For founders, innovation is a necessity, but the financial burden of R&D activities can feel prohibitive when determining where to allocate funds. The R&D tax credit is a valuable tool designed to alleviate some of these costs. Introduced in 1981, it was made permanent in 2015 under the PATH Act, and it’s essential for many startups to fully understand how to leverage it.

An aspect of this credit exists in IRS Section 174, allowing the deduction of R&D expenditures. However, these deductions can vary, and recent changes may alter how they are applied.

Many startups overlook this opportunity, potentially missing out on savings of $500,000 or more annually. Let’s break down how founders can make the most of this credit.

Frequently asked questions

The R&D tax credit offers a dollar-for-dollar reduction in tax liability for qualifying research activities. Understanding what qualifies is key for startups.

1. What’s innovative? Many believe only groundbreaking research qualifies, but the credit covers a wide range of activities, such as improving products or technologies. What matters is showing that technological uncertainty existed and experimentation was used to resolve it.
2. What if you’re not profitable yet? Startups with less than $5 million in gross receipts can apply the credit against payroll taxes for up to $500,000 annually, even if they aren’t profitable.
3. What about overseas efforts? The credit applies only to research conducted in the U.S., so accurate documentation of where activities occur is essential.
4. When will the money come? While the benefits are significant, the process takes time. Startups must file the correct forms with their tax return, and the sooner they begin the documentation process, the quicker they can realize the benefits.

Maximizing the R&D tax credit

To fully capitalize on this credit, startups should follow these steps:

1. Documentation: Keep accurate, detailed records throughout the year, capturing R&D activities, financial records and related expenses like wages, supplies and contractor fees.
2. Review qualifying research: The IRS uses a four-part test to determine qualification:
   • Is the research technological in nature?
   • Does it aim to improve a product, process, software or formula?
   • Does it address uncertainty in development?
   • Does it involve a systematic experimentation process?
3. Qualified research expenses: Identify and include eligible expenses, such as wages for employees involved in R&D, supplies used in research, third-party contractor costs, and expenses related to hosting or server rentals.
4. Stay current on the law: Changes like the 2017 Tax Cuts and Jobs Act required R&D expenses to be amortized, and ongoing discussions could impact how credits are handled. Keep an eye on legislation that could affect the credit.
5. Enlist an expert: Engaging a tax professional early in the process ensures accurate documentation and maximizes benefits, especially given the complexity of R&D credits.

Strategic advantages

The R&D tax credit offers additional strategic advantages.

1. Cash flow: Reducing tax liabilities frees up capital for reinvestment in innovation and growth.
2. Competitive edge: More funds for R&D allow startups to continuously improve and differentiate themselves.
3. Investor appeal: A demonstrated ability to secure tax credits positions a startup as fiscally responsible, attracting investment.

Next Steps and additional resources

To take full advantage of the R&D tax credit, startups should stay informed and proactive. A tax professional can help navigate complex regulations, ensure thorough documentation and streamline the process. Additionally, reviewing common tax mistakes and exploring other tax break opportunities can help maximize savings.

The R&D tax credit is designed to reward investment in innovation — a core focus for startups. Don’t miss out on an opportunity to save and accelerate the growth of your business.

is the head of R&D credits and incentives at . He brings nearly a decade of accounting, tax and auditing experience, including years of experience preparing and filing R&D credits for tech companies.

Payments could remain the most-funded sector within fintech, especially startups focused on B2B payments. On the other side, cryptocurrency and blockchain, which experienced a large increase in funding in recent years, will most likely face a pullback in the wake of ’s collapse.��

Leading sectors

Venture investment into fintech companies in 2022 reached $81 billion as of Dec. 14 — down 41% so far from the peak of 2021 at $137 billion. Still, that $81 billion figure still exceeds 2020 amounts by more than $30 billion.��

All told, the sector has grown more than 10 times in the last decade from $7 billion in 2013.��

Within the fintech sector, payments- and banking-related startups received the most venture funding over the past five years, Crunchbase data shows. Cryptocurrency startup funding exceeded these two leading sectors in 2021, but dropped back a bit in 2022. Blockchain technology also received more funding in 2021 and grew its share into 2022.��

E-commerce and insurance, meanwhile, fell as a proportion of overall dollars invested.��

First innings in fintech

The fintech sector is still in early innings, according to from venture firm that analyzes the changes modern fintech has brought to the world of finance.��

The New York-based firm, an investor in private and public company stocks, wrestles with the question of value creation in the fintech sector in the report on the state of fintech.��

Of the $11 trillion in market capitalization in financial services companies as of October 2022, only $508 billion — 2% — was in modern fintech companies, Coatue notes. That proportion was higher in 2021 at 5% due to high valuations given to public technology stocks, but in prior years it did not reach 1%.��

“On the way up everybody values growth,” , the co-head of its fintech practice and co-COO of Coatue’s growth practice, said in an interview. “On the way down, everybody is valuing profitability and retention. The highest-quality business models within fintech have actually been hit a lot less than the rest of the market.” 

