guys have any other questions on our platform, I think that wraps that part of it up. Or any other questions in general. Sybil and I would be happy to answer.

Yeah, John, why don't you go to full screen again or get rid of the slides and we'll see. There we go. Lots of faces.

Perfect.

So definitely, I mean, every orthopedic startup that I can have ever heard of or know would qualify for this because it's all product development. So that. That makes a lot of sense.

John, do you do anything help file account, file taxes? Is there a branch that works as in accounting as well or to this?

Yeah, so our company only focuses on R D credits. We. We have, I think Civil would probably have some CPAs that our company partners with. So we. We definitely have a network out there. Our company works with. With hundreds of CPAs all over the country. Country. So we definitely have a good network. If you guys need more specific.

And how do you get paid?

Yeah, so Civil, do you want to jump in on that one?

Yep. So we are paid a percentage of the credit size. So our fee is a $500 base fee and then between 8 and 20% of the credit. So as your credit grows larger, our tiers work. And actually being a Bone Chat member, you actually do get a 10% reduction off of each of those fees.

Another benefit of Bone Chat. Unbelievable.

Yeah, look at that.

So. And. Oh, go ahead, Michael.

Yeah, just sort of going off of what you were saying, Tiger, about how pretty much every orthopedic startup seems to qualify for this. How common is it that companies are taking this credit? Like, what percentage of startups are just missing out on this? It's definitely underclaimed. So the goal of founding our company in, and once the Path act was passed in 16, is to help software startups and other smaller companies claim the credit. And we realized in doing that that it was very underclaimed. And it's not just underclaimed in that industry. So startups across the board, not a lot of them. You know, you have a lot of information coming at you in this first couple of years. So not a lot of people know about it or know how to claim it. And a lot of CPAs, it's another line on the return. And so they don't, you know, they're trying to get the rest of the return done. And, you know, a lot of times they. No fault of theirs, but just skip over it and it can be. It can be a really good benefit for early stage companies. Thank you.

So are there any state programs? I mean, this is all federal, but yeah.

So there are 38 states that have R and D benefits. And the way that that works is if you have a liability, a tax liability, they'll offset that tax liability. There's only one state currently that allows you to offset on a payroll basis similar to the federal credit, that would be Georgia. So if you guys have operations in Georgia at all, there is an opportunity to offset against the payroll tax as well for the state level. But probably the most beneficial one is California. From a state perspective, that state has an indefinite carry forward of the credit. So even if you're in an early stage, you don't have a liability yet. It comes out to about 75% of the federal credit. So if you're generating about $100,000 federal credit, California would be right in that 75 range. And then if you can't use it yet, you can carry that forward. You can't use that one against payroll credit or the payroll tax in California. But as soon as you guys start generating or you're profitable, you can then use that.

Any, anything, any questions? I just want to say thanks, John and Sybil, that was very, very illuminating and I have to jump to another meeting. But Tiger, thanks a lot for bringing this in. I'm going to send this to our cpa. Perfect. Yeah, Mark's in Georgia.

Thanks, Mark. Yeah, I put the slide deck as well as some other resources in the chat, so you can use those whenever you're ready to kind of start looking.

Thank you. Bye bye. Thanks, Sybil. What's that PDF? What is that? Is that a.

So the first PDF is just the slide deck that we went through. Are you able to access that? Okay. And then the second one is just an easy two pager, very high level of what the credit is. So if you want to keep it simple, if you want to share it with friends, just learn a little bit more about the credit. And then the other one is just a link to schedule. Using that link, our team will know that you guys came from Bone Chat and we'll make sure to give that bone chat 10% discount.

Perfect.

All right, well that's. I'm surprised. It's a dry topic, but it's important. So if that's it, no other questions, we'll just cut it off here. But I think everybody got all the information to take advantage. This is like a no brainer, you know, I mean it give basically gives You a discount on your, on your wages, your payroll. So once a year. And you can carry it over, right? You can pass it over year to year. Yeah, it's a no brainer.

Yeah. Yep. With the carry forward, you can continue to use that credit either on payroll or income tax as long as you guys are generating this.

Yeah.

And if you guys do think, yeah.

No, it's really nice for acquisition purposes as well. And that's a benefit to. For a company that acquires you. They. And then there's the angel investor tax credit that I've heard of. I don't know if you guys deal with that, but I know Maryland, the state of Maryland, if, if, let's say somebody invests $100,000 into a company, into a startup, they get a 30% tax credit back and that is transferable or I mean it's not transferable. You can sell it, meaning you can sell those tax credits. So Joe Haysh actually did that in, in somebody's. He invested 10,000 and got $3,000 back.

Very cool. Yeah, we don't work with that. But that's. I hadn't heard of that. Yeah, me neither.

Awesome.

Well, just. Missouri's in session. I'm sorry, Sybil. Missouri's in session right now. They're voting on it this week of up to 75%. If the person lives in Missouri and is an angel investor in a Missouri company, they get 70 up to 75% back. I don't think it's going to pass, but I think it's a big deal. So check your states.

What?

All right, well, thanks guys. And this has been great. This is a great topic. Dry topic, but super useful. Yeah.

Like I said, the slide deck is in the chat and it has John and I's information. So if you guys do come up with questions later, don't hesitate to reach out. We'll be happy to answer those or over email or jump on a call.

Perfect. All right, thanks guys. Have a great day.

Thank you, everybody.

Have a great one.