By Tyler Kem
Strike Tax Advisory
Little known and underutilized, the research and development (R&D) tax credit could hold the key to economic recovery in the wake of the COVID-19 pandemic. For companies who are innovating, applying for the credit could mean the difference between having the capital to hire more employees versus putting off growth for another year because of cash flow problems.
Despite widespread economic turmoil in 2020, there are promising signs that the American economy is on the upswing. Disruptions in 2020 resulted in an additional 200,000 small businesses closing—a 30 percent increase over a normal year. In contrast, the U.S. Census Bureau is reporting a record number of new business applications for 2021. As entrepreneurs shift to accommodate consumers' pandemic preferences, different sectors of the economy are poised for innovation.
At the onset of the COVID-19 pandemic, industries like restaurants and bars were hit particularly hard by government shutdowns, with around 110,000 restaurants closing for good. Service-based sectors like gyms, daycares, and nail salons also bore the brunt of the pandemic's economic impact, while supply chain disruptions and labor shortages squeezed retail and manufacturing industries.
The news isn't all bad though. The decade following the Great Recession was notable for its stagnation in startup growth. New business formations simply stalled at levels lower than pre-2008 amounts, and this contributed to a slow post-recession recovery. But the combination of federal stimulus money and the American entrepreneurial spirit promises to make 2022 a banner year that turns economic stagnation around.
In Using data from the U.S. Census Bureau, Economic Innovation Group noted in "The Startup Surge: Business Formation in 2021 on Pace to Break Record" that "In 2020, there was an explosion in new business applications, reaching nearly 4.5 million by year's end—a 24.3 percent increase from 2019 and 51.0 percent higher than the 2010-19 average. Between 2005 and 2019, business applications hovered around 2.5 million per year and were roughly evenly split between what Census calls 'high-propensity business applications' and all other business applications."
High-propensity businesses are businesses the Census Bureau said are more likely to succeed because they're a corporate entity that has hired employees, and they exist in the food service industry, construction, manufacturing, retail, professional, science and technical services or healthcare. Businesses like these have the potential to change the face of the economy going forward.
The rate of failure for new businesses varies across industries. The National Restaurant Association said that 30 percent of restaurants fail in the first year. The Brewers Association reported a failure rate of 48 percent in the first year. Forbes also notes that 90 percent of startups don't make it. Business analytics firm CB Insights placed a lack of capital as the number one reason for new business failure.
As old businesses pivot into their next new business iteration or new businesses form to meet changing consumer demands, investing in new tech, processes or software becomes essential. Businesses that started during the pandemic, or that flexed to meet new consumer demands, need capital to sustain their business operations and meet the demands of a post-pandemic economy.
Economic Innovation Group cautioned that "Maintaining this high level of new business formation will be crucial in placing the economy on a strong and durable path to its recovery and helping eliminate the startup deficit that had built up in recent years." Startups and new businesses are perfectly positioned to be the engine for the economy's recovery. They just need a little fuel.
From its debut in 1981, the R&D tax credit's purpose has been clear—to keep high-paying jobs in the United States by rewarding companies that invest in risk and innovation. After its creation, the tax credit underwent several amendments, all with the intention of making it easier to claim. In 2015, the PATH Act made the R&D tax credit a permanent fixture in the American tax code system.
Software companies currently dominate the R&D industry. Some of the biggest tech companies like Alphabet, Amazon and Microsoft spend 7 to 21 percent of their total budget on R&D, all eligible expenses for reimbursement. But here's the surprising news—many retail businesses can also apply. So can ecommerce businesses, engineering firms, manufacturers, and fintech companies. The recent ruling from United States vs McFerrin broadened the definition of R&D. Now the idea of only getting credit for patented or brand new ideas is outdated. Instead, companies can get credit for processes or packaging that is just new to them.
Before the passage of the PATH Act, companies viewed claiming tax credits as a risky bet since there was no guarantee that legislation would support the credits through the next year. Now that their status has been solidified, the R&D sector has over $18 billion in funds for anyone who's a mover-and-shaker in their industry. And that's good news for the American economy.
Tyler Kem is co-founder and president of Strike Tax Advisory, which helps businesses discover and claim government-provided tax credits and incentives available to them. Strike Tax helps SMBs compete more efficiently while keeping jobs in the United States. For more information, visit www.striketax.com.
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