There is a large amount of gross profit for modern fintechs to eat into: Across the financial services sector, gross profits globally totaled $6.5 trillion in 2021, Coatue estimates.��

Fintech business models

Not all fintech businesses and business models are created equal. Newer and in some cases unproven business models that have been hit harder in the public markets are consumer finance, insurtech and SMB payments, according to the report.��

Source: Coatue Whitepaper: Fintech and the Pursuit of the Prize, October 2022.

Public fintech

Coatue analyzed the strength of public financial services businesses across four measures: revenue retention, gross margin, operating margin and revenue growth. It then used its “rule of 200%,” which states that if those four factors combined add up to 200% or more, a company is in a stronger position in this market.��

By that measure, public fintechs leading on the list are Uruguay-based cross-border payment provider , Palo Alto, California-based back office financial startup and North Carolina-based banking platform .��

Source: Coatue Whitepaper: Fintech and the Pursuit of the Prize, October 2022.

Sectors for investment in 2023

“It’s very clear that it’s easier than ever to offer financial services, whether as a standalone business or as part of incremental margin and revenue in an otherwise non-financial business,” said of . “And we believe that trend is going to continue for the rest of our lives.”

With the slump in new tech listings in 2022 and the nosedive in value in public technology stocks including fintechs, where do investors see opportunities in 2023? Here are some sectors that stand out.��

B2B fintech 

Coatue continues to focus on B2B fintech, Gilroy said. Based on an analysis of the firm’s investments the best business models are in B2B. That’s because business-oriented financial services tend to have lower churn — compared to consumer fintech — and business customers often grow over time, increase spend and provide opportunities to cross-sell with new products.��

There is also opportunity in a “verticalized approach, whether you’re going after landlords in the real estate market or restaurants,” Gilroy said.��

Emerging markets 

Emerging markets present another growth opportunity for fintech startups.

“There’s a lot of underserved communities around the world in terms of access to even the most basic financial products,” said , a principal at and an investor in the firm’s early-stage practice in fintech and B2B software.��

Coatue noted in its report that “for incumbents who often struggle with customer service and innovation, doing business in emerging markets is practically impossible due to the increasing rate at which locals are coming online.”

Latin American fintechs that have gone public include cross-border payments dLocal, neobank and e-commerce platform , which went public in 2007.��

CFO stack

Then there’s the so-called “CFO stack,” or technologies that would make a finance executive’s job easier.

“There’s a tremendous amount of digitalization yet to come. A lot of that is around payments, but a lot of that is also around what we would characterize as the CFO stack, all of the different functions a CFO might ultimately have to navigate,” said Savage.��

Areas of innovation in this stack include tackling expense management, payroll and benefits, stock allocation, business analytics, financial planning and accounting.��

“The opportunity areas in fintech focus on the boring areas of infrastructure, fraud, payment operations, compliance, and taxes. CFOs will be more focused than ever on impact to the bottom line,” , a general partner at , said via email. “Fintechs that can demonstrate an improvement in payment authorization rates, better reconciliation rates, or reduction in fraud that is measurable will weather the downturn.”

Owning the balance sheet

Becoming a bank is expensive and time consuming in the U.S., according to Coatue, but can ultimately provide longer-term stability for a fintech company.�� 

With that in mind, many fintechs are applying to get banking licenses in order to hold customer deposits, manage money transfers and offer loans instead of partnering with an established bank. received a banking license in March 2021 to be able to originate loans through Square Financial Services. has a banking license in the European Union but has yet to be approved for a banking license in the U.K. Neobanks Nubank and Chime are not licensed as banks.��  

 “In a rising interest rate environment, legacy banks, insurance providers, and asset managers have the potential to weather down cycles better than capital-light business models, e.g., insurtech and consumer-facing fintech,” said Coatue in its report.

“Through this last cycle, balance sheets have kind of been a bad word within financial services, and we’re learning that owning the balance sheet, whether you’re consumer facing or business facing, puts you in control of your own destiny and takes you away from the need to maybe go and partner with somebody and continuously work on these these balance sheet agreements,” said Gilroy.

Looking forward

Last year, the big themes in financial services were infrastructure building, embedded finance, consumer fintech and a big interest in buy now, pay later platforms.��

With an increase in interest rates and the market downturn, consumer fintech and lending companies face choppier waters while those focused on enterprise payments have a greater potential for consistent growth in 2023.��

We expect consolidation as funding dries up, and fewer companies can scale up.��