The research and development (R&D) tax credit was created to reward innovative companies for building and improving products and processes, including software development. Yet software companies often overlook claiming this lucrative credit. Less than one-third of eligible companies take advantage of R&D tax credits from the U.S. federal government. While the software development community may already be aware of R&D tax credits, they often lack the knowledge and resources to make the most of the system. If you’re a software developer thinking of starting your own company or building your own application or you work for a company that would benefit from the credit, here are three important pieces of the R&D puzzle you should know to optimize and defend their R&D tax credits.
Each year, the federal government provides billions of dollars to businesses that develop and improve technologies, products and processes. Beginning in 1981 as part of the Economic Recovery Tax Act, the federal government allowed for a temporary tax credit of up to 13% on spending for qualified research on products and processes that have been developed or improved through the application of either the physical sciences, biological sciences, computer science or engineering. This can include costs associated with developing a patent, a new product or service offering or even a new technology that is sold to third parties or used internally within the business.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act permanently extended the R&D tax credit and expanded its benefits to startups and small businesses. Early-stage businesses can use the credit to eliminate up to $250K per year in federal payroll taxes.
The Required Documentation: Meeting the Four-Part Test
While the benefits associated with the R&D credit are significant, documentation is crucial. Historically, the cost and work involved in meeting the documentation requirements has kept many businesses from participating. Fortunately, IRS regulations outline a straightforward four-part test that creates a fairly low bar for qualification. As you read the test, you can see that the development and testing–even time spent questioning if the advancements might work–are things that should be considered.
Permitted Purpose: Are you developing or improving a product, process, formula or software?
Technological in Nature: Is your work within physical or biological sciences, engineering or computer sciences?
Elimination of Uncertainty: Are you asking questions like, “Can we develop it?” or “How do we develop it?”
Process of Experimentation: Are you systematically evaluating one or more alternatives?
Examples might include:
Designing and developing new or improved technologies, algorithms, applications or databases
Platform design and testing
Compiling, programming and testing software source code
Newly developed techniques (architecture, algorithms, databases)
Software and hardware development to further communication/interaction
Image processing, AI and other specialty tech design
Creating mockups, UX design or technical design work
Testing automation to ensure quality during development
Establishing functional relationships between software modules for internal use or to better serve clients
Developing feature enhancements
Improving internal processes and conducting QA testing during development
Although meeting the four-part test can be relatively straightforward, documenting it appropriately can be cumbersome. Technology can help streamline and simplify the process of claiming the credit.
External Vs. Internal
The government has different qualifications for different types of software development: External use/third-party software (like Microsoft) versus internal use software. Internal use software has stricter requirements in addition to the four-part test above, and must meet these extra criteria to be claimed for the credits:
Software must be highly innovative.
Similar products must not be available commercially.
Development must introduce significant economic risk.
The R&D tax credit is available mostly on wages paid to employees who carry out the R&D work, as well as a part of the wages of contractors who carry out R&D work, as long as they are not based outside the U.S.
Other items to note:
The company must own the intellectual property rights to the software being created.
Funded research is not considered for an R&D tax credit.
Qualified expenses can range from supplies to cloud computing costs and costs associated with offsite servers.
Both traditional IT coding and low-code platforms can be claimed under the tax credit. Low-code and no-code platforms allow businesses to build solutions without major coding investment using flexible templates that increase the experience and overall efficiency.
If you’re a software developer thinking of starting your own company or building your own application or you work for a company that would benefit from the credit, it’s a great time to consider taking advantage of it